3 Structure of Interest RatesCHAPTER OBJECTIVESThe specific ob.docx

3 Structure of Interest Rates
CHAPTER OBJECTIVES
The specific objectives of this chapter are to:
· ▪ describe how characteristics of debt securities cause their
yields to vary,
· ▪ demonstrate how to estimate the appropriate yield for any
particular debt security, and
· ▪ explain the theories behind the term structure of interest
rates (relationship between the term to maturity and the yield of
securities).
The annual interest rate offered by debt securities at any given
time varies among debt securities. Individual and institutional
investors must understand why quoted yields vary so that they
can determine whether the extra yield on a given security
outweighs any unfavorable characteristics. Financial managers
of corporations or government agencies in need of funds must
understand why quoted yields of debt securities vary so that
they can estimate the yield they would have to offer in order to
sell new debt securities.
3-1 WHY DEBT SECURITY YIELDS VARY
Debt securities offer different yields because they exhibit
different characteristics that influence the yield to be offered. In
general, securities with unfavorable characteristics will offer
higher yields to entice investors. Some debt securities have
favorable features; therefore, they can offer relatively low
yields and still attract investors. The yields on debt securities
are affected by the following characteristics:
· ▪ Credit (default) risk
· ▪ Liquidity
· ▪ Tax status
· ▪ Term to maturity
The yields on bonds may also be affected by special provisions,
as described in Chapter 7.
3-1a Credit (Default) Risk

Because most securities are subject to the risk of default,
investors must consider the creditworthiness of the security
issuer. Although investors always have the option of purchasing
risk-free Treasury securities, they may prefer other securities if
the yield compensates them for the risk. Thus, if all other
characteristics besides credit (default) risk are equal, securities
with a higher degree of default risk must offer higher yields
before investors will purchase them.
EXAMPLE
Investors can purchase a Treasury bond with a 10-year maturity
that presently offers an annualized yield of 7 percent if they
hold the bond until maturity. Alternatively, investors can
purchase bonds that are being issued by Zanstell Co. Although
Zanstell is in good financial condition, there is a small
possibility that it could file for bankruptcy during the next 10
years, in which case it would discontinue making payments to
investors who purchased the bonds. Thus there is a small
possibility that investors could lose most of their investment in
these bonds. The only way in which investors would even
consider purchasing bonds issued by Zanstell Co. is if the
annualized yield offered on these bonds is higher than the
Treasury bond yield. Zanstell's bonds presently offer a yield of
8 percent, which is 1 percent higher than the yield offered on
Treasury bonds. At this yield, some investors are willing to
purchase Zanstell's bonds because they think Zanstell Co.
should have sufficient cash flows to repay its debt over the next
1 0 years.
Credit risk is especially relevant for longer-term securities
that expose creditors to the possibility of default for a longer
time. Credit risk premiums of 1 percent, 2 percent, or more may
not seem significant. But for a corporation borrowing $30
million through the issuance of bonds, an extra percentage point
as a premium reflects $300,000 in additional interest expenses
per year.
Investors can personally assess the creditworthiness of
corporations that issue bonds, but they may prefer to rely on

bond ratings provided by rating agencies. These ratings are
based on a financial assessment of the issuing corporation, with
a focus on whether the corporation will receive sufficient cash
flows over time to cover its payments to bondholders. The
higher the rating on the bond, the lower the perceived credit
risk.
As time passes, economic conditions can change, which can
influence the ability of a corporation to repay its debt. Thus
bonds previously issued by a firm may be rated at one level,
whereas a subsequent issue from the same firm is rated at a
different level. The ratings can also differ if the collateral
provisions differ among the bonds. Rating agencies can also
change bond ratings over time in response to changes in the
issuing firm's financial condition or to changes in economic
conditions.
3-1b Assessing Credit Risk
To assess the credit risk of a corporation that issues bonds,
investors can evaluate the corporation's financial statements.
Specifically, investors use financial statements to predict the
level of cash flows a corporation will generate over future
periods, which helps determine if the company will have
sufficient cash flows to cover its debt payments. However,
financial statements might not indicate how a corporation will
perform in the future. Many corporations that were in good
financial condition just before they issued debt failed before
they repaid their debt.
Rating Agencies Many investors rely heavily on the ratings of
debt securities assigned by rating agencies, so that they do not
have to assess the financial statements of corporations. The
rating agencies charge the issuers of debt securities a fee for
assessing the credit risk of those securities. The ratings are then
provided through various financial media outlets at no cost to
investors. The most popular rating agencies are Moody's
Investors Service and Standard & Poor's Corporation. A
summary of their rating classification schedules is provided
in Exhibit 3.1. The ratings issued by Moody's range from Aaa

for the highest quality to C for the lowest quality, and those
issued by Standard & Poor's range from AAA to D. Because
these rating agencies use different methods to assess the
creditworthiness of firms and state governments, a particular
bond could be rated at a different quality level by each agency.
However, the differences are usually small.
Commercial banks typically invest only in investment-grade
bonds, which are bonds rated as Baa or better by Moody's and
as BBB or better by Standard & Poor's. Other financial
institutions, such as pension funds and insurance companies,
invest in bonds that are rated lower and offer the potential for
higher returns.
WEB
www.moodys.com
Credit rating information.
Exhibit 3.1 Rating Classification by Rating Agencies
Accuracy of Credit Ratings The ratings issued by the agencies
are opinions, not guarantees. Bonds that are assigned a low
credit rating experience default more frequently than bonds
assigned a high credit rating, which suggests that the rating can
be a useful indicator of credit risk. However, credit rating
agencies do not always detect firms' financial problems.
Credit rating agencies were criticized for being too liberal in
their assignment of ratings on debt issued shortly before the
credit crisis, as many highly rated debt issues defaulted over the
next few years. The credit rating agencies might counter that
they could not have anticipated the credit crisis and that they
used all the information available to them when assigning
ratings to new securities. Yet because credit rating agencies are
paid by the issuers of debt securities and not the investors who
purchase those securities, agencies may have a natural incentive
to assign a high rating. Doing so facilitates a firm's issuing of
debt securities, which in turn should attract more business from
other issuers of debt securities.
In response to the criticism, credit rating agencies made some

changes to improve their rating process and their transparency.
They now disclose more information about how they derived
their credit ratings. In addition, employees of each credit rating
agency that promote the services of the agency are not allowed
to influence the ratings assigned by the rating agency. They are
giving more attention to sensitivity analysis in which they
assess how creditworthiness might change in response to abrupt
changes in the economy.
Oversight of Credit Rating Agencies The Financial Reform Act
of 2010 established an Office of Credit Ratings within the
Securities and Exchange Commission in order to regulate credit
rating agencies. The act also mandated that credit rating
agencies establish internal controls to ensure that their process
of assigning ratings is more transparent. The agencies must
disclose their rating performance over time, and they are to be
held accountable if their ratings prove to be inaccurate. The
Financial Reform Act also allows investors to sue an agency for
issuing credit ratings that the agency should have known were
inaccurate.
3-1c Liquidity
Investors prefer securities that are liquid, meaning that they
could be easily converted to cash without a loss in value. Thus,
if all other characteristics are equal, securities with less
liquidity will have to offer a higher yield to attract investors.
Debt securities with a short-term maturity or an active
secondary market have greater liquidity. Investors that need a
high degree of liquidity (because they may need to sell their
securities for cash at any moment) prefer liquid securities, even
if it means that they will have to accept a lower return on their
investment. Investors who will not need their funds until the
securities mature are more willing to invest in securities with
less liquidity in order to earn a slightly higher return.
3-1d Tax Status
Investors are more concerned with after-tax income than before-
tax income earned on securities. If all other characteristics are
similar, taxable securities must offer a higher before-tax yield

than tax-exempt securities. The extra compensation required on
taxable securities depends on the tax rates of individual and
institutional investors. Investors in high tax brackets benefit
most from tax-exempt securities.
When assessing the expected yields of various securities with
similar risk and maturity, it is common to convert them into an
after-tax form, as follows:
Yat = Ybt (1 − T
where
Yat
= after-tax yield
Ybt
= before-tax yield
T
= investor's marginal tax rate
Investors retain only a percentage (1 − T) of the before-tax
yield once taxes are paid.
EXAMPLE
Consider a taxable security that offers a before-tax yield of 8
percent. When converted into aftertax terms, the yield will be
reduced by the tax percentage. The precise after-tax yield is
dependent on the tax rate T. If the tax rate of the investor is 20
percent, then the after-tax yield will be
Yat
= Ybt (1 − T)
= 8% (1 − 0.2)
= 16.4%
Exhibit 3.2 presents after-tax yields based on a variety of tax
rates and before-tax yields. For example, a taxable security with
a before-tax yield of 6 percent will generate an after-tax yield
of 5.4 percent to an investor in the 10 percent tax bracket, 5.10
percent to an investor in the 15 percent tax bracket, and so on.
This exhibit shows why investors in high tax brackets are
attracted to tax-exempt securities.

