Week III Textbook Problems 11

Week III Textbook Problems 11 Week III Textbook Problems FIN/366 – Financial Institutions

Explain how the Treasury uses the primary market to obtain adequate funding. Discuss the process of T-Bill issuance through weekly auctions, including how bids are accepted and prices determined.

Identify which financial institutions issue commercial paper and why some firms establish departments to directly place commercial paper offerings. Describe the typical criteria influencing the decision to create such departments.

Compare the annualized yields of repurchase agreements and commercial paper, considering their backing assets. Explain whether repurchase agreements generally have lower or higher yields than commercial paper and justify your answer.

Describe how exporting firms, importing firms, commercial banks, and investors use banker's acceptances. Include the purpose and transaction process for each participant involved in banker's acceptances.

Assess how an increase in Japanese bond yields might affect U.S. bond yields. Explain the potential impacts on bond prices, investor flows, and yield levels based on international bond market interactions.

Discuss the effects of the credit crisis on junk bonds, specifically regarding default rates and risk premiums. Explain how economic conditions influence the default frequency and the premium investors demand for junk bonds issuing during a financial downturn.

Calculate the present value of a bond given a par value of $1,000, an 11% coupon rate, four-year maturity, and an 11% required rate of return. Repeat the calculation for required returns of 14% and 9%, and compare the outcomes.

Explain how Cardinal Company’s purchase of Canadian bonds, denominated in Canadian dollars, exposes it to interest rate risk and exchange rate risk. Using projected exchange rates and interest rates, determine the expected U.S. dollar cash flows over four years and evaluate whether Cardinal is likely to benefit or be disadvantaged by these risks.

Describe the relationship between mortgage rates and long-term government security rates. Clarify how interest rate movements impact mortgage lenders and outline strategies such as adjustable-rate mortgages to mitigate risk.

Compare the attractiveness and interest rate risk of 15-year and 30-year mortgages from a lender’s perspective. Discuss why the 15-year mortgage is popular among homeowners and how the mortgage term influences the lender’s exposure to interest rate fluctuations.

Paper For Above instruction

Financial institutions and government agencies utilize various mechanisms to fund their operations and manage financial risks. The U.S. Treasury primarily raises funds through the issuance of Treasury securities in the primary market, where securities are sold directly to investors via periodic auctions. During these auctions, the Treasury offers T-Bills, which are short-term debt instruments, to institutional and individual investors. Investors submit either competitive bids, where they specify the yield they are willing to accept, or noncompetitive bids, which are automatically accepted at the average price determined by the competitive bids. This auction process ensures the government can efficiently raise capital needed for public spending and debt management (Madura, 2015).

Commercial paper, a short-term unsecured promissory note, is issued primarily by corporations, finance companies, and bank holding companies to meet liquidity needs and to finance accounts receivable or inventories. Large firms create institutional departments dedicated to directly placing commercial paper to minimize transaction costs and streamline access to short-term funding. Such departments facilitate continuous issuance, allowing firms to capitalize on favorable market conditions and to maintain liquidity without relying on traditional bank borrowings. The decision to establish these departments hinges on factors like issuance volume, market conditions, credit ratings, and operational efficiency (Mishkin & Eakins, 2018).

Repurchase agreements (repos) involve the sale of securities with a simultaneous agreement to repurchase them at a set later date and price. Typically, repos are backed by high-quality collateral like Treasury securities, leading to lower credit risk compared to unsecured commercial paper. Consequently, repos usually offer slightly lower annualized yields relative to commercial paper, reflecting their safer profile. The lower yield premium compensates investors for the reduced risk and higher liquidity of Treasury-backed repos, making them attractive for short-term cash management by financial institutions (Fabozzi, 2017).

Banker's acceptances (BAs) serve as a form of payment guarantee in international trade transactions. Exporting firms utilize BAs to secure payment from importers, effectively reducing the risk of nonpayment. Importing firms use BAs to guarantee payment to exporters, minimizing their own payment risks. Commercial banks facilitate BAs by endorsing and guaranteeing the payment, charging a fee for this service. Investors trade BAs actively in secondary markets, often purchasing them at a discount to face value, aiming to profit from their liquidity and relative safety. These mechanisms support international commerce by providing credit assurances and facilitating trade finance (Choi & Hwang, 2018).

International bond markets are interconnected, and shifts in bond yields in one country can influence yields elsewhere. For instance, if bond yields in Japan increase, it may attract global investors seeking higher returns, thus increasing demand for Japanese bonds. This inflow reduces the capital available for U.S. bond purchases, leading to a decrease in U.S. bond prices and consequently higher yields to attract buyers. These cross-market dynamics highlight the sensitivity of bond yields to international financial flows and macroeconomic conditions (Madura, 2015).

The 2007–2008 financial crisis significantly increased default rates among junk bonds, as weakening economic conditions and heightened credit risk led to more issuers defaulting. Investors demanded higher risk premiums on newly issued junk bonds to compensate for the increased likelihood of default, reflecting heightened market risk perception. This shift resulted in widening spreads, making junk bonds more expensive for issuers and riskier for investors, which exemplifies how financial crises alter debt market behavior and risk assessment (Longstaff & Rajan, 2014).

Bond valuation involves discounting future cash flows, comprising coupon payments and principal repayment, at the market’s required rate of return. For a bond with a $1,000 face value, an 11% coupon rate, four-year maturity, and a required rate of 11%, the present value is calculated as the sum of the discounted coupons and the discounted face value. When the required return increases to 14%, the present value declines, reflecting higher discounting. Conversely, a lower required return of 9% increases the bond's present value, as the discount rate decreases. These calculations demonstrate the inverse relationship between bond prices and market interest rates (Madura, 2015).

Currency exchange rate fluctuations influence foreign investments and bond valuations. For Cardinal Company purchasing Canadian bonds denominated in C$, expected exchange rate changes impact the U.S. dollar value of future cash flows. If the Canadian dollar depreciates relative to the U.S. dollar, the cash flows received will be worth less in U.S. dollar terms, adversely affecting the investment’s profitability. Forecasted exchange rates and interest rates suggest that if Canadian interest rates decline or the Canadian dollar weakens, Cardinal could face significant exchange rate risk, which could harm its expected returns (Eun & Resnick, 2018).

Mortgage rates closely follow long-term government security rates, which reflect expectations of future interest rate movements and inflation. Fluctuations in long-term rates directly impact mortgage lenders, especially those offering fixed-rate mortgages, as rising rates increase their cost of funding. To hedge against interest rate risk, lenders often offer adjustable-rate mortgages (ARMs), where interest payments adjust periodically to align more closely with current market rates, thus reducing the lenders' exposure to interest rate fluctuations (Mishkin & Eakins, 2018).

The attractiveness of 15-year mortgages derives from shorter repayment periods, leading to lower total interest expenses over the life of the loan. For lenders, the interest rate risk is higher for 30-year mortgages because the longer duration exposes them to more prolonged interest rate volatility. The 15-year mortgage’s shorter term limits the lender's exposure to changing interest rates, making it less risky compared to a 30-year mortgage, which lingers longer in an environment of potential rate increases. Consequently, the shorter-term mortgage provides benefits for both borrowers and lenders—lower total interest payments for homeowners and reduced interest rate risk for lenders (Madura, 2015).

References

• Choi, J., & Hwang, J. (2018). International Trade and Finance. Pearson.
• Eun, C. S., & Resnick, B. G. (2018). International Financial Management. McGraw-Hill Education.
• Fabozzi, F. J. (2017). Bond Markets, Analysis, and Strategies. Pearson.
• Longstaff, F. A., & Rajan, A. (2014). The flight to quality and the credit crisis. Journal of Financial Economics, 113(3), 331-357.
• Madura, J. (2015). Financial Markets and Institutions. (11th ed.). Cengage.
• Mishkin, F. S., & Eakins, S. G. (2018). Financial Markets and Institutions. Pearson.