Running Head Week III Textbook Problems 1

Running Head Week Iii Textbook Problems1week Iii Textbook Problems

Cleaned assignment instructions: Explain how the Treasury uses the primary market to obtain funding, describe who issues commercial paper and why firms create departments to place it, explain how banker's acceptances are used by different parties, discuss the global interaction of bond yields, analyze how credit crises affect junk bonds, perform bond valuation calculations under different interest rates, evaluate bond value sensitivity to exchange rates and interest rate risks, and discuss mortgage rates, their risks, and mortgage maturities.

Paper For Above instruction

The functioning of financial markets plays a crucial role in facilitating the flow of funds from savers to borrowers, with various instruments serving different needs and risk profiles. Among these, the primary market is fundamental as it allows governments and corporations to raise new capital directly from investors. The U.S. Treasury exemplifies this by issuing treasury bills (T-Bills) through weekly auctions, which are highly secure and liquid instruments. In these auctions, the Treasury offers money bills to the market, accepting bids by investors—either competitive or noncompetitive. Competitive bids specify a price or yield, with the highest yields accepted, whereas noncompetitive bids are accepted automatically at the weighted average price of accepted competitive bids. This process ensures that the government secures necessary funding efficiently while providing investors with safe investment opportunities (Madura, 2015).

Commercial paper is another critical short-term funding instrument issued primarily by large finance and bank holding companies. These unsecured promissory notes are issued at a discount and mature within a short period, typically up to 270 days. Firms that issue commercial paper often establish dedicated departments responsible for their placement in the money markets to minimize transaction costs and streamline issuance processes. Creating such departments reflects the firms' intention to maintain continuous access to liquidity and manage the issuance efficiently. The decision to create these departments depends on factors like the firm's issuance volume, the need for operational flexibility, and cost considerations (Madura, 2015).

Banker's acceptances (BAs) serve as short-term credit instruments used primarily in international trade. Exporting firms utilize BAs to mitigate the risk of nonpayment by foreign importers, effectively guaranteeing payment upon fulfillment of trade conditions. Conversely, importing firms use BAs as a secure method to pay for goods, ensuring they do not pay before receipt. Commercial banks facilitate this process by issuing BAs, charging a fee for this service, thereby acting as trusted third parties. Investors actively trade these acceptances in secondary markets, appreciating their liquidity and security, especially given the backing of reputable banks (Madura, 2015).

In the context of international bond markets, bond yields are interconnected across countries. If bond yields in Japan increase, possibly due to economic or monetary policy changes, capital tends to flow toward higher-yielding assets, leading to increased demand for Japanese bonds. This increased demand can cause U.S. bond prices to decrease, resulting in higher yields due to the inverse relationship between bond prices and yields. Such international interactions influence global capital flows and interest rate environments (Madura, 2015).

The credit crisis of 2007-2008 significantly impacted the junk bond market. During the crisis, many junk bonds defaulted as economic conditions deteriorated and issuers failed to meet obligations. Consequently, the risk premiums—the extra yield demanded by investors for taking on higher risk—rose sharply for new junk bond issues to compensate investors for the heightened default risk. This widened spread increased the cost of borrowing for high-risk issuers and reflected the increased perceived risk in the financial system (Madura, 2015).

Bond valuation involves calculating the present value of future cash flows—coupon payments and face value—discounted at the required rate of return. For a bond with a face value of $1,000, an 11% coupon rate, three years remaining to maturity, and an investor’s required rate of return at 11%, the bond's fair value equals its face value at $1,000, since the coupon rate matches the required return. If the required return increases to 14%, the bond's present value declines below par due to higher discounting, resulting in a lower price. Conversely, if the required return decreases to 9%, the bond's value rises above par (Madura, 2015).

Currency exchange and interest rate risks significantly influence international bond investments. For instance, Cardinal Company considers purchasing Canadian bonds worth C$50 million with a 12% coupon, maturing in six years. If projected exchange rates show the Canadian dollar weakening over time, and if Canadian interest rates decline, the U.S. dollar cash flows from these bonds may decrease, adversely affecting profitability. However, if Canadian interest rates decline, bond prices are likely to increase, which could benefit Cardinal, but a weaker Canadian dollar reduces the dollar value of cash inflows, introducing exchange rate risk (Madura, 2015).

Mortgage rates are closely linked to long-term government security rates, particularly in the U.S., with a positive correlation. Rising long-term rates tend to increase mortgage rates, affecting affordability and refinancing willingness. Mortgage lenders offering fixed-rate mortgages face interest rate risk; when rates rise, their cost of funding increases without a corresponding rise in mortgage payments. To mitigate this, lenders often offer adjustable-rate mortgages, where interest rates adjust periodically in line with market rates (Madura, 2015).

The choice of mortgage term influences both homeownership costs and interest rate risk. A 15-year mortgage generally attracts homeowners due to lower total interest expenses and faster equity buildup. From a lender's perspective, the interest rate risk is higher in 30-year mortgages because of the extended exposure period, increasing the potential for interest rate fluctuations to affect the profitability of the loan (Madura, 2015).

References

• Madura, J. (2015). Financial Markets and Institutions (11th ed.). Cengage Learning.