Exhibit 3.2 After-Tax Yields Based on Various Tax Rates and
Before-Tax Yields
BEFORE-TAX YIELD
TAX RATE
6%
8%
10%
12%
14%
10%
5.40%
7.20%
9.00%
10.80%
12.60%
15
5.10
6.80
8.50
10.20
11.90
25
4.50
6.00
7.50
9.00
10.50
28
4.32
5.76
7.20
8.64
10.08
35
3.90
5.20

6.50
7.80
9.10
Computing the Equivalent Before-Tax Yield In some cases,
investors wish to determine the before-tax yield necessary to
match the after-tax yield of a tax-exempt security that has a
similar risk and maturity. This can be done by rearranging the
terms of the previous equation:
Ybt =
Yat
1 − T
For instance, suppose that a firm in the 20 percent tax bracket is
aware of a tax-exempt security that is paying a yield of 8
percent. To match this after-tax yield, taxable securities must
offer a before-tax yield of
Ybt =
Yat
1 − T
=
8%
1 − 02
= b
State taxes should be considered along with federal taxes in
determining the after-tax yield. Treasury securities are exempt
from state income tax, and municipal securities are sometimes
exempt as well. Because states impose different income tax
rates, a particular security's after-tax yield may vary with the
location of the investor.
3-1e Term to Maturity
Maturity differs among debt securities and is another reason
that debt security yields differ. The term structure of interest
rates defines the relationship between the term to maturity and
the annualized yield of debt securities at a specific moment in
time while holding other factors, such as risk, constant.
WEB
www.treasury.gov

Treasury yields among different maturities.
EXAMPLE
Assume that, as of today, the annualized yields for federal
government securities (which are free from credit risk) of varied
maturities are as shown in Exhibit 3.3. The curve created by
connecting the points plotted in the exhibit is commonly
referred to as a yield curve. Notice that the yield curve exhibits
an upward slope.
Exhibit 3.3 Example of Relationship between Maturity and
Yield of Treasury Securities (as of March 2013)
The term structure of interest rates in Exhibit 3.3 shows that
securities that are similar in all ways except their term to
maturity may offer different yields. Because the demand and
supply conditions for securities may vary among maturities, so
may the price (and therefore the yield) of securities. A
comprehensive explanation of the term structure of interest
rates is provided later in this chapter.
WEB
www.bloomberg.com
The section on market interest rates and bonds presents the most
recent yield curve.
Since the yield curve in Exhibit 3.3 is based on Treasury
securities, the curve is not influenced by credit risk. The yield
curve for AA-rated corporate bonds would typically have a
slope similar to that of the Treasury yield curve, but the yield of
the corporate issue at any particular term to maturity would be
higher to reflect the risk premium.
3-2 EXPLAINING ACRUAL YIELD DIFFERENTIALS
Even small differentials in yield can be relevant to financial
institutions that are borrowing or investing millions of dollars.
Yield differentials are sometimes measured in basis points; a
basis point equals 0.01 percent, so 100 basis points equals 1
percent. If a security offers a yield of 4.3 percent while the a
risk-free security offers a yield of 4.0 percent, then the yield
differential is 0.30 percent or 30 basis points. Yield

differentials are described for money market securities next,
followed by differentials for capital market securities.
3-2a Yield Differentials of Money Market Securities
The yields offered on commercial paper (short-term securities
offered by creditworthy firms) are typically just slightly higher
than Treasury-bill rates, since investors require a slightly higher
return (10 to 40 basis points on an annualized basis) to
compensate for credit risk and less liquidity. Negotiable
certificates of deposit offer slightly higher rates than yields on
Treasury bills (“T-bills”) with the same maturity because of
their lower degree of liquidity and higher degree of credit risk.
Market forces cause the yields of all securities to move in the
same direction. To illustrate, assume that the budget deficit
increases substantially and that the Treasury issues a large
number of T-bills to finance the increased deficit. This action
creates a large supply of T-bills in the market, placing
downward pressure on the price and upward pressure on the T-
bill yield. As the yield begins to rise, it approaches the yield of
other short-term securities. Businesses and individual investors
are now encouraged to purchase T-bills rather than these risky
securities because they can achieve about the same yield while
avoiding credit risk. The switch to T-bills lowers the demand
for risky securities, thereby placing downward pressure on their
price and upward pressure on their yields. Thus the risk
premium on risky securities would not disappear completely.
3-2b Yield Differentials of Capital Market Securities
Municipal bonds have the lowest before-tax yield, yet their
after-tax yield is typically above that of Treasury bonds from
the perspective of investors in high tax brackets. Treasury
bonds are expected to offer the lowest yield because they are
free from credit risk and can easily be liquidated in the
secondary market. Investors prefer municipal or corporate bonds
over Treasury bonds only if the after-tax yield is sufficiently
higher to compensate for the higher credit risk and lower degree
of liquidity.
To illustrate how capital market security yields can vary over

time because of credit risk, Exhibit 3.4 shows yields of
corporate bonds in two different credit risk classes. The Aaa-
rated bonds have very low credit risk, whereas the BAA bonds
are perceived to have slightly more risk. Notice that the yield
differential between BAA bonds and AAA bonds was relatively
large during the recessions (shaded areas), such as in 1991 and
in the 2000–2003 period when economic conditions were weak.
During these periods, corporations had to pay a relatively high
premium if their bonds were rated Baa. The yield differential
narrowed during 2004–2007, when economic conditions
improved. However, during the credit crisis of 2008–2009, the
yield differential increased substantially. At one point during
the credit crisis, the yield differential was about 3 percentage
points.
Exhibit 3.4 Yield Differentials of Corporate Bonds
Many corporations whose bonds are rated Baa or below were
unwilling to issue bonds because of the high credit risk
premium they would have to pay to bondholders. This illustrates
why the credit crisis restricted access of corporations to credit.
3-3 ESTIMATING THE APPROPRIATE YIELD
The discussion so far suggests that the appropriate yield to be
offered on a debt security is based on the risk-free rate for the
corresponding maturity, with adjustments to capture various
characteristics. A model that captures this estimate may be
specified as follows:
Yn = Rf,n + DP + LP + TA
where
Yn
= yield of an n-day debt security
Rf,n
= yield return of an n-day Treasury risk-free security
DP
= default premium to compensate for credit risk
LP
= liquidity premium to compensate for less liquidity

TA
= adjustment due to the difference in tax status
These are the characteristics identified earlier that explain yield
differentials among securities (special provisions applicable to
bonds also may be included, as described in Chapter
7). Although maturity is another characteristic that can affect
the yield, it is not included here because it is controlled for by
matching the maturity of the security with that of a risk-free
security.
EXAMPLE
Suppose that the three-month T-bill's annualized rate is 8
percent and that Elizabeth Company plans to issue 90-day
commercial paper. Elizabeth Company must determine the
default premium (DP) and liquidity premium (LP) to offer on its
commercial paper in order to make it as attractive to investors
as a three-month (13-week) T-bill. The federal tax status of
commercial paper is the same as for T-bills. However, income
earned from investing in commercial paper is subject to state
taxes whereas income earned from investing in T-bills is not.
Investors may require a premium for this reason alone if they
reside in a location where state and (and perhaps local) income
taxes apply.
Assume Elizabeth Company believes that a 0.7 percent default
risk premium, a 0.2 percent liquidity premium, and a 0.3
percent tax adjustment are necessary to sell its commercial
paper to investors. The appropriate yield to be offered on the
commercial paper, Ycp, is then
Ycp,n
= Rf,n + DP + LP + TA
= 8% + 0.7% + 0.2% + 0.3%
= 9.2%
The appropriate commercial paper rate will change over time,
perhaps because of changes in the risk-free rate and/or the
default premium, liquidity premium, and tax adjustment factors.

Some corporations may postpone plans to issue commercial
paper until the economy improves and the required premium for
credit risk is reduced. Even then, however, the market rate of
commercial paper may increase if interest rates increase.
EXAMPLE
If the default risk premium decreases from 0.7 percent to 0.5
percent but Rf,n increases from 8 percent to 8.7 percent, the
appropriate yield to be offered on commercial paper (assuming
no change in the previously assumed liquidity and tax
adjustment premiums) would be
Ycp
= Rf,n + DP + LP + TA
= 8.7% + 0.5% + 0.2% + 0.3%
= 9.7%
The strategy of postponing the issuance of commercial paper
would backfire in this example. Even though the default
premium decreased by 0.2 percent, the general level of interest
rates rose by 0.7 percent, so the net change in the commercial
paper rate is +0.5 percent.
As this example shows, the increase in a security's yield over
time does not necessarily mean that the default premium has
increased. The assessment of yields as described here could also
be applied to long-term securities. If, for example, a firm
desires to issue a 20-year corporate bond, it will use the yield of
a new 20-year Treasury bond as the 20-year risk-free rate and
add on the premiums for credit risk, liquidity risk, and so on
when determining the yield at which it can sell corporate bonds.
A simpler and more general relationship is that the yield
offered on a debt security is positively related to the prevailing
risk-free rate and the security's risk premium (RP). This risk
premium captures any risk characteristics of the security,
including credit risk and liquidity risk. A more detailed model
for the yield of a debt security could be applied by including
additional characteristics that can vary among bonds, such as

whether the bond is convertible into stock and whether it
contains a call premium. The conversion option is favorable for
investors, so it could reduce the yield that needs to be offered
on a bond. The call premium is unfavorable for investors, so it
could increase the yield that needs to be offered on a bond.
3-4 A CLOSER LOOK AT THE TERM STRUCTURE
Of all the factors that affect the yields offered on debt
securities, the one that is most difficult to understand is term to
maturity. For this reason, a more comprehensive explanation of
the relationship between term to maturity and annualized yield
(referred to as the term structure of interest rates) is necessary.
Various theories have been used to explain the relationship
between maturity and annualized yield of securities. These
theories include pure expectations theory, liquidity premium
theory, and segmented markets theory, and each is explained in
this section.
3-4a Pure Expectations Theory
According to pure expectations theory, the term structure of
interest rates (as reflected in the shape of the yield curve) is
determined solely by expectations of interest rates.
Impact of an Expected Increase in Interest Rates To understand
how interest rate expectations may influence the yield curve,
assume that the annualized yields of short-term and long-term
risk-free securities are similar; that is, suppose the yield curve
is flat. Then assume that investors begin to believe that interest
rates will rise. Investors will respond by investing their funds
mostly in the short term so that they can soon reinvest their
funds at higher yields after interest rates increase. When
investors flood the short-term market and avoid the long-term
market, they may cause the yield curve to adjust as shown in
Panel A of Exhibit 3.5. The large supply of funds in the short-
term markets will force annualized yields down. Meanwhile, the
reduced supply of long-term funds forces long-term yields up.
Even though the annualized short-term yields become lower
than annualized long-term yields, investors in short-term funds
are satisfied because they expect interest rates to rise. They will

make up for the lower short-term yield when the short-term
securities mature, and they reinvest at a higher rate (if interest
rates rise) at maturity.
Assuming that the borrowers who plan to issue securities also
expect interest rates to increase, they will prefer to lock in the
present interest rate over a long period of time. Thus, borrowers
will generally prefer to issue long-term securities rather than
short-term securities. This results in a relatively small demand
for short-term funds. Consequently, there is downward pressure
on the yield of short-term funds. There is a corresponding
increase in the demand for long-term funds by borrowers, which
places upward pressure on long-term funds. Overall, the
expectation of higher interest rates changes the demand for
funds and the supply of funds in different maturity markets,
which forces the original flat yield curve (labeled YC1 in the
two rightmost graphs) to pivot upward (counterclockwise) and
become upward sloping (YC2).
Impact of an Expected Decline in Interest Rates If investors
expect interest rates to decrease in the future, they will prefer to
invest in long-term funds rather than short-term funds because
they could lock in today's interest rate before interest rates fall.
Borrowers will prefer to borrow short-term funds so that they
can refinance at a lower interest rate once interest rates decline.
Exhibit 3.5 How Interest Rate Expectations Affect the Yield
Curve
Based on the expectation of lower interest rates in the future,
the supply of funds provided by investors will be low for short-
term funds and high for long-term funds. This will place upward
pressure on short-term yields and downward pressure on long-
term yields, as shown in Panel B of Exhibit 3.5. Overall, the
expectation of lower interest rates causes the shape of the yield
curve to pivot downward (clockwise).
Algebraic Presentation Investors monitor the yield curve to
determine the rates that exist for securities with various
maturities. They can either purchase a security with a maturity

that matches their investment horizon or purchase a security
with a shorter term and then reinvest the proceeds at maturity.
They may select the strategy that they believe will generate a
higher return over the entire investment horizon. This could
affect the prices and yields of securities with different
maturities, so that the expected return over the investment
horizon is similar regardless of the strategy used. If investors
were indifferent to maturities, the return of any security should
equal the compounded yield of consecutive investments in
shorter-term securities. That is, a two-year security should offer
a return that is similar to the anticipated return from investing
in two consecutive one-year securities. A four-year security
should offer a return that is competitive with the expected
return from investing in two consecutive two-year securities or
four consecutive one-year securities, and so on.
EXAMPLE
To illustrate these equalities, consider the relationship between
interest rates on a two-year security and a one-year security as
follows:
(1 + ti2)2 = (1 + ti1)(1 + t+1r1)
where
ti 2
= known annualized interest rate of a two-year security as of
time t
ti 1
= known annualized interest rate of a one-year security as of
time t
t+1 r 1
= one-year interest rate that is anticipated as of time t + 1 (one
year ahead)
The term i represents a quoted rate, which is therefore known,
whereas r represents a rate to be quoted at some point in the
future, so its value is uncertain. The left side of the equation
represents the compounded yield to investors who purchase a
two-year security, and the right side represents the anticipated
compounded yield from purchasing a one-year security and

reinvesting the proceeds in a new one-year security at the end of
one year. If time t is today, then t+1r1 can be estimated by
rearranging terms:
The term t+1r1, referred to as the forward rate, is commonly
estimated in order to represent the market's forecast of the
future interest rate. Here is a numerical example. Assume that,
as of today (time t), the annualized two-year interest rate is 10
percent and the one-year interest rate is 8 percent. The forward
rate is then estimated as follows:
This result implies that, one year from now, a one-year interest
rate must equal about 12.037 percent in order for consecutive
investments in two one-year securities to generate a return
similar to that of a two-year investment. If the actual one-year
rate beginning one year from now (i.e., at time t + 1) is above
12.037 percent, the return from two consecutive one-year
investments will exceed the return on a two-year investment.
The forward rate is sometimes used as an approximation of
the market's consensus interest rate forecast. The reason is that,
if the market had a different perception, the demand and supply
of today's existing two-year and one-year securities would
adjust to capitalize on this information. Of course, there is no
guarantee that the forward rate will forecast the future interest
rate with perfect accuracy.
The greater the difference between the implied one-year
forward rate and today's one-year interest rate, the greater the
expected change in the one-year interest rate. If the term
structure of interest rates is solely influenced by expectations of
future interest rates, the following relationships hold:
SCENARIO
STRUCTURE OF YIELD CURVE
EXPECTATIONS ABOUT THE FUTURE INTEREST RATE
1. t+1r1 > ti1
Upward slope
Higher than today's rate

2. t+1r1 = ti1
Flat
Same as today's rate
3. t+1r1 < ti1
Downward slope
Lower than today's rate
Forward rates can be determined for various maturities. The
relationships described here can be applied when assessing the
change in the interest rate of a security with any particular
maturity.
The previous example can be expanded to solve for other
forward rates. The equality specified by the pure expectations
theory for a three-year horizon is
All other terms were defined previously. By rearranging terms,
we can isolate the forward rate of a one-year security beginning
two years from now:
If the one-year forward rate beginning one year from now
(t+1r1) has already been estimated, then this estimate can be
combined with actual one-year and three-year interest rates to
estimate the one-year forward rate two years from now. Recall
that our previous example assumed ti1 = 8 percent and
estimated t+1r1 to be about 12.037 percent.
EXAMPLE
Assume that a three-year security has an annualized interest rate
of 11 percent (i.e., ti3 = 11 percent). Given this information, the
one-year forward rate two years from now can be calculated as
follows:
Thus, the market anticipates that, two years from now, the one-
year interest rate will be 13.02736 percent.
The yield curve can also be used to forecast annualized
interest rates for periods other than one year. For example, the
information provided in the last example could be used to
determine the two-year forward rate beginning one year from

now.
According to pure expectations theory, a one-year investment
followed by a two-year investment should offer the same
annualized yield over the three-year horizon as a three-year
security that could be purchased today. This relation is
expressed as follows:
(1 + t+1i3)3 = (1 + ti1)(1 + t + 1r2)2
where t+1r2 is the annual interest rate of a two-year security
anticipated as of time t+1. By rearranging terms, t+1r2 can be
isolated:
(1 + t+1r2)2 =
(1 + ti3)
1 + ti1
EXAMPLE
Recall that today's annualized yields for one-year and three-year
securities are 8 percent and 11 percent, respectively. With this
information, t+1r2 is estimated as follows:
Thus, the market anticipates an annualized interest rate of about
12.53 percent for two-year securities beginning one year from
now.
Pure expectations theory is based on the premise that forward
rates are unbiased estimators of future interest rates. If forward
rates are biased, investors can attempt to capitalize on the bias.
EXAMPLE
In the previous numerical example, the one-year forward rate
beginning one year ahead was estimated to be about 12.037
percent. If the forward rate was thought to contain an upward
bias, the expected one-year interest rate beginning one year
ahead would actually be less than 12.037 percent. Therefore,
investors with funds available for two years would earn a higher
yield by purchasing two-year securities rather than purchasing
one-year securities for two consecutive years. However, their
actions would cause an increase in the price of two-year
securities and a decrease in that of one-year securities, and the
yields of these securities would move inversely with the price

movements. Hence any attempt by investors to capitalize on the
forward rate bias would essentially eliminate the bias.
If forward rates are unbiased estimators of future interest
rates, financial market efficiency is supported and the
information implied by market rates about the forward rate
cannot be used to generate abnormal returns. In response to new
information, investor preferences would change, yields would
adjust, and the implied forward rate would adjust as well.
If a long-term rate is expected to equal a geometric average of
consecutive short-term rates covering the same time horizon (as
is suggested by pure expectations theory), longterm rates would
likely be more stable than short-term rates. As expectations
about consecutive short-term rates change over time, the
average of these rates is less volatile than the individual short-
term rates. Thus long-term rates are much more stable than
short-term rates.
3-4b Liquidity Premium Theory
Some investors may prefer to own short-term rather than long-
term securities because a shorter maturity represents greater
liquidity. In this case, they may be willing to hold long-term
securities only if compensated by a premium for the lower
degree of liquidity. Although long-term securities can be
liquidated prior to maturity, their prices are more sensitive to
interest rate movements. Short-term securities are normally
considered to be more liquid because they are more likely to be
converted to cash without a loss in value.
The preference for the more liquid short-term securities
places upward pressure on the slope of a yield curve. Liquidity
may be a more critical factor to investors at some times than at
others, and the liquidity premium will accordingly change over
time. As it does, the yield curve will change also. This is the
liquidity premium theory (sometimes referred to as the liquidity
preference theory).
Exhibit 3.6 contains three graphs that reflect the existence of
both expectations theory and a liquidity premium. Each graph
shows different interest rate expectations by the market.

Regardless of the interest rate forecast, the yield curve is
affected in a similar manner by the liquidity premium.
Exhibit 3.6 Impact of Liquidity Premium on the Yield Curve
under Three Different Scenarios
Estimation of the Forward Rate Based on a Liquidity
Premium When expectations theory is combined with liquidity
theory, the yield on a security will not necessarily be equal to
the yield from consecutive investments in shorter-term
securities over the same investment horizon. For example, the
yield on a two-year security is now determined as
(1 + t+1i2)2 = (1 + ti1)(1 + t+1r1 + LP2
where LP2 denotes the liquidity premium on a two-year
security. The yield generated from the two-year security should
exceed the yield from consecutive investments in one-year
securities by a premium that compensates the investor for less
liquidity. The relationship between the liquidity premium and
term to maturity can be expressed as follows:
0 < LP1 < LP2 < LP3 < ··· < LP20
where the subscripts represent years to maturity. This implies
that the liquidity premium would be more influential on the
difference between annualized interest rates on one-year and
20-year securities than on the difference between one-year and
two-year securities.
If liquidity influences the yield curve, the forward rate
overestimates the market's expectation of the future interest
rate. A more appropriate formula for the forward rate would
account for the liquidity premium. By rearranging terms in the
previous equation for forward rates, the one-year forward rate
can be derived as follows:
t+1r1 =
(1 + ti2)2
1 + ti1
− 1 −
LP2
1 + ti1

EXAMPLE
Reconsider the example where i1 = 8 percent and i2 = 10
percent, and assume that the liquidity premium on a two-year
security is 0.5 percent. The one-year forward rate can then be
derived from this information as follows:
This estimate of the one-year forward rate is lower than the
estimate derived in the previous related example in which the
liquidity premium was not considered. The previous estimate
(12.037 percent) of the forward rate probably overstates the
market's expected interest rate because it did not account for a
liquidity premium. Thus forecasts of future interest rates
implied by a yield curve are reduced slightly when accounting
for the liquidity premium.
Even with the existence of a liquidity premium, yield curves
could still be used to interpret interest rate expectations. A flat
yield curve would be interpreted to mean that the market is
expecting a slight decrease in interest rates (without the effect
of the liquidity premium, the yield curve would have had a
slight downward slope). A slight upward slope would be
interpreted as no expected change in interest rates: if the
liquidity premium were removed, this yield curve would be flat.
3-4c Segmented Markets Theory
According to the segmented markets theory, investors and
borrowers choose securities with maturities that satisfy their
forecasted cash needs. Pension funds and life insurance
companies may generally prefer long-term investments that
coincide with their long-term liabilities. Commercial banks may
prefer more short-term investments to coincide with their short-
term liabilities. If investors and borrowers participate only in
the maturity market that satisfies their particular needs, then
markets are segmented. That is, investors (or borrowers) will
shift from the long-term market to the short-term market, or
vice versa, only if the timing of their cash needs changes.
According to segmented markets theory, the choice of long-term
versus short-term maturities is determined more by investors'

needs than by their expectations of future interest rates.
EXAMPLE
Assume that most investors have funds available to invest for
only a short period of time and therefore desire to invest
primarily in short-term securities. Also assume that most
borrowers need funds for a long period of time and therefore
desire to issue mostly long-term securities. The result will be
downward pressure on the yield of short-term securities and
upward pressure on the yield of long-term securities. Overall,
the scenario described would create an upward-sloping yield
curve.
Now consider the opposite scenario in which most investors
wish to invest their funds for a long period of time while most
borrowers need funds for only a short period of time. According
to segmented markets theory, this situation will cause upward
pressure on the yield of short-term securities and downward
pressure on the yield of long-term securities. If the supply of
funds provided by investors and the demand for funds by
borrowers were better balanced between the short-term and
long-term markets, the yields of short-and long-term securities
would be more similar.
The preceding example distinguished maturity markets as
either short-term or longterm. In reality, several maturity
markets may exist. Within the short-term market, some
investors may prefer maturities of one month or less whereas
others may prefer maturities of one to three months. Regardless
of how many maturity markets exist, the yields of securities
with various maturities should be influenced in part by the
desires of investors and borrowers to participate in the maturity
market that best satisfies their needs. A corporation that needs
additional funds for 30 days would not consider issuing long-
term bonds for such a purpose. Savers with short-term funds
would avoid some long-term investments (e.g., 10-year
certificates of deposit) that cannot be easily liquidated.
Limitation of the Theory A limitation of segmented markets
theory is that some borrowers and savers have the flexibility to

choose among various maturity markets. Corporations that need
long-term funds may initially obtain short-term financing if
they expect interest rates to decline, and investors with long-
term funds may make short-term investments if they expect
interest rates to rise. Moreover, some investors with short-term
funds may be willing to purchase long-term securities that have
an active secondary market.
Some financial institutions focus on a particular maturity
market, but others are more flexible. Commercial banks obtain
most of their funds in short-term markets but spread their
investments into short-, medium-, and long-term markets.
Savings institutions have historically focused on attracting
short-term funds and lending funds for long-term periods. Note
that if maturity markets were completely segmented, then an
interest rate adjustment in one market would have no impact on
other markets. However, there is clear evidence that interest
rates among maturity markets move nearly in concert over time.
This evidence indicates that there is some interaction among
markets, which implies that funds are being transferred across
markets. Note also that the theory of segmented markets
conflicts with the general presumption of pure expectations
theory that maturity markets are perfect substitutes for one
another.
Implications Although markets are not completely segmented,
the preference for particular maturities can affect the prices and
yields of securities with different maturities and thereby affect
the yield curve's shape. For this reason, the theory of segmented
markets seems to be a partial explanation for the yield curve's
shape but not the sole explanation.
A more flexible variant of segmented markets theory, known
as preferred habitat theory, offers a compromise explanation for
the term structure of interest rates. This theory proposes that,
although investors and borrowers may normally concentrate on
a particular maturity market, certain events may cause them to
wander from their “natural” market. For example, commercial
banks that obtain mostly short-term funds may select

investments with short-term maturities as a natural habitat.
However, if they wish to benefit from an anticipated decline in
interest rates, they may select medium- and long-term maturities
instead. Preferred habitat theory acknowledges that natural
maturity markets may influence the yield curve, but it also
recognizes that interest rate expectations could entice market
participants to stray from their natural, preferred markets.
3-4d Research on Term Structure Theories
Much research has been conducted on the term structure of
interest rates and has offered considerable insight into the
various theories. Researchers have found that interest rate
expectations have a strong influence on the term structure of
interest rates. However, the forward rate derived from a yield
curve does not accurately predict future interest rates, and this
suggests that other factors may be relevant. The liquidity
premium, for example, could cause consistent positive
forecasting errors, meaning that forward rates tend to
overestimate future interest rates. Studies have documented
variation in the yield–maturity relationship that cannot be
entirely explained by interest rate expectations or liquidity. The
variation could therefore be attributed to different supply and
demand conditions for particular maturity segments.
General Research Implications Although the results of research
differ, there is some evidence that expectations theory, liquidity
premium theory, and segmented markets theory all have some
validity. Thus, if term structure is used to assess the market's
expectations of future interest rates, then investors should first
“net out” the liquidity premium and any unique market
conditions for various maturity segments.
3-5 INTEGRATING THE THEORIES OF TERM STRUCTURE
In order to understand how all three theories can simultaneously
affect the yield curve, first assume the following conditions.
· 1. Investors and borrowers who select security maturities
based on anticipated interest rate movements currently expect
interest rates to rise.
Exhibit 3.7Effect of Conditions in Example of Yield Curve

· 2. Most borrowers are in need of long-term funds, while most
investors have only short-term funds to invest.
· 3. Investors prefer more liquidity to less.
The first condition, which is related to expectations theory,
suggests the existence of an upward-sloping yield curve (other
things being equal); see curve E in Exhibit 3.7. The segmented
markets information (condition 2) also favors the upward-
sloping yield curve. When conditions 1 and 2 are considered
simultaneously, the appropriate yield curve may look like curve
E + S in the graph. The third condition (regarding liquidity)
would then place a higher premium on the longer-term
securities because of their lower degree of liquidity. When this
condition is included with the first two, the yield may be
represented by curve E + S + L.
In this example, all conditions placed upward pressure on
long-term yields relative to short-term yields. In reality, there
will sometimes be offsetting conditions: one condition may put
downward pressure on the slope of the yield curve while other
conditions cause upward pressure. If condition 1 in the example
here were revised so that future interest rates were expected to
decline, then this condition (by itself) would result in a
downward-sloping yield curve. So when combined with the
other conditions, which imply an upward-sloping curve, the
result would be a partial offsetting effect. The actual yield
curve would exhibit a downward slope if the effect of the
interest rate expectations dominated the combined effects of
segmented markets and a liquidity premium. In contrast, there
would be an upward slope if the liquidity premium and
segmented markets effects dominated the effects of interest rate
expectations.
3-5a Use of the Term Structure
The term structure of interest rates is used to forecast interest
rates, to forecast recessions, and to make investment and
financing decisions.
Forecasting Interest Rates At any point in time, the shape of the

yield curve can be used to assess the general expectations of
investors and borrowers about future interest rates. Recall from
expectations theory that an upward-sloping yield curve
generally results from the expectation of higher interest rates
whereas a downward-sloping yield curve generally results from
the expectation of lower interest rates. Expectations about
future interest rates must be interpreted cautiously, however,
because liquidity and specific maturity preferences could
influence the yield curve's shape. Still, it is generally believed
that interest rate expectations are a major contributing factor to
the yield curve's shape. Thus the curve's shape should provide a
reasonable indication (especially once the liquidity premium
effect is accounted for) of the market's expectations about
future interest rates.
Although they can use the yield curve to interpret the market's
consensus expectation of future interest rates, investors may
have their own interest rate projections. By comparing their
projections with those implied by the yield curve, they can
attempt to capitalize on the difference. For example, if an
upward-sloping yield curve exists, investors expecting stable
interest rates could benefit from investing in long-term
securities. From their perspective, long-term securities are
undervalued because they reflect the market's (presumed
incorrect) expectation of higher interest rates. Strategies such as
this are effective only if the investor can consistently forecast
better than the market.
Forecasting Recessions Some analysts believe that flat or
inverted yield curves indicate a recession in the near future. The
rationale for this belief is that, given a positive liquidity
premium, such yield curves reflect the expectation of lower
interest rates. This in turn is commonly associated with
expectations of a reduced demand for loanable funds, which
could be attributed to expectations of a weak economy.
The yield curve became flat or slightly inverted in 2000. At
that time, the shape of the curve indicated expectations of a
slower economy, which would result in lower interest rates. In

2001, the economy weakened considerably. And in March 2007,
the yield curve exhibited a slight negative slope that caused
some market participants to forecast a recession. During the
credit crisis in 2008 and in the following two years, yields on
Treasury securities with various maturities declined. The short-
term interest rates experienced the most pronounced decline,
which resulted in an upward-sloping yield curve in 2010.
Making Investment Decisions If the yield curve is upward
sloping, some investors may attempt to benefit from the higher
yields on longer-term securities even though they have funds to
invest for only a short period of time. The secondary market
allows investors to implement this strategy, which is known
as riding the yield curve. Consider an upward-sloping yield
curve such that some one-year securities offer an annualized
yield of 7 percent while 10-year bonds offer an annualized yield
of 10 percent. An investor with funds available for one year
may decide to purchase the bonds and sell them in the
secondary market after one year. The investor earns 3 percent
more than was possible on the one-year securities, but only if
the bonds can be sold (after one year) at the price for which
they were purchased. The risk of this strategy is the uncertainty
in the price for which the security can be sold in the near future.
If the upward-sloping yield is interpreted as the market's
consensus of higher interest rates in the future, then the price of
a security would be expected to decrease in the future.
The yield curve is commonly monitored by financial
institutions whose liability maturities are distinctly different
from their asset maturities. Consider a bank that obtains much
of its funds through short-term deposits and uses the funds to
provide long-term loans or purchase long-term securities. An
upward-sloping yield curve is favorable to the bank because
annualized short-term deposit rates are significantly lower than
annualized long-term investment rates. The bank's spread is
higher than it would be if the yield curve were flat. However, if
it believes that the upward slope of the yield curve indicates
higher interest rates in the future (as predicted by expectations

theory), then the bank will expect its cost of liabilities to
increase over time because future deposits would be obtained at
higher interest rates.
Making Decisions about Financing The yield curve is also
useful for firms that plan to issue bonds. By assessing the
prevailing rates on securities for various maturities, firms can
estimate the rates to be paid on bonds with different maturities.
This may enable them to determine the maturity of the bonds
they issue. If they need funds for a two-year period, but notice
from the yield curve that the annualized yield on one-year debt
is much lower than that of two-year debt, they may consider
borrowing for a one-year period. After one year when they pay
off this debt, they will need to borrow funds for another one-
year period.
3-5b Why the Slope of the Yield Curve Changes
If interest rates at all maturities were affected in the same
manner by existing conditions, then the slope of the yield curve
would remain unchanged. However, conditions may cause short-
term yields to change in a manner that differs from the change
in long-term yields.
EXAMPLE
Suppose that last July the yield curve had a large upward slope,
as shown by yield curve YC1 in Exhibit 3.8. Since then, the
Treasury decided to restructure its debt by retiring $300 billion
of long-term Treasury securities and increasing its offering of
short-term Treasury securities. This caused a large increase in
the demand for short-term funds and a large decrease in the
demand for long-term funds. The increase in the demand for
short-term funds caused an increase in short-term interest rates
and thereby increased the yields offered on newly issued short-
term securities. Conversely, the decline in demand for long-
term funds caused a decrease in long-term interest rates and
thereby reduced the yields offered on newly issued long-term
securities. Today, the yield curve is YC2 and is much flatter
than it was last July.
Exhibit 3.8 Potential Impact of Treasury Shift from Long-term

to Short-term Financing
3-5c How the Yield Curve Has Changed over Time
Yield curves at various dates are illustrated in Exhibit 3.9. The
yield curve is usually upward sloping, but a slight downward
slope has sometimes been evident (see the exhibit's curve for
March 21, 2007). Observe that the yield curve for March 18,
2013, is below the other yield curves shown in the exhibit,
which means that the yield to maturity was relatively low
regardless of the maturity considered. This curve existed during
the credit crisis, when economic conditions were extremely
weak.
3-5d International Structure of Interest Rates
Because the factors that affect the shape of the yield curve can
vary among countries, the yield curve's shape at any given time
also varies among countries. Exhibit 3.10 plots the yield curve
for six different countries in July 2013. Each country has a
different currency with its own interest rate levels for various
maturities, and each country's interest rates are based on
conditions of supply and demand.
Interest rate movements across countries tend to be positively
correlated as a result of internationally integrated financial
markets. Nevertheless, the actual interest rates may vary
significantly across countries at a given point in time. This
implies that the difference in interest rates is attributable
primarily to general supply and demand conditions across
countries and less so to differences in default risk premiums,
liquidity premiums, or other characteristics of the individual
securities.
Exhibit 3.9 Yield Curves at Various Points in Time
Exhibit 3.10 Yield Curves among Foreign Countries (as of July
2013)
Because forward rates (as defined in this chapter) reflect the

market's expectations of future interest rates, the term structure
of interest rates for various countries should be monitored for
the following reasons. First, with the integration of financial
markets, movements in one country's interest rate can affect
interest rates in other countries. Thus some investors may
estimate the forward rate in a foreign country to predict the
foreign interest rate, which in turn may affect domestic interest
rates. Second, foreign securities and some domestic securities
are influenced by foreign economies, which are dependent on
foreign interest rates. If the foreign forward rates can be used to
forecast foreign interest rates, they can enhance forecasts of
foreign economies. Because exchange rates are also influenced
by foreign interest rates, exchange rate projections may be more
accurate when foreign forward rates are used to forecast foreign
interest rates.
If the real interest rate were fixed, inflation rates for future
periods could be predicted for any country in which the forward
rate could be estimated. Recall from Chapter 2 that the nominal
interest rate consists of an expected inflation rate plus a real
interest rate. Because the forward rate represents an expected
nominal interest rate for a future period, it also represents an
expected inflation rate plus a real interest rate in that period.
The expected inflation in that period is estimated as the
difference between the forward rate and the real interest rate.
SUMMARY
· ▪ Quoted yields of debt securities at any given time may vary
for the following reasons. First, securities with higher credit
(default) risk must offer a higher yield. Second, securities that
are less liquid must offer a higher yield. Third, taxable
securities must offer a higher before-tax yield than tax-exempt
securities. Fourth, securities with longer maturities offer a
different yield (not consistently higher or lower) than securities
with shorter maturities.
· ▪ The appropriate yield for any particular debt security can be
estimated by first determining the risk-free yield that is
currently offered by a Treasury security with a similar maturity.

Then adjustments are made that account for credit risk,
liquidity, tax status, and other provisions.
· ▪ The term structure of interest rates can be explained by three
theories. The pure expectations theory suggests that the shape
of the yield curve is dictated by interest rate expectations. The
liquidity premium theory suggests that securities with shorter
maturities have greater liquidity and therefore should not have
to offer as high a yield as securities with longer terms to
maturity. The segmented markets theory suggests that investors
and borrowers have different needs that cause the demand and
supply conditions to vary across different maturities; in other
words, there is a segmented market for each term to maturity,
which causes yields to vary among these maturity markets.
Consolidating the theories suggests that the term structure of
interest rates depends on interest rate expectations, investor
preferences for liquidity, and the unique needs of investors and
borrowers in each maturity market.
POINT COUNTER-POINT
Should a Yield Curve Influence a Borrower's Preferred Maturity
of a Loan?
Point Yes. If there is an upward-sloping yield curve, then a
borrower should pursue a short-term loan to capitalize on the
lower annualized rate charged for a short-term period. The
borrower can obtain a series of short-term loans rather than one
loan to match the desired maturity.
Counter-Point No. The borrower will face uncertainty regarding
the interest rate charged on subsequent QUESTIONS AND
APPLICATIONS 1. Characteristics That Affect Security Yields
Identify the relevant characteristics of any security that can
affect its yield. 2. Impact of Credit Risk on Yield What effect
does a high credit risk have on securities? 3. Impact of
Liquidity on Yield Discuss the relationship between the yield
and liquidity of securities. 4. Tax Effects on Yields Do
investors in high tax brackets or those in low tax brackets
benefit more from tax-exempt securities? Why? At a given point
in time, loans that are needed. An upward-sloping yield curve

suggests that interest rates may rise in the future, which will
cause the cost of borrowing to increase. Overall, the cost of
borrowing may be higher when using a series of loans than
when matching the debt maturity to the time period in which
funds are needed.
Who Is Correct? Use the Internet to learn more about this issue
and then formulate your own opinion.
QUESTIONS AND APPLICATIONS
· 1.Characteristics That Affect Security Yields Identify the
relevant characteristics of any security that can affect its yield.
· 2.Impact of Credit Risk on Yield What effect does a high
credit risk have on securities?
· 3.Impact of Liquidity on Yield Discuss the relationship
between the yield and liquidity of securities.
· 4.Tax Effects on Yields Do investors in high tax brackets or
those in low tax brackets benefit more from tax-exempt
securities? Why? At a given point in time, which offers a higher
before-tax yield: municipal bonds or corporate bonds? Why?
Which has the higher aftertax yield? If taxes did not exist,
would Treasury bonds offer a higher or lower yield than
municipal bonds with the same maturity? Why?
· 5.Pure Expectations Theory Explain how a yield curve would
shift in response to a sudden expectation of rising interest rates,
according to the pure expectations theory.
· 6.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?
· 7.Pure Expectation Theory Assume there is a sudden
expectation of lower interest rates in the future. What would be
the effect on the shape of the yield curve? Explain.
· 8.Liquidity Premium Theory Explain the liquidity premium
theory.
· 9.Impact of Liquidity Premium on Forward Rate Explain how
consideration of a liquidity premium affects the estimate of a
forward interest rate.

· 10.Segmented Markets Theory If a downward-sloping yield
curve is mainly attributed to segmented markets theory, what
does that suggest about the demand for and supply of funds in
the short-term and long-term maturity markets?
· 11.Segmented Markets Theory If the segmented markets
theory causes an upward-sloping yield curve, what does this
imply? If markets are not completely segmented, should we
dismiss the segmented markets theory as even a partial
explanation for the term structure of interest rates? Explain.
· 12.Preferred Habitat Theory Explain the preferred habitat
theory.
· 13.Yield Curve What factors influence the shape of the yield
curve? Describe how financial market participants use the yield
curve.
Advanced Questions
· 14.Segmented Markets Theory Suppose that the Treasury
decides to finance its deficit with mostly longterm funds. How
could this decision affect the term structure of interest rates? If
short-term and long-term markets were segmented, would the
Treasury's decision have a more or less pronounced impact on
the term structure? Explain.
· 15.Yield Curve Assuming that liquidity and interest rate
expectations are both important for explaining the shape of a
yield curve, what does a flat yield curve indicate about the
market's perception of future interest rates?
· 16.Global Interaction among Yield Curves Assume that the
yield curves in the United States, France, and Japan are flat. If
the U.S. yield curve suddenly becomes positively sloped, do you
think the yield curves in France and Japan would be affected? If
so, how?
· 17.Multiple Effects on the Yield Curve Assume that (1)
investors and borrowers expect that the economy will weaken
and that inflation will decline, (2) investors require a small
liquidity premium, and (3) markets are partially segmented and
the Treasury currently has a preference for borrowing in short-
term markets. Explain how each of these forces would affect the

term structure, holding other factors constant. Then explain the
effect on the term structure overall.
· 18.Effect of Crises on the Yield Curve During some crises,
investors shift their funds out of the stock market and into
money market securities for safety, even if they do not fear
rising interest rates. Explain how and why these actions by
investors affect the yield curve. Is the shift best explained by
expectations theory, liquidity premium theory, or segmented
markets theory?
· 19.How the Yield Curve May Respond to Prevailing
Conditions Consider how economic conditions affect the default
risk premium. Do you think the default risk premium will likely
increase or decrease during this semester? How do you think the
yield curve will change during this semester? Offer some logic
to support your answers.
· 20.Assessing Interest Rate Differentials among Countries In
countries experiencing high inflation, the annual interest rate
may exceed 50 percent; in other countries, such as the United
States and many European countries, annual interest rates are
typically less than 10 percent. Do you think such a large
difference in interest rates is due primarily to the difference
between countries in the risk-free rates or in the credit risk
premiums? Explain.
· 21.Applying the Yield Curve to Risky Debt Securities Assume
that the yield curve for Treasury bonds has a slight upward
slope, starting at 6 percent for a 10-year maturity and slowly
rising to 8 percent for a 30-year maturity. Create a yield curve
that you believe would exist for A-rated bonds and a
corresponding one for B-rated bonds.
· 22.Changes to Credit Rating Process Explain how credit raters
have changed their process following criticism of their ratings
during the credit crisis.
Interpreting Financial News
Interpret the following comments made by Wall Street analysts
and portfolio managers.
· a. “An upward-sloping yield curve persists because many

investors stand ready to jump into the stock market.”
· b. “Low-rated bond yields rose as recession fears caused a
flight to quality.”
· c. “The shift from an upward-sloping yield curve to a
downward-sloping yield curve is sending a warning about a
possible recession.”?
Managing in Financial Markets
Monitoring Yield Curve Adjustments As an analyst of a bond
rating agency, you have been asked to interpret the implications
of the recent shift in the yield curve. Six months ago, the yield
curve exhibited a slight downward slope. Over the last six
months, long-term yields declined while short-term yields
remained the same. Analysts said that the shift was due to
revised expectations of interest rates.
· a. Given the shift in the yield curve, does it appear that firms
increased or decreased their demand for long-term funds over
the last six months?
· b. Interpret what the shift in the yield curve suggests about the
market's changing expectations of future interest rates.
· c. Recently, an analyst argued that the underlying reason for
the yield curve shift is that many large U.S. firms anticipate a
recession. Explain why an anticipated recession could force the
yield curve to shift as it has.
· d. What could the specific shift in the yield curve signal about
the ratings of existing corporate bonds? What types of
corporations would be most likely to experience a change in
their bond ratings as a result of this shift in the yield curve?
PROBLEMS
· 1.Forward Rate
· a. Assume that, as of today, the annualized two-year interest
rate is 13 percent and the one-year interest rate is 12 percent.
Use this information to estimate the one-year forward rate.
· b. Assume that the liquidity premium on a two-year security is
0.3 percent. Use this information to estimate the one-year
forward rate.
· 2.Forward Rate Assume that, as of today, the annualized

interest rate on a three-year security is 10 percent and the
annualized interest rate on a two-year security is 7 percent. Use
this information to estimate the one-year forward rate two years
from now.
· 3.Forward Rate If ti1 > ti2, what is the market consensus
forecast about the one-year forward rate one year from now? Is
this rate above or below today's one-year interest rate? Explain.
· 4.After-Tax Yield You need to choose between investing in a
one-year municipal bond with a 7 percent yield and a one-year
corporate bond with an 11 percent yield. If your marginal
federal income tax rate is 30 percent and no other differences
exist between these two securities, which would you invest in?
· 5.Deriving Current Interest Rates Assume that interest rates
for one-year securities are expected to be 2 percent today, 4
percent one year from now, and 6 percent two years from now.
Using only pure expectations theory, what are the current
interest rates on two-year and three-year securities?
· 6.Commercial Paper Yield
· a. A corporation is planning to sell its 90-day commercial
paper to investors by offering an 8.4 percent yield. If the three-
month T-bill's annualized rate is 7 percent, the default risk
premium is estimated to be 0.6 percent, and there is a 0.4
percent tax adjustment, then what is the appropriate liquidity
premium?
· b. Suppose that, because of unexpected changes in the
economy, the default risk premium increases to 0.8 percent.
Assuming that no other changes occur, what is the appropriate
yield to be offered on the commercial paper?
· 7.Forward Rate
· a. Determine the forward rate for various one-year interest rate
scenarios if the two-year interest rate is 8 percent, assuming no
liquidity premium. Explain the relationship between the one-
year interest rate and the one-year forward rate while holding
the two-year interest rate constant.
· b. Determine the one-year forward rate for the same one-year
interest rate scenarios described in question (a) while assuming

a liquidity premium of 0.4 percent. Does the relationship
between the one-year interest rate and the forward rate change
when the liquidity premium is considered?
· c. Determine how the one-year forward rate would be affected
if the quoted two-year interest rate rises; hold constant the
quoted one-year interest rate as well as the liquidity premium.
Explain the logic of this relationship.
· d. Determine how the one-year forward rate would be affected
if the liquidity premium rises and if the quoted one-year interest
rate is held constant. What if the quoted two-year interest rate is
held constant? Explain the logic of this relationship.
· 8.After-Tax Yield Determine how the after-tax yield from
investing in a corporate bond is affected by higher tax rates,
holding the before-tax yield constant. Explain the logic of this
relationship.
· 9.Debt Security Yield
· a. Determine how the appropriate yield to be offered on a
security is affected by a higher risk-free rate. Explain the logic
of this relationship.
· b. Determine how the appropriate yield to be offered on a
security is affected by a higher default risk premium. Explain
the logic of this relationship.
FLOW OF FUNDS EXERCISE
Influence of the Structure of Interest Rates
Recall that Carson Company has obtained substantial loans from
finance companies and commercial banks. The interest rate on
the loans is tied to the six-month Treasury bill rate (and
includes a risk premium) and is adjusted every six months.
Therefore, Carson's cost of obtaining funds is sensitive to
interest rate movements. The company expects that the U.S.
economy will strengthen, so it plans to grow in the future by
expanding its business and by making acquisitions. Carson
anticipates needing substantial long-term financing to pay for
its growth and plans to borrow additional funds, either through
loans or by issuing bonds; it is also considering issuing stock to
raise funds in the next year.

· a. Assume that the market's expectations for the economy are
similar to Carson's expectations. Also assume that the yield
curve is primarily influenced by interest rate expectations.
Would the yield curve be upward sloping or downward sloping?
Why?
· b. If Carson could obtain more debt financing for 10- year
projects, would it prefer to obtain credit at a longterm fixed
interest rate or at a floating rate? Why?
· c. If Carson attempts to obtain funds by issuing 10-year bonds,
explain what information would help in estimating the yield it
would have to pay on 10-year bonds. That is, what are the key
factors that would influence the rate Carson would pay on its
10-year bonds?
· d. If Carson attempts to obtain funds by issuing loans with
floating interest rates every six months, explain what
information would help in estimating the yield it would have to
pay over the next 10 years. That is, what are the key factors that
would influence the rate Carson would pay over the 10-year
period?
· e. An upward-sloping yield curve suggests that the initial rate
financial institutions could charge on a longterm loan to Carson
would be higher than the initial rate they could charge on a loan
that floats in accordance with short-term interest rates. Does
this imply that creditors should prefer offering Carson a fixed-
rate loan to offering them a floating-rate loan? Explain why
Carson's expectations of future interest rates are not necessarily
the same as those of some financial institutions.
INTERNET/EXCEL EXERCISES
· 1. Assess the shape of the yield curve by using the
website www.bloomberg.com. Click on “Market data” and then
on “Rates & bonds.” Is the Treasury yield curve upward or
downward sloping? What is the yield of a 90-day Treasury bill?
What is the yield of a 30-year Treasury bond?
· 2. Based on the various theories attempting to explain the
yield curve's shape, what could explain the difference between
the yields of the 90-day Treasury bill and the 30-year Treasury

bond? Which theory, in your opinion, is the most reasonable?
Why?
WSJ EXERCISE
Interpreting the Structure of Interest Rates
· a.Explaining Yield Differentials Using the most recent issue
of the Wall Street Journal, review the yields for the following
securities:
TYPE
MATURITY
YIELD
Treasury
10-year
___
Corporate: high-quality
10-year
___
Corporate: medium-quality
10-year
___
Municipal (tax-exempt)
10-year
___
· If credit (default) risk is the only reason for the yield
differentials, then what is the default risk premium on the
corporate high-quality bonds? On the medium-quality bonds?
· During a recent recession, high-quality corporate bonds
offered a yield of 0.8 percent above Treasury bonds while
medium-quality bonds offered a yield of about 3.1 percent
above Treasury bonds. How do these yield differentials compare
to the differentials today? Explain the reason for any change.
· Using the information in the previous table, complete the
following table. In Column 2, indicate the before-tax yield
necessary to achieve the existing after-tax yield of tax-exempt
bonds. In Column 3, answer this question: If the tax-exempt
bonds have the same risk and other features as high-quality
corporate bonds, which type of bond is preferable for investors

in each tax bracket?
MARGINAL TAX BRACKET OF INVESTORS
EQUIVALENT BEFORE-TAX YIELD
PREFERRED BOND
10%
___
___
15%
___
___
20%
___
___
28%
___
___
34%
___
___
· b.Examining Recent Adjustments in Credit Risk Using the
most recent issue of the Wall Street Journal, review the
corporate debt section showing the high-yield issue with the
biggest price decrease.
· ▪ Why do you think there was such a large decrease in price?
· ▪ How does this decrease in price affect the expected yield for
any investors who buy bonds now?
· c.Determining and Interpreting Today's Term Structure Using
the most recent issue of the Wall Street Journal, review the
yield curve to determine the approximate yields for the
following maturities:
TERM TO MATURITY
ANNUALIZED YIELD
1 year
___
2 years
___

3 years
___
· Assuming that the differences in these yields are due solely
to interest rate expectations, determine the one-year forward
rate as of one year from now and the one-year forward rate as of
two years from now.
· d.The Wall Street Journal provides a “Treasury Yield Curve.”
Use this curve to describe the market's expectations about
future interest rates. If a liquidity premium exists, how would
this affect your perception of the market's expectations?
ONLINE ARTICLES WITH REAL-WORLD EXAMPLES
Find a recent practical article available online that describes a
real-world example regarding a specific financial institution or
financial market that reinforces one or more concepts covered in
this chapter.
If your class has an online component, your professor may ask
you to post your summary of the article there and provide a link
to the article so that other students can access it. If your class is
live, your professor may ask you to summarize your application
of the article in class. Your professor may assign specific
students to complete this assignment or may allow any students
to do the assignment on a volunteer basis.
For recent online articles and real-world examples related to
this chapter, consider using the following search terms (be sure
to include the prevailing year as a search term to ensure that the
online articles are recent):
· 1. credit risk
· 2. credit ratings AND risk
· 3. risk premium
· 4. yield curve
· 5. yield curve AND interest rate
· 6. interest rate AND liquidity premium
· 7. interest rate AND credit risk
· 8. rating agency AND risk
· 9. term structure AND maturity
· 10. yield curve AND financing

PART 1 INTEGRATIVE PROBLEM: Interest Rate Forecasts
and Investment Decisions
This problem requires an understanding of how economic
conditions affect interest rates and bond yields (Chapters 1, 2,
and 3).
Your task is to use information about existing economic
conditions to forecast U.S. and Canadian interest rates. The
following information is available to you.
· 1. Over the past six months, U.S. interest rates have declined
and Canadian interest rates have increased.
· 2. The U.S. economy has weakened over the past year while
the Canadian economy has improved.
· 3. The U.S. saving rate (proportion of income saved) is
expected to decrease slightly over the next year; the Canadian
saving rate will remain stable.
· 4. The U.S. and Canadian central banks are not expected to
implement any policy changes that would have a significant
impact on interest rates.
· 5. You expect the U.S. economy to strengthen considerably
over the next year but still be weaker than it was two years ago.
You expect the Canadian economy to remain stable.
· 6. You expect the U.S. annual budget deficit to increase
slightly from last year but be significantly less than the average
annual budget deficit over the past five years. You expect the
Canadian budget deficit to be about the same as last year.
· 7. You expect the U.S. inflation rate to rise slightly but still
remain below the relatively high levels of two years ago; you
expect the Canadian inflation rate to decline.
· 8. Based on some events last week, most economists and
investors around the world (including yourself) expect the U.S.
dollar to weaken against the Canadian dollar and against other
foreign currencies over the next year. This expectation was
already accounted for in your forecasts of inflation and
economic growth.
· 9. The yield curve in the United States currently exhibits a
consistent downward slope. The yield curve in Canada currently

exhibits an upward slope. You believe that the liquidity
premium on securities is quite small.
Questions
· 1. Using the information available to you, forecast the
direction of U.S. interest rates.
· 2. Using the information available to you, forecast the
direction of Canadian interest rates.
· 3. Assume that the perceived risk of corporations in the United
States is expected to increase. Explain how the yield of newly
issued U.S. corporate bonds will change to a different degree
than will the yield of newly issued U.S. Treasury bonds.
2 Determination of Interest Rates
CHAPTER OBJECTIVES
· ▪ apply the loanable funds theory to explain why interest rates
change,
· ▪ identify the most relevant factors that affect interest rate
movements, and
· ▪ explain how to forecast interest rates.
An interest rate reflects the rate of return that a creditor
receives when lending money, or the rate that a borrower pays
when borrowing money. Since interest rates change over time,
so does the rate earned by creditors who provide loans or the
rate paid by borrowers who obtain loans. Interest rate
movements have a direct influence on the market values of debt
securities, such as money market securities, bonds, and
mortgages. They have an indirect influence on equity security
values because they can affect the return by investors who
invest in equity securities. Thus, participants in financial
markets attempt to anticipate interest rate movements when
restructuring their investment or loan positions.
Interest rate movements also affect the value of most financial
institutions. They influence the cost of funds to depository
institutions and the interest received on some loans by financial

institutions. Since many financial institutions invest in
securities (such as bonds), the market value of their investments
is affected by interest rate movements. Thus managers of
financial institutions attempt to anticipate interest rate
movements and commonly restructure their assets and liabilities
to capitalize on their expectations. Individuals attempt to
anticipate interest rate movements so that they can monitor the
potential cost of borrowing or the potential return from
investing in various debt securities.
2-1 LOANABLE FUNDS THEORY
WEB
www.bloomberg.com
Information on interest rates in recent months.
The loanable funds theory, commonly used to explain interest
rate movements, suggests that the market interest rate is
determined by factors controlling the supply of and demand for
loanable funds. The theory is especially useful for explaining
movements in the general level of interest rates for a particular
country. Furthermore, it can be used (along with other concepts)
to explain why interest rates among some debt securities of a
given country vary, which is the focus of the next chapter. The
phrase “demand for loanable funds” is widely used in financial
markets to refer to the borrowing activities of households,
businesses, and governments. This chapter describes the sectors
that commonly affect the demand for loanable funds and then
describes the sectors that supply loanable funds to the markets.
Finally, the demand and supply concepts are integrated to
explain interest rate movements.
Exhibit 2.1 Relationship between Interest Rates and Household
Demand (Dh) for Loanable Funds at a Given Point in Time
2-1a Household Demand for Loanable Funds
Households commonly demand loanable funds to finance
housing expenditures. In addition, they finance the purchases of
automobiles and household items, which results in installment
debt. As the aggregate level of household income rises, so does

installment debt. The level of installment debt as a percentage
of disposable income has been increasing over time, although it
is generally lower in recessionary periods.
If households could be surveyed at any given time to indicate
the quantity of loanable funds they would demand at various
interest rate levels, the results would reveal an inverse
relationship between the interest rate and the quantity of
loanable funds demanded. This simply means that, at any
moment in time, households would demand a greater quantity of
loanable funds at lower rates of interest; in other words, they
are willing to borrow more money (in aggregate) at lower rates
of interest.
EXAMPLE
Consider the household demand-for-loanable-funds schedule
(also called the demand curve) in Exhibit 2.1, which shows how
the amount of funds that would be demanded is dependent on
the interest rate. Various events can cause household borrowing
preferences to change and thereby shift the demand curve. For
example, if tax rates on household income are expected to
decrease significantly in the future, households might believe
that they can more easily afford future loan repayments and thus
be willing to borrow more funds. For any interest rate, the
quantity of loanable funds demanded by households would be
greater as a result of the tax rate change. This represents an
outward shift (to the right) in the demand curve.
2-1b Business Demand for Loanable Funds
Businesses demand loanable funds to invest in long-term (fixed)
and short-term assets. The quantity of funds demanded by
businesses depends on the number of business projects to be
implemented. Businesses evaluate a project by comparing the
present value of its cash flows to its initial investment, as
follows:
where
· NPV= net present value of project
· INV= initial investment

· CFt= cash flow in period t
· k= required rate of return on project
Projects with a positive net present value (NPV) are accepted
because the present value of their benefits outweighs the costs.
The required return to implement a given project will be lower
if interest rates are lower because the cost of borrowing funds to
support the project will be lower. Hence more projects will have
positive NPVs, and businesses will need a greater amount of
financing. This implies that, all else being equal, businesses
will demand a greater quantity of loanable funds when interest
rates are lower; this relation is illustrated in Exhibit 2.2.
In addition to long-term assets, businesses also need funds to
invest in their short-term assets (such as accounts receivable
and inventory) in order to support ongoing operations. Any
demand for funds resulting from this type of investment is
positively related to the number of projects implemented and
thus is inversely related to the interest rate. The opportunity
cost of investing in short-term assets is higher when interest
rates are higher. Therefore, firms generally attempt to support
ongoing operations with fewer funds during periods of high
interest rates. This is another reason that a firm's total demand
for loanable funds is inversely related to prevailing interest
rates. Although the demand for loanable funds by some
businesses may be more sensitive to interest rates than others,
all businesses are likely to demand more funds when interest
rates are lower.
Shifts in the Demand for Loanable Funds The business demand-
for-loanable funds schedule (as reflected by the demand curve
in Exhibit 2.2) can change in reaction to any events that affect
business borrowing preferences. If economic conditions become
more favorable, the expected cash flows on various proposed
projects will increase. More proposed projects will then have
expected returns that exceed a particular required rate of return
(sometimes called the hurdle rate). Additional projects will be
acceptable as a result of more favorable economic forecasts,
causing an increased demand for loanable funds. The increase in

demand will result in an outward shift (to the right) in the
demand curve.
WEB
www.treasurydirect.gov
Information on the U.S. government's debt.
Exhibit 2.2 Relationship between Interest Rates and Business
Demand (Db) for Loanable Funds at a Given Point in Time
2-1c Government Demand for Loanable Funds
Whenever a government's planned expenditures cannot be
completely covered by its incoming revenues from taxes and
other sources, it demands loanable funds. Municipal (state and
local) governments issue municipal bonds to obtain funds; the
federal government and its agencies issue Treasury securities
and federal agency securities. These securities constitute
government debt.
The federal government's expenditure and tax policies are
generally thought to be independent of interest rates. Thus the
federal government's demand for funds is referred to as interest-
inelastic, or insensitive to interest rates. In contrast, municipal
governments sometimes postpone proposed expenditures if the
cost of financing is too high, implying that their demand for
loanable funds is somewhat sensitive to interest rates.
Like household and business demand, government demand for
loanable funds can shift in response to various events.
EXAMPLE
The federal government's demand-for-loanable-funds schedule
is represented by Dg1 in Exhibit 2.3. If new bills are passed that
cause a net increase of $200 billion in the deficit, the federal
government's demand for loanable funds will increase by that
amount. In the graph, this new demand schedule is represented
by Dg2.
2-1d Foreign Demand for Loanable Funds
The demand for loanable funds in a given market also includes
foreign demand by foreign governments or corporations. For

example, the British government may obtain financing by
issuing British Treasury securities to U.S. investors; this
represents British demand for U.S. funds. Because foreign
financial transactions are becoming so common, they can have a
significant impact on the demand for loanable funds in any
given country. A foreign country's demand for U.S. funds (i.e.,
preference to borrow U.S. dollars) is influenced by, among
other factors, the difference between its own interest rates and
U.S. rates. Other things being equal, a larger quantity of U.S.
funds will be demanded by foreign governments and
corporations if their domestic interest rates are high relative to
U.S. rates. As a result, for a given set of foreign interest rates,
the quantity of U.S. loanable funds demanded by foreign
governments or firms will be inversely related to U.S. interest
rates.
WEB
www.bloomberg.com/markets
Interest rate information.
Exhibit 2.3 Impact of Increased Government Deficit on the
Government Demand for Loanable Funds
Exhibit 2.4 Impact of Increased Foreign Interest Rates on the
Foreign Demand for U.S. Loanable Funds
The foreign demand curve can shift in response to economic
conditions. For example, assume the original foreign demand
schedule is represented by Df1 in Exhibit 2.4. If foreign interest
rates rise, foreign firms and governments will likely increase
their demand for U.S. funds, as represented by the shift
from Df1to Df2.
2-1e Aggregate Demand for Loanable Funds
The aggregate demand for loanable funds is the sum of the
quantities demanded by the separate sectors at any given
interest rate, as shown in Exhibit 2.5. Because most of these
sectors are likely to demand a larger quantity of funds at lower
interest rates (other things being equal), it follows that the

aggregate demand for loanable funds is inversely related to the
prevailing interest rate. If the demand schedule of any sector
changes, the aggregate demand schedule will also be affected.
2-1f Supply of Loanable Funds
The term “supply of loanable funds” is commonly used to refer
to funds provided to financial markets by savers. The household
sector is the largest supplier, but loanable funds are also
supplied by some government units that temporarily generate
more tax revenues than they spend or by some businesses whose
cash inflows exceed outflows. Yet households as a group are a
net supplier of loanable funds, whereas governments and
businesses are net demanders of loanable funds.
Suppliers of loanable funds are willing to supply more funds
if the interest rate (reward for supplying funds) is higher, other
things being equal. This means that the supply-of-loanable-
funds schedule (also called the supply curve) is upward sloping,
as shown in Exhibit 2.6. A supply of loanable funds exists at
even a very low interest rate because some households choose to
postpone consumption until later years, even when the reward
(interest rate) for saving is low. Foreign households,
governments, and businesses commonly supply funds to their
domestic markets by purchasing domestic securities. In
addition, they have been a major creditor to the U.S.
government by purchasing large amounts of Treasury securities.
The large foreign supply of funds to the U.S. market is due in
part to the high saving rates of foreign households.
Effects of the Fed The supply of loanable funds in the United
States is also influenced by the monetary policy implemented by
the Federal Reserve System. The Fed conducts monetary policy
in an effort to control U.S. economic conditions. By affecting
the supply of loanable funds, the Fed's monetary policy affects
interest rates (as will be described shortly). By influencing
interest rates, the Fed is able to influence the amount of money
that corporations and households are willing to borrow and
spend.
Exhibit 2.5 Determination of the Aggregate Demand Curve for

Loanable Funds
Exhibit 2.6 Aggregate Supply Curve for Loanable Funds
Aggregate Supply of Funds The aggregate supply schedule of
loanable funds represents the combination of all sector supply
schedules along with the supply of funds provided by the Fed's
monetary policy. The steep slope of the aggregate supply curve
in Exhibit 2.6 means that it is interest-inelastic. The quantity of
loanable funds demanded is normally expected to be more
elastic, meaning more sensitive to interest rates, than the
quantity of loanable funds supplied.
The supply curve can shift inward or outward in response to
various conditions. For example, if the tax rate on interest
income is reduced, then the supply curve will shift outward as
households save more funds at each possible interest rate level.
Conversely, if the tax rate on interest income is increased, then
the supply curve will shift inward as households save fewer
funds at each possible interest rate level.
In this section, minimal attention has been given to financial
institutions. Although financial institutions play a critical
intermediary role in channeling funds, they are not the ultimate
suppliers of funds. Any change in a financial institution's
supply of funds results only from a change in habits of the
households, businesses, or governments that supply those funds.
2-1g Equilibrium Interest Rate
An understanding of equilibrium interest rates is necessary to
assess how various events can affect interest rates. In reality,
there are several different interest rates because some borrowers
pay a higher rate than others. At this point, however, the focus
is on the forces that cause the general level of interest rates to
change, since interest rates across borrowers tend to change in
the same direction. The determination of an equilibrium interest
rate is presented first from an algebraic perspective and then
from a graphical perspective. Following this presentation,
several examples are offered to reinforce the concept.

Algebraic Presentation The equilibrium interest rate is the rate
that equates the aggregate demand for funds with the aggregate
supply of loanable funds. The aggregate demand for funds (DA)
can be written as
DA = Dh + Db + DgDm + Df
where
· Dh= household demand for loanable funds
· Db= business demand for loanable funds
· Dg= federal government demand for loanable funds
· Dm= municipal government demand for loanable funds
· Df= foreign demand for loanable funds
The aggregate supply of funds (SA) can likewise be written as
SA = Sh + Sb + Sg + Sm + Sf
where
· Sh=household supply of loanable funds
· Sb=business supply of loanable funds
· Sg=federal government supply of loanable funds
· Sm=municipal government supply of loanable funds
· Sf=foreign supply of loanable funds
In equilibrium, DA = SA. If the aggregate demand for
loanable funds increases without a corresponding increase in
aggregate supply, there will be a shortage of loanable funds. In
this case, interest rates will rise until an additional supply of
loanable funds is available to accommodate the excess demand.
Conversely, an increase in the aggregate supply of loanable
funds without a corresponding increase in aggregate demand
will result in a surplus of loanable funds. In this case, interest
rates will fall until the quantity of funds supplied no longer
exceeds the quantity of funds demanded.
In many cases, both supply and demand for loanable funds are
changing. Given an initial equilibrium situation, the equilibrium
interest rate should rise when DA > SA and fall when DASA.
Graphical Presentation By combining the aggregate demand and
aggregate supply curves of loanable funds (refer to Exhibits
2.5 and 2.6), it is possible to compare the total amount of funds
that would be demanded to the total amount of funds that would

be supplied at any particular interest rate. Exhibit 2.7 illustrates
the combined demand and supply schedules. At the equilibrium
interest rate of i, the supply of loanable funds is equal to the
demand for loanable funds.
At any interest rate above i, there is a surplus of loanable
funds. Some potential suppliers of funds will be unable to
successfully supply their funds at the prevailing interest rate.
Once the market interest rate decreases to i, the quantity of
funds supplied is sufficiently reduced and the quantity of funds
demanded is sufficiently increased such that there is no longer a
surplus of funds. When a disequilibrium situation exists, market
forces should cause an adjustment in interest rates until
equilibrium is achieved.
If the prevailing interest rate is below i, there will be a
shortage of loanable funds; borrowers will not be able to obtain
all the funds that they desire at that rate. The shortage of funds
will cause the interest rate to increase, resulting in two
reactions. First, more savers will enter the market to supply
loanable funds because the reward (interest rate) is now higher.
Second, some potential borrowers will decide not to demand
loanable funds at the higher interest rate. Once the interest rate
rises to i, the quantity of loanable funds supplied has increased
and the quantity of loanable funds demanded has decreased to
the extent that a shortage no longer exists. Thus an equilibrium
position is achieved once again.
Exhibit 2.7 Interest Rate Equilibrium
2-2 FACTORS THAT AFFECT INTEREST RATES
Although it is useful to identify those who supply or demand
loanable funds, it is also necessary to recognize the underlying
economic forces that cause a change in either the supply of or
the demand for loanable funds. The following economic factors
influence this supply and demand and thereby influence interest
rates.
2-2a Impact of Economic Growth on Interest Rates
Changes in economic conditions cause a shift in the demand

curve for loanable funds, which affects the equilibrium interest
rate.
EXAMPLE
When businesses anticipate that economic conditions will
improve, they revise upward the cash flows expected for various
projects under consideration. Consequently, businesses identify
more projects that are worth pursuing, and they are willing to
borrow more funds. Their willingness to borrow more funds at
any given interest rate reflects an outward shift (to the right) in
the demand curve.
The supply-of-loanable-funds schedule may also change in
response to economic growth, but it is difficult to know in
which direction it will shift. It is possible that the increased
expansion by businesses will lead to more income for
construction crews and others who service the expansion. In this
case, the quantity of savings (loanable funds supplied) could
increase regardless of the interest rate, causing an outward shift
in the supply schedule. However, there is no assurance that the
volume of savings will actually increase. Even if such a shift
does occur, it will likely be of smaller magnitude than the shift
in the demand schedule.
Overall, the expected impact of the increased expansion by
businesses is an outward shift in the demand curve but no
obvious change in the supply schedule; see Exhibit 2.8. Note
that the shift in the aggregate demand curve to DA2 causes an
increase in the equilibrium interest rate to i2.
Just as economic growth puts upward pressure on interest
rates, an economic slowdown puts downward pressure on the
equilibrium interest rate.
EXAMPLE
A slowdown in the economy will cause the demand curve to
shift inward (to the left), reflecting less demand for loanable
funds at any given interest rate. The supply curve may shift a
little, but the direction of its shift is uncertain. One could argue
that a slowdown should cause increased saving (regardless of
the interest rate) as households prepare for possible layoffs. At

the same time, the gradual reduction in labor income that occurs
during an economic slowdown could reduce households' ability
to save. Historical data support this latter expectation. Once
again, any shift that does occur will likely be minor relative to
the shift in the demand schedule. The equilibrium interest rate
is therefore expected to decrease, as illustrated in Exhibit 2.9.
Exhibit 2.8 Impact of Increased Expansion by Firms
2-2b Impact of Inflation on Interest Rates
Changes in inflationary expectations can affect interest rates by
affecting the amount of spending by households or businesses.