DISCUSSION QUESTIONS (from Mishkin and Eakins, 2018)

Chapter 1:
3. How does a decline in the value of the pound sterling affect German consumers in the Eurozone?

If the value of the pound sterling declines in comparison to the euro, it makes British goods less
expensive. German consumers can consume more British goods in the Eurozone as British-made
goods will be relatively cheaper than similar goods made in Germany or other countries in the
Eurozone.

4. How does an increase in the value of the U.S. dollar affect businesses in the Eurozone?

Eurozone businesses will benefit from an increase in the value of the U.S. dollar as they will be able
to price products more competitively against American goods. U.S. importers of foreign-made goods
like French wine and German appliances can expect a windfall as their products become cheaper.

5. What effect might a fall in stock prices have on business investment?

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. Explain the main difference between a bond and a common stock.

A bond is a debt instrument, which entitles the owner to receive periodic amounts of money
(predetermined by the characteristics of the bond) until its maturity date. A common stock,
however, represents a share of ownership in the institution that has issued the stock. In addition to
its definition, it is not the same to hold bonds or stock of a given corporation, since regulations state
that stockholders are residual claimants (i.e. the corporation has to pay all bondholders before
paying stockholders).

7. Why are stock market conditions usually newsworthy?

People around the world follow stock markets. Due to fluctuating market conditions, people who
trade on the stock markets can make a lot of money in a day or lose much of it. Apart from this,
people often speculate where the market is heading, which is often determined by changes in prices.
This is why stock market conditions are usually newsworthy.

8. Discuss the role of banks as financial institutions that fuel the economic growth of a nation.

Banks play a key role as the most important financial intermediary in fuelling the economic growth
process by allowing the expansion of physical and human capital and promoting financial innovation
(the three key factors of economic growth). Infrastructure projects like roads, dams, and ports can
be built because banks channel funds from saving accounts into these projects.

10. How do you think financial institutions help financial markets to work?

Financial institutions are what make financial markets work. Without them, financial markets would
not be able to move money from people who save to people or companies who need to borrow.
Financial institutions thus play a crucial role in improving the efficiency of the economy.

11. “A robust financial market is one of the pillars of stable economic growth and financial
sustainability for the future.” Discuss.
A robust financial market creates conditions for economic growth and financial sustainability for the
future by ensuring a constant (uninterrupted) flow of funds between savers and borrowers based on
credible information on the best possible uses of these funds. However, when the information flow
is not credible (i.e., lacks transparency), the system becomes susceptible to crises, and proper
channeling of funds is interrupted, thus stalling economic growth and financial sustainability for the
future.

12. How can monetary policies created by a central bank affect financial markets and financial
institutions?

Monetary policy involves the management of interest rates and money supply. Hence, a monetary
policy affects interest rates, inflation levels, and business cycles. All of these individually and
cumulatively have a huge influence on financial markets and financial institutions.

13. Can you date the latest financial crisis in the United States or in Europe? Are there reasons to
think that these crises might have been related? Why?

The latest financial crisis in the US and Europe occurred in 2007 – 2009. At the beginning it hit mostly
the US financial system, but it then quickly moved to Europe, since financial markets are highly
interconnected. One specific way in which these markets were related, is that some financial
intermediaries in Europe held securities backed by mortgages originated in the US, and when these
securities lost their a considerable part of their value, the balance sheet of European financial
intermediaries were adversely affected.

14. What is a debt market and how does a bond work within it?

A debt market, or a bond market, is crucial to any economic activity as it enables corporations and
governments to borrow in order to finance their activities; it is also where interest rates are
determined. Other than borrowing funds from banks, a company can also issue bonds to the public
in order to raise money to finance their activities. A company issues bonds for the general public to
buy. The buyer pays cash in return for the bonds, and the issuer pays an annual interest to the
buyer. This transaction is operated within a debt market, which is different from the trading of
shares of companies in the equity market by the general public.

15. Why is there a need to manage risk in financial institutions?

The latest financial crisis in Europe and the United States occurred in the 2007–09 period due to
which we have witnessed a riskier economic environment, fluctuating interest rates, crumbling stock
markets, and speculative crises in foreign exchange markets. All these developments affect the
functioning of financial institutions negatively; thus, institutions must learn to manage risks.

Chapter 2:
1. What is the main function of financial markets? Who is usually better off in case of well-
functioning markets? Explain your answer.

The main function of financial markets is to transfer funds from lender-savers to borrower-spenders.
Households, business firms, governments, as well as foreigners and their governments sometimes
find themselves with surplus funds. This enables them to lend money to those that have a shortage
of funds and earn an interest on it. Financial markets make it possible for savers and lenders to meet
and interact, and when they are operating efficiently, they improve the economic welfare of
everyone in the society.
DISCUSSION QUESTIONS (from Ch. 3 in Mishkin and Eakins, 2018)
1. What is the concept of present value? What is discounting?

The concept of present value is based on the commonsense notion that a dollar of cash flow paid to
you one year from now is less valuable to you than a dollar paid to you today. This is so because you
can deposit a dollar in a savings account that earns interest and have more than a dollar in one year.
The process of calculating today’s value of money received in the future is called discounting the
future.

2. Analyze the risk profiles of short-term bonds and long-term bonds during economic instability and
fluctuating interest rates.

Due to the fixed income nature of bonds and debentures, they are often referred to as “fixed-
income securities”. When an investor purchases a corporate bond, they are actually purchasing a
portion of a company’s debt. This debt is issued with specific details regarding periodic coupon
payments, the principal amount of the debt, and the time period until the bond’s maturity. Another
concept that is important for understanding interest rate risk in bonds is that bond prices are
inversely related to interest rates. When interest rates go up, bond prices go down, and vice versa.

There are two primary reasons why long-term bonds are subject to greater interest rate risk than
short-term bonds:

 There is a greater probability that interest rates will rise (and thus negatively affect a bond’s
market price) within a longer time period than a shorter one. As a result, investors who buy
long-term bonds and then attempt to sell them before maturity may be faced with a deeply
discounted market price. With short-term bonds, this risk is not as significant because
interest rates are less likely to substantially change in the shorter time period. Short-term
bonds are also easier to hold until maturity, thereby alleviating an investor’s concern about
the effect of interest rate driven changes in the price of bonds.
 Since long-term bonds have greater duration than short-term bonds, a change in the interest
rate will have greater impact on them. This concept of duration can be difficult to
conceptualize, but just think of it as the length of time that your bond will be affected by an
interest rate change. For example, suppose interest rates rise today by 0.25%. A bond with
one coupon payment left until maturity will be underpaying the investor by 0.25% for only
that one. On the other hand, a bond with 20 coupon payments left will be underpaying the
investor for a much longer period. This difference in remaining payments will cause a greater
drop in a long-term bond’s price than it will in a short-term bond’s price when interest rates
rise.

3. What is the yield to maturity? Why it is considered as a good measure of interest rates?

The yield to maturity is the interest rate that equates the present value of cash flows received from a
debt instrument with its value today. Because the concept behind the calculation of the yield to
maturity makes good economic sense, it is considered a good measure of interest rates.

4. Property investment constitutes a large and longterm commitment to an individual. Describe the
outcome of taking a property loan during fluctuating interest rates.

During fluctuating interest rates, people who have taken property loans would have to pay
fluctuating monthly installments, which means instability in the repayment schedule for the duration
of the variable loan. This is defined as interest-rate risk.
DISCUSSION QUESTIONS (from Ch. 5 in Mishkin and Eakins, 2018)
1. What is the relationship between a corporate bond rating and a risk premium?

In investment, a corporate bond rating represents the creditworthiness of the corporate bond. The
ratings are published by credit rating agencies and used by investment professionals to assess the
likelihood the debt will be repaid. Generally, the lower the corporate bond rating, the higher the
likelihood of default and thus, the higher the bond’s yield. Risk premium is defined as the return in
excess of the risk-free rate of return that an investment is expected to yield. An asset’s risk premium
is a form of compensation for investors to tolerate the extra risk compared to that of a risk-free
investment. Lower corporate bond ratings mean that the yield of the corporate bonds will be higher
and causes the risk premium to increase.

2. What is default risk and risk premium? How can default risk influence interest rates?

Default risk occurs when an issuer of security or a borrower is unable to precede interest and face
value payments. There are certain default-free bonds or government Treasury bonds, which never
fail in repaying debt (governments may increase taxes to repay its debt). The Spread between the
interest rates on bonds with default risk and default-free bonds is risk premium. So bonds with
default risk always have a positive risk premium; thus, higher the default risk higher is the interest
rates on the securities.

3. “Corporate bonds and stocks are a bad combination of investments as both have different
characteristics that do not complement each other.” Discuss.

Corporate bonds and stocks can be a good or bad combination based on the timing of the
investment concerned. During times of increasing interest rates, the bond value will go down. So, it
is better to purchase stocks and vice versa at such times. Bonds and equity shares have different
characteristics that can complement each other in a portfolio held by an investor. Equity shares are
riskier compared to government bonds which can generate a fixed income. A portfolio should be
balanced, and it should include a combination of risky as well as less-risky assets.

4. Describe the relationship between bond prices and interest rates during a recession.

Bond prices and interest rates have an inverse relationship. When interest rates go up, bond prices
drop, and vice versa. During times of economic recession, interest rates in general decline, increasing
bond prices. The main reason for this is the phenomenon called flight to quality, where investors sell
high-risk investments and purchase safer investments. This was clearly indicated by the rise of
Treasury bond prices in the wake of the Global Financial Crisis of 2008.

5. Just before the collapse of the subprime mortgage market in 2007, the most important credit-
rating agencies rated mortgage-backed securities with Aaa and AAA ratings. Explain how it was
possible that a few months into 2008, the same securities had the lowest possible ratings. Should we
always trust credit-rating agencies?

Historically, mortgage backed securities were considered low risk assets, since homeowners had the
highest incentives to pay their mortgages (otherwise they might lose their home). However, after
standards on lending practices decreased during the first years of the new century, many individuals
were able to buy a house, but not to make their mortgage payments. This resulted in poor quality
mortgage backed securities that should never have had such good ratings. Both Standard and Poor´s
and Moody´s were investigated for assigning such good ratings and therefore misleading investors in
buying these instruments. Sometimes credit rating agencies also make mistakes in assigning risks.
6. If a yield curve looks like the one shown here, what is the market predicting about the movement
of future short-term interest rates? What might the yield curve indicate about the market’s
predictions concerning the inflation rate in the future?

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. If a yield curve looks like the one below, what is the market predicting about the movement of
future short-term interest rates? What might the yield curve indicate about the market’s predictions
concerning the inflation rate in the future?

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. How will a reduction in tax rates affect an individual’s preference for municipal bonds compared to
Treasury bonds? What conclusion can you draw regarding tax rates and interest rates on securities?

A 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. So, this will result in a
declining demand for municipal bonds and increase the demand for Treasury bonds. Accordingly,
interest rates on Treasury bonds will fall and vice versa. In general, when bonds have tax-exempt
features, interest rates are lower.
9. Predict what will happen to interest rates on corporate bonds if governments adopt a new
regulation that guarantees payment of principal in case of default in order to encourage investment
in corporate bonds. Will it affect the demand for Treasury securities?

If the government guarantees the payment of principal on a bond in case of default, it would actually
reduce the default risk for investors. Thus, the default risk premium and interest rates on corporate
bonds will decline. The demand for secured corporate bonds will increase, which will result in a
decline in the demand for Treasury securities and raise interest rates on them.

10. If the current interest rate on one-year bonds is 6%, you may expect an increase in interest rates
by 1% in the following year. Predict what interest rate would be suitable now for two-year bonds.
Explain your answer and state the theory that justifies it.

If the current interest rate on one-year bonds is 6%, and it is expected to rise by 1% in the following
year, it will become 7%. Accordingly, the current two-year bonds must have an interest rate of (6% +
7%)/2 = 6.5%. This calculation is based on the expectation theory, which states that interest rates
with different maturities move together over time and long-term rates are the average of expected
future short-term rates.

11. If the income tax exemption on municipal bonds were abolished, what would happen to the
interest rates on these bonds? What effect would it have on interest rates on U.S. Treasury
securities?

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.

DISCUSSION QUESTIONS (from Ch. 7 in Mishkin and Eakins, 2018)

1. How can economies of scale help explain the existence of financial intermediaries?

Financial intermediaries can take advantage of economies of scale and thus lower transaction costs.
For example, mutual funds take advantage of lower commissions because the scale of their
purchases is higher than for an individual, while banks’ large scale allows them to keep legal and
computing costs per transaction low. Economies of scale which help financial intermediaries lower
transaction costs explains why financial intermediaries exist and are so important to the economy.

2. Explain why dating can be considered a method to solve the adverse selection problem.

When a couple dates, they are (explicitly or implicitly) extracting information about the significant
other. At the same time, they are sharing information about themselves. This information flow helps
both individuals to make better decisions about a probable (or not) future life together. In this way,
one can think that this process is formally no different from the one in which the loan officer tries to
choose the right borrower.

3. Would moral hazard and adverse selection still arise in financial markets if information were not
asymmetric? Explain.

No. If the lender knows as much about the borrower as the borrower does, then the lender is able to
screen out the good from the bad credit risks and so adverse selection will not be a problem.
Similarly, if the lender knows what the borrower is up to, then moral hazard will not be a problem
because the lender can easily stop the borrower from engaging in moral hazard.
4. How do standard accounting principles help financial markets work more efficiently?

Standard accounting principles make profit verification easier, thereby reducing adverse selection
and moral hazard problems in financial markets, hence making them operate better. Standard
accounting principles make it easier for investors to screen out good firms from bad firms, thereby
reducing the adverse selection problem in financial markets. In addition, they make it harder for
managers to understate profits, thereby reducing the principal-agent (moral hazard) problem.

5. Suppose you have data about two groups of countries, one with efficient legal systems and the
other with slow, costly, and inefficient legal systems. Which group of countries would you expect to
exhibit higher living standards?

One would expect the group of countries with more efficient legal systems to exhibit higher living
standards. Legal systems are an important part in the lending process, precisely because they are
part of the mechanisms of enforcement of contracts that deal with the moral hazard problem.
Costly, slow and inefficient legal systems do not promote lending and thereby funding of investment
opportunities.

6. Which relationship would you expect to exist between measures of corruption and living standards
at the country level? Explain by which channel corruption might affect living standards.

One would expect corruption measures to be negatively correlated with living standards. Corruption
usually deters investment, since it undermines the legal system. Countries in which corruption is
prevalent have trouble encouraging individuals or companies to invest in them. Corruption affects
living standards by undermining the efficiency of the legal system, thereby lowering investment, one
fundamental ingredient to economic growth, the basis of higher living standards.

7. How can the existence of asymmetric information provide a rationale for government regulation
of financial markets?

Because there is asymmetric information and the free-rider problem, not enough information is
available in financial markets. Thus there is a rationale for the government to encourage information
production through regulation so that it is easier to screen out good from bad borrowers, thereby
reducing the adverse selection problem. The government can also help reduce moral hazard and
improve the performance of financial markets by enforcing standard accounting principles and
prosecuting fraud.

8. Would you be more willing to lend to a friend if she put all of her life savings into her business than
you would if she had not done so? Why?

Yes. The person who is putting her life savings into her business has more to lose if the business
takes on too much risk or engages in personally beneficial activities that don’t lead to higher profits.
So she will act more in the interest of the lender, making it more likely that the loan will be paid off.

9. Suppose you are applying for a mortgage loan. The loan officer tells you that if you get the loan,
the bank will keep the house title until you pay back the loan. Which problem of asymmetric
information is the bank trying to solve?

The bank is trying to solve the moral hazard problem by placing a lien on the house title. In general,
the bank does not “keep the house title”, but it places a lien on it instead to prevent the house
owner to sell the house without its supervision. In this case, the bank wants to make sure that you
do not sell the house, get the money and never pay back the loan.

10. “The more collateral there is backing a loan, the less the lender has to worry about adverse
selection.” Is this statement true, false, or uncertain? Explain your answer.

True. If the borrower turns out to be a bad credit risk and goes broke, the lender loses less because
the collateral can be sold to make up any losses on the loan. Thus adverse selection is not as severe
a problem.

13. Which specific asymmetric information problem do credit-rating agencies help to reduce in the
bond market? Explain the effect of the subprime mortgage crisis on the trustworthiness of these
agencies and on the quality of information.

Credit rating agencies try to mitigate the problem of adverse selection. By compiling information and
evaluating default risks, credit rating agencies help investors to decide which bonds have the highest
risks of default and which ones are relatively safer investments. The subprime mortgage crisis
undermined the trustworthiness of these agencies, since securities that were assigned good ratings
were in fact bad investments.

14. Explain the problem faced by an accounting firm when they offer more than one service to a
client, which is also known as the “Chinese Wall.”

The “Chinese wall” is a term used in audit firms when a client might need two different services from
the same company. For example in PwC, client X might need accounts preparation services from the
Transaction Services department and audit services from the Audit and Assurance department at the
same time. This is legal in Europe but illegal in America. When faced with such a situation (where it is
legal), the two departments must put up a proverbial Chinese wall between each other to prevent
the sharing private information.

15. Discuss the principal–agent problems that occur in multinational corporations.

The principal–agent problem may occur in a multinational company where the owners or
shareholders do not run the business on a day-to-day basis. The shareholders or the owners are the
principal. The business is run by the agents—the board of directors, CEO, and CFO—which could
conflict with the interest of the owners. This is a common problem for MNCs as most are public
listed and run by the board, who are often not shareholders, so both principal and agent suffer from
goal incongruence which is detrimental to the overall financial health of a company.

16. Describe two conflicts of interest that occur when underwriting and research are provided by a
single investment firm.

a. Research analysts in investment banks might distort their research to please issuers of
securities so underwriters in the investment bank can get their business.

b. Investment banks might engage in spinning, a form of kickback in which they allocate hot,
but underpriced, IPOs to executives in return for their companies’ future business.

17. Which problem of asymmetric information are prospective employers trying to solve when they
ask applicants to go through a job interview. Is that the end of the information asymmetry?

When prospective employers ask job applicants to go through a job interview, they are trying to
solve the adverse selection problem. Prospective employers want to know more about potential
workers, much in the same way loan officers want to know more about potential borrowers. As it is
the case with a loan transaction, the information asymmetry does not end here, since if hired,
worker and employer will have to solve the moral hazard problem. Usually employers try to solve
this problem with paying schemes that encourage workers to provide more effort.

20. Lucia, Cecilia, and Julia have to do a midterm project. While Lucia works hard on the project for
two weeks, Cecilia and Julia do not even answer the phone. The project is a success and everybody
gets an A. How would you refer to Cecilia and Julia? What do you think might happen if the same
three classmates are assigned to do a final project?

Cecilia and Julia are free-riders. Even though they have provided no effort, they had accepted the
reward of a good grade. Looking into the future, Lucia now has no incentive to work hard, if
everybody gets the same grade regardless of their effort. One can expect that Lucia will either not
participate or decide to provide no effort at all, with the result that the project will most probably be
a failure. It is very difficult to completely eliminate the free rider problem, both in financial markets
and in our everyday lives.

DISCUSSION QUESTIONS (from Ch. 11 in Mishkin and Eakins, 2018)

1. What is the main characteristic of money market transactions which enables it to have an active
secondary market?

Money market transactions do not take place in any particular location. Traders arrange purchases
and sales between participants over the phone and complete them electronically, which makes it
relatively easy to find buyers for securities in the future. It is this characteristic of money market
transactions which enables it to have an active secondary market.

2. If a 15-year bond is supposed to mature in the next three months, is it considered to be a money
market instrument?

Money market securities are securities that are issued for less than one year. So, although the bond
has only three months to maturity, it is still considered to be a capital market security as it was
originally issue for 15 years.

3. What cost advantages does the money market have over the banking sector?

The banking industry is subject to more regulations and governmental costs than the money
markets. For instance, commercial banks have interest-rate ceilings, limited interest payments on
deposits, etc. Though some of these regulations have been eliminated, banks still face more
restrictions than money markets. Thus, the money market has relative advantage in cost
effectiveness.

4. What are the main purposes of money markets? Why is there a need for money markets?

The well-developed secondary market for money market instruments makes the money market an
ideal place for a firm or financial institution to “warehouse” surplus funds until they are needed.
Similarly, the money markets provide a low-cost source of funds to companies, the government and
intermediaries that need a short-term infusion of funds. These are the main purposes of money
markets. Money markets are needed because revenues and expenses occur at different times. At
times when there is no cash inflow but corporations and the government need funds quickly, money
markets provide an efficient, low-cost means of borrowing cash.

5. How did asset-backed commercial papers contribute to the financial crises of 2007-2008?
The majority of the sponsors of the asset-backed commercial paper (ABCP) programs had credit
ratings from major rating agencies, but the quality of the pledged assets was not understood
properly. When the poor quality of the subprime mortgages used to secure ABCP was exposed in
2007-2008, a run on them began. Moreover, issuers of such papers had exercised their option to
extend the maturities at low rates which threatened the money market mutual fund market. In
September 2008, the Federal Reserve set up a guarantee program to prevent the collapse of the
money market mutual fund market and to allow for an orderly liquidation of the ABCP holdings.

6. Why are T-Bills a favorable money market instrument for the U.S. government? For investors?

T-bills have virtually zero default risk because even if the government ran out of money, it could
simply print more to redeem them when they mature. The risk of unexpected changes in inflation is
also low because of the short term to maturity. The market for T-bills is extremely deep and liquid.
But as expected for a risk-free security, the interest rate earned on them is among the lowest in the
economy.

7. Why do businesses use the money markets?

Businesses both invest and borrow in the money markets. They borrow to meet short-term cash
flow needs, often by issuing commercial paper. They invest in all types of money market securities as
an alternative to holding idle cash balances.

8. The Eurodollar market dates back to the period after World War II, when started with the
circulation of dollars overseas followed by the development of a separate, less-regulated market.
Why did the Eurodollar market grow so rapidly?

The primary reason for the growth of the Eurodollar market is that depositors often receive a higher
rate of return on a dollar deposit in the Eurodollar market than in their domestic market when the
borrower is able to receive a more favorable rate in the Eurodollar market than in their domestic
market. This is mainly because multinational banks are free from the same restrictions that regulate
U.S. banks and also because they are willing and able to accept narrower spreads between the
interest paid on deposits and the interest earned on loans.

9. What is meant by the Eurodollar market? Why is it an important source of financing? Discuss.

The Eurodollar market consists of banks that accept deposits and make loans in currencies other
than those in their own country. The modern Eurodollar market evolved from special circumstances
of the post-World War II international finance system. Early in this period, many foreigners found it
convenient to deposit dollar balances with banks in Europe.

The primary reason for the expansion of the Eurodollar market is that it reduces the costs of
international trade by offering traders an efficient means of economizing on transaction balances in
a world where most trade is denominated and transacted in U.S dollars. Since Eurodollar deposits
are located outside the United States, they are not subject to reserve requirements set by the
Federal Reserve.

10. How are interest rates usually settled for negotiable CDs?

Usually interest rates are negotiated between the bank and the customer. They are similar to other
money market instruments. Larger banks may offer smaller rates if they lack confidence in
customers. In short, the market for the negotiable CDs is still thin.

11. How can you characterize the Treasury bill’s interest rates? How are investment rates different
from mentioned interest rates?
Since T-Bills are very close to being risk-free, the interest rates are extremely low. In some cases,
investors come to realize that their earnings on T-bills do not even compensate for changes in
purchasing power due to inflation. The investment rate is a more accurate representation of what
the investor will earn, since it uses the actual number of days per year and the true initial investment
in calculation.

12. What are the terms of federal funds? Why are these terms often misleading?

Usually such funds are overnight investments. Banks invest or borrow fed funds according to their
position in reserve. Actually, Fed funds do not have anything common with federal government, they
usually are held by Federal Reserve Bank that is how the name came up.

13. How does the Federal Reserve control interest rates on Fed funds? How are interest rates settled
on Fed funds?

The Federal Reserve cannot directly control interest rates on fed funds. It can and does indirectly
influence them by adjusting the level of reserves available to banks in the financial system. The Fed
can increase the amount of money in the system by buying securities, thus lowering interest rates.
Alternatively, the Fed can remove reserves by selling securities, and then interest rates will increase.
In reality, the forces of supply and demand set the interest rates in competitive markets.

14. Why do commercial paper securities mature within 270 days or less?

The 270-day maximum maturity is due to a Securities and Exchange Commission (SEC) rule that
securities with a maturity of 270 days and above must register with the SEC and be subject to its
regulations for public issuance.

15. Why is the banker’s acceptance form of financing ideal for foreign transactions?

When trading is done across borders, there is no guarantee that the counterparty to an international
financial transaction is able to pay in the future. So, rather than relying on the ability and
creditworthiness of the counterparty, exporters usually require the counterparty to obtain a ‘letter
of credit’ from a well-known bank that will agree to make good the importer’s obligation. When the
exporter complies with all terms of the transaction, the bank ‘accepts’ the obligation to make
payment to complete the transaction if the importer does not. Because the bank’s credit is good, the
banker’s acceptance can be sold easily in the money markets and when it comes due; the bank will
pay, if necessary, if the importer does not.

DISCUSSION QUESTIONS (from Ch. 12 in Mishkin and Eakins, 2018)

1. Contrast investors’ use of capital markets with their use of money markets.

Investors use capital markets for long-term investment purposes. They use money markets, which
have lower yields, primarily for temporary or transaction purposes.

2. Differentiate between primary and secondary capital markets. What is an initial public offering
(IPO)?

At the primary market, new issues of stocks and bonds are introduced; it could also be regarded as
the market where the issuer of securities actually receives the proceeds from the sale of securities.
An initial public offering is issued when companies sell securities for the very first time. In secondary
markets, the sale of previously issued securities takes place.

3. What two characteristics make bonds a more popular long-term alternative to investing in stocks?
Firstly, bonds are safer assets than stock, since they have a higher priority of payment than stock.
Should the firm be in trouble or has to be liquidated, bondholders will receive their payments before
stockholders. Secondly, bond prices fluctuate less than stock prices, making it a better option for the
risk-averse investor.

5. Distinguish between an investment-grade bond and a junk bond.

Bonds that are rated Baa or better by Moody’s and BBB or better by S&P are considered investment
grade bonds. Financial institutions are generally prohibited by state and federal law from purchasing
anything but investment grade bonds. Bonds with a lower rating are considered speculative grade
bonds and are often called junk bonds, or high-yield bonds. In the junk bond market, there is a very
real chance that the issuing firms would default on their bond payments. In comparison, the default
risk of investment-grade bonds is negligible.

6. As interest rates in the market change over time, the market price of bonds rises and falls. The
change in the value of bonds due to changes in interest rates is a risk incurred by bond investors.
What is this risk called?

The risk that a bond’s price will change due to changes in market interest rates is called interest rate
risk.

7. What does it mean when a bond is referred to as a convertible bond? Would a convertible bond
be more or less attractive to a bond holder than a non-convertible bond?

Convertible bonds are bonds that may be exchanged for another security of the issuing firm such as
common stock at the discretion of the bond holder. If the market value of the securities the bond
holder receives with the conversion exceeds the market value of the bonds, the bond holder will
return the bonds to the issuer in exchange for the new securities and make a profit. As a result,
conversion is an attractive feature to bond holders. It gives the bond holder an investment
opportunity that is not available with nonconvertible bonds. As a result, the yield on a convertible
bond is lower than a nonconvertible bond.

8. A call provision on a bond allows the issuer to redeem the bond at will. Investors do not like call
provisions and so require higher interest on callable bonds. Why do issuers continue to issue callable
bonds anyway?

Firms like having the flexibility to adjust their capital structure by paying off debt they no longer
need. They also need to pay off debt to remove restrictive covenants. Call provisions permit both
these actions at the issuer’s discretion.

9. What are restrictive covenants? Why are they associated with interest rates of bonds?

In certain cases, bondholders face a situation where the managers of the bond-issuing company may
be more likely to protect its shareholders rather than the bondholders. Restrictive covenants are
rules that protect bondholders’ interests. Such rules can include restrictions on dividends and on
issuing new debts. Usually interest rates are lower in the situations mentioned because investors
consider them less risky.

11. What are the risks an investor would face when making an investment in corporate bonds?

An investor would face the possibility of default risk if the company fails to make timely interest or
principal payments and thus defaults on its bonds. The investor could also be exposed to interest
rate risk which is the possible reduction in returns that is associated with changes in interest rates.
Investors may be exposed to inflation risk where a general rise in prices of goods and services causes
a decline in purchasing power. With inflation over time, the amount of money received on the
bond’s interest and principal payments will purchase fewer goods and services than before. In
certain cases, bond holders may be exposed to call risk whereby the terms of the bond give the
company the right to buy back the bond before the maturity date. Lastly, bond holders may also face
liquidity risk which is the risk that bond holders seeking to sell their bonds may not receive a price
that reflects the true value of the bonds (based on the bond’s interest rate and creditworthiness of
the company).

DISCUSSION QUESTIONS (from Ch. 13 in Mishkin and Eakins, 2018)

1. Why would economic growth affect the value of a stock?

A firm’s stock market 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. Keeping all else constant, the value of a
stock or a stock’s movement is determined to a great extent by the economic growth of a market;
economic growth indirectly contributes to earnings growth. For example, as experienced during the
global financial crisis of 2007, economic depression can lead to a bear market.

2. Why do people invest in stocks? Is stock a riskier investment than bonds? Why or why not? How is
preferred stock similar to bonds? To common stock?

Ownership of a share of stock represents a certain amount of ownership of a company. Apart from
this, investors earn returns from stock in two ways: by paid dividends on stock and by the gain from
stock price increase. Stock is riskier rather than bonds because dividends are not guaranteed. In
addition, they have lesser priority than bonds in times of financial difficulties for the company.
Preferred stocks receive fixed dividends like bonds do throughout their lifetime. Preferred stocks
usually have unlimited lifetime like common stocks.

3. What are the limitations of the generalized dividend model?

The dividend discount valuation model measures the value of a firm as the present value of future
expected dividends to be received by the investor. The model can account for uncertainty by
allowing dividends to be revised in response to revised expectations about a firm’s cash flows, or by
allowing the required rate of return to be revised in response to changes in the required rate of
return by investors. The dividend discount model may result in an inaccurate valuation of a firm
because of potential errors in determining the dividend to be paid over the next year, or the growth
rate, or the required rate of return by investors. The limitations of this model are more pronounced
when valuing firms that retain most of their earnings rather than distribute them as dividends,
because the model relies on the dividend as the base for applying the growth rate. For example,
many Internet-related stocks retain any earnings to support growth and thus are not expected to
pay any dividends.

4. What are the risks faced by investors investing in stocks in emerging markets?

Stocks in emerging markets are more exposed to major government turnover and other forms of
political risk. They also expose investors to a high degree of exchange rate risk because their local
currencies are typically very volatile.

5. To capture investor interests, Exchange Traded Funds (ETF) have become the latest market
innovation. Since 1990, they have been actively traded in a form of basket of securities. What are
the main features of ETF? Do they have some disadvantages?
Exchange Traded Funds have the following features: they are listed and traded as individual stocks
on a stock exchange, they are indexed and their value is based on underlying net asset value of the
stock which is held in the index basket. The main disadvantage of ETF is that they trade like stocks
and investors have to pay commission to the dealer, which is a cost disadvantage compared to
mutual funds.

6. What is the motivation for buying foreign stocks?

Investors have come to realize that some risk can be eliminated by diversifying their portfolio by
buying stocks from across different countries. When one country is suffering from a recession,
others may be booming. If inflationary concerns in the United States cause stock prices to drop,
falling inflation in Japan may cause Japanese stocks to rise.

DISCUSSION QUESTIONS (from Ch. 15 in Mishkin and Eakins, 2018)

1. What are the reasons for financial institutions to engage in foreign exchange trading activities?

Financial institutions generally engage in foreign exchange trading activities for the following
purposes:

a) The buying and selling of foreign currencies on behalf of their customers so as to allow their
customers to engage in and complete international trading transactions with counterparty.

b) The buying and selling of foreign currencies on the behalf of their customers (or on its own behalf)
in order to take positions in foreign real and financial investments.

c) The buying and selling of foreign currencies for hedging purposes to offset customer (or its own)
exposure to any given currency.

d) The buying and selling of foreign currencies for speculation purposes to profit from future
forecasts and anticipated movements in the foreign exchange rates.

2. What is the law of the one price? How does it work?

The starting point for understanding how exchange rates are determined is a simple idea called the
law of one price. If two countries produce an identical good, and transportation costs and trade
barriers are very low, the price of this good should be the same around the world no matter which
country produces it. If exchange rate changes, for instance, if the U.S. dollar appreciates against the
euro, European good will become cheaper in the United States and the United States can sell its
good in Europe at a greater price. Because it is an identical good, the demand for the U.S. good will
fall in Europe. Given the fixed rate, the excess supply of the U.S. good in Europe will be eliminated
only if the U.S. dollar depreciates against the euro.

3. In 2017, Hurricane Maria caused Puerto Rico to suffer an average loss of U.S. $504.96 million, if
purchasing power parity is considered. Define purchasing power parity (PPP). How is it related to the
definition of real exchange rate?

The theory of PPP suggests that exchange rates between any two countries will adjust to reflect the
changes in the price levels. That is, if the price level in one county increases, its currency should
depreciate. The real exchange rate is the rate at which domestic goods will be exchanged for foreign
goods. One way of describing the theory of PPP is to that it predicts the real exchange rate is always
equal to 1.0, so that the purchasing power of the U.S. dollar, for example, is the same that of other
currencies such as the yen or the euro.

4. Suppose that price levels in Indonesia rise by 20% relative to price levels in the Eurozone countries
and that the purchasing power parity theory holds. How would this affect the value of the
Indonesian rupiah relative to the euro?

The purchasing power parity theory predicts that the Indonesian rupiah will suffer a 20% decline in
value in relation to the euro.

5. If the demand for a country’s exports falls at the same time that tariffs on imports are raised, will
the country’s currency tend to appreciate or depreciate in the long run?

In the long run, the fall in the demand for a country’s exports leads to a depreciation of its currency,
but the higher tariffs lead to an appreciation. Therefore, the effect on the exchange rate is uncertain.

6. If Malaysia experiences a decline in economic growth (and experiences a decline in inflation and
nominal interest rates as a result), what would the probable impact on its currency be when it is
compared with the U.S. dollar, and why?

A decline in the growth of the Malaysian economy will reduce Malaysian consumers’ demand for
U.S. products, which places upward pressure on the Malaysian currency. However, given that there
is also a decline in interest rates, Malaysian corporations with excess cash may now invest in the
U.S., thereby increasing the demand for U.S. dollars. Therefore, a decline in Malaysian interest rates
will place downward pressure on the value of the Malaysian currency. The overall impact depends
on the magnitude of the forces as described above.

7. Suppose a country announces that it will put quotas and tariffs on imported goods to promote
domestic production. How will it affect the country’s currency in the long run?

The increase in trade barriers will increase the demand for domestic goods since imported goods will
become more expensive. So, the domestic currency will appreciate in the long run because domestic
goods are selling well with a higher value of home currency.

10. Suppose the U.S. government announces to implement a new economic program that will
strengthen the dollar in relation to other currencies. If you are an investor and have the option of
investing in dollar or in euro assets, what would be your expectations?

If the expectation is that the U.S. dollar (USD) will appreciate in relation to other currencies, the
expected return on U.S. dollar-denominated assets will be higher. This will result in a situation where
investors will be willing to invest in U.S. dollar-denominated assets. With this expectation, the
demand for U.S. dollar-denominated assets will increase, which is likely to promote positive trends
in U.S. dollar exchange rates in the future.

11. If American auto companies make a breakthrough in automobile technology and are able to
produce a car that gets 60 miles to the gallon, what will happen to the U.S. exchange rate?

The dollar will appreciate. The increase in U.S. productivity raises the expected future exchange rate
and thus raises the expected return on dollar assets at any exchange rate.

13. Suppose that the U.S. Federal Reserve decides to raise interest rates to combat inflation. How
will this decision affect the exchange rate between the U.S. dollar and the euro?
If the interest rate increases, then the expected return on U.S. dollar-denominated assets will also
increase, which will in turn increase the demand for U.S. dollar-denominated assets. This process will
lead to an appreciation of the U.S. dollar. Thus, the exchange rate between the U.S. dollar and the
euro will also increase as the euro will depreciate.

14. If you expect higher productivity in your country due to some technological changes, what would
you expect regarding the domestic currency?

When domestic productivity in a country is expected to rise, the exchange rate and the quantity
demanded on exchange rate will also be expected to increase, which will lead to currency
appreciation.

15. On June 23, 2016, the United Kingdom voted on whether to remain or leave the European Union.
From June 16 to June 23 the exchange rate between the British pound and the dollar increased from
1.4075 US/GBP to 1.4800 US/GBP (Source: FRED database). What can you say about the market
expectations regarding the result of the referendum and its impact on the UK economy?

This question is open to various answers. One answer is that the news that the U.K had voted to
leave the European Union would lead to a fall in U.K. exports to fall, thereby leading to a lower long-
run value of the British pound. The result would then be an expected deprecation of the pound, and
hence a decline in the demand for pound assets, which would cause the pound to fall in value.
Alternatively, the vote to exit the EU would cause the economy to weaken and so the Bank of
England would lower interest rates (as they did) causing the future value of the pound to decline.
The expected depreciation would then decrease the demand for pound assets, leading to a decline
in the value of the pound.

DISCUSSION QUESTIONS (from Ch. 16 in Mishkin and Eakins, 2018)

1. What is one difference between sterilized and unsterilized foreign exchange intervention? In what
circumstances will the Federal Reserve apply each intervention?

With unsterilized foreign exchange intervention, the Fed usually sells domestic currency to purchase
foreign assets in the foreign exchange market, this action results in rise of international reserves and
in equal rise of reserves in banking system. Using this approach, the Fed allows the purchase of
domestic currency to have an effect on international reserves. In case if Fed does not want to have
such effect, it uses sterilized approach by offsetting the open market operation in the government
bond market: it purchases government bonds that leaves reserves in the banking system unchanged.

2. How do the sterilized and unsterilized approaches affect exchange rates? Which approach is
better for currency exchange rate appreciation?

In Sterilized approach central bank engages in offsetting open market operations, so there is no
impact on reserves and hence no impact on exchange rate. Even more, there is no impact on
interest rates as well. In case of unsterilized approach, central bank sells domestic currency and
purchases foreign assets, which leads to declining in domestic interest rates and depreciation of
domestic currency, and in opposite, buys domestic currency and sells foreign assets, which leads to a
fall in reserves, rise in domestic interest rates and appreciation of domestic currency.

5. Fixed exchange rate fuels a country’s economic growth. Briefly discuss the advantages and
disadvantages.

Fixed exchange rates can fuel economic growth if buyers and sellers in a market agree on a fixed
price where rates do not fluctuate, thereby reducing the risk of prices going up or down
unexpectedly. Further to that, speculative risks can also be reduced greatly in the short-term while
the country adopts financial liberalization measures that spur economic growth. Fixed exchange
rates also introduce discipline in economic management and prevent governments from introducing
inflationary policies. On the other hand, fixed exchange rates could deter economic growth by
forcing the government to hold large foreign exchange reserves to sustain the fixed rate.
Furthermore, no automatic balance of payments adjustments can be carried out without
government interference. There is also a loss of freedom to frame polices regarding the
unemployment rate and inflation rate targets.

6. What would be the effect of a devaluation on a country’s imports and exports? If a country
imports most of the goods included in the basket of goods and services used to calculate the CPI,
what do you think the effect will be on this country’s inflation rate?

When a country devaluates its currency, the fixed exchange rate is set at a lower level, meaning that
the central bank will no longer exchange domestic currency at the previous (higher) exchange rate.
This means that foreigners with the same amount of foreign currency can get more units of domestic
currency, thereby making that country’s exports cheaper for them, leading to an increase in the
country’s exports. On the other hand, domestic buyers of foreign products now need more units of
domestic currency to buy the same amount of foreign currency, so imports become more expensive
and imports will decrease. If many of the goods that are taken into consideration to measure the
cost of living are imported, then the cost of living (as measured by the percentage change in the CPI)
will most probably increase after the devaluation.

7. Suppose your country has perfect capital mobility, would a sterilized approach work? Will it affect
the country? Why or why not?

If perfect capital mobility is the case, the sterilized approach will not work to keep exchange rate.
This is because in such a case there are no barriers to buy or sell foreign or domestic assets. With
sterilized approach relative expected return on domestic assets are not affected, and this will
continue in case of, for instance, overvalued currency. If the central bank continues to buy domestic
currency, it will finally loose international reserves, which will force to value of currency to be at
lower level.

8. Why might a country that is suffering a recession not want to intervene in the foreign exchange
market if its currency is overvalued? Assume this country participates in a fixed exchange rate
regime.

When a country is engaged in a fixed exchange rate regime, it has a commitment to intervene in the
foreign exchange market to maintain the system of fixed exchange rates. However, the combination
of a recession and an overvalued currency is quite complicated to solve. The required unsterilized
foreign exchange market intervention implies buying the domestic currency, decreasing reserves of
the banking system and thereby increasing the domestic interest rate. This increase in domestic
interest rates negatively affects the economy, reducing credit and expenditure on durable goods.
This is why countries engaged in fixed exchange rate regimes were sometimes reluctant to intervene
in the foreign exchange market.

9. The World Trade Organization (WTO) (https://www.wto.org/) is the sole international

organization that coordinates international trade between all the countries around the world.
Discuss its functions in a global financial context.

The functions of the WTO include:

1. Administering world trade agreements between countries trading with each other.

2. Organizing forums, seminars, and conferences related to world trade.

3. Mediating trade disputes between trading nations.

4. Monitoring and reviewing trade policies and procedures so that they do not conflict with
international laws.

5. Providing technical support, training, and assistance for trade officers within member
countries.

11. What are the detrimental effects of balance-of-payments deficits on a country?

Balance of payments is a record of all receipts and payments that directly impact the movement of
funds between a nation and foreign countries. Balance-of-payments deficit indicates that the
summation of the current account balance and the capital account balance shows a deficit. The
balance-of-payments deficit occurs if the current account balance deficit is not counterbalanced with
a capital inflow. Balance-of-payments deficits lead to debts which in turn impede future economic
growth as most of the earnings go into clearing debts rather than building the economy.

12. What problem would a country face if it ties its own currency exchange rate to another
currency? Can such a country face a policy trilemma? Briefly describe this phenomenon.

Usually the main problem with currency ties is that the country loses its own monetary policy,
especially in smaller countries cases; such counties usually depreciate or appreciate own currencies
according to bigger country’s interest rate fluctuations, which results in international reserves
shortages. None of the counties can pursue the three following at the same time: 1) free capital
mobility, 2) fixed exchange rate, and 3) independent monetary policy. This phenomenon is known as
a policy trilemma.

15. “The abandonment of fixed exchange rates after 1973 has meant that countries have pursued
more independent monetary policies.” Is this statement true, false, or uncertain? Explain your
answer.

Uncertain. Although after 1973, countries no longer must intervene in the foreign exchange market
to keep their currencies at a par level and so could pursue more independent monetary policy, they
have not chosen to do so; rather, they have continued to engage in substantial intervention in the
foreign exchange market. Thus they continue to have substantial fluctuations in international
reserves, which affect their money supply.

16. How do controls on capital outflow or inflow work for a country’s economy? Is control in general
a good tool?

Control on capital outflow may play a positive role in some cases, when a country needs to prevent
pulling capital out of the country by domestic or international residents. This is especially good in
times of economic crises, since it helps country to make devaluation less likely. Controls on capital
inflow works well in such cases like when the country’s government is sure that the country might, in
the future, suffer from speculative inflows and from unexpected outflows. However, in general,
controls are rarely effective not only because they lead to corruption but also because they allow a
government to walk away from sound financial reforms.

17. Recently the IMF became a lender of last recourse. Explain why this was the case. What
unfavourable developments might this involve?
The IMF plays a role of a lender of last recourse because central banks in emerging economies
usually can’t do that; thus, the IMF needs to pursue this role to prevent financial instability.
However, this may create moral hazard problems that can encourage excessive risk taking and lead
to financial crises. Not lending money may not be reasonable due to politics. In general, the IMF
needs to provide liquidity quickly during crises and keep managing the loan provided.

18. Why might central banks in emerging market countries find that engaging in a lender-of-last-
resort operation might be counterproductive? Does this provide a rationale for having an
international lender of last resort like the IMF?

Engaging in a lender-of-last resort operation is likely to weaken the credibility of the central bank
and lead to inflation and an even larger depreciation of the domestic currency. Because debt is
short-term and denominated in foreign currency in emerging-market countries, the depreciation
would lead to a deterioration of balance sheets; thus, the lender-of-last resort operation is likely to
make the financial crisis even worse.

20. What steps should an international lender of last resort take to limit moral hazard?

The international lender of last resort needs to make it clear that it will extend liquidity only to
governments that take measures to prevent excessive risk taking. It can also reduce moral hazard by
restricting the ability of governments to bail out stockholders and large uninsured creditors of
domestic financial institutions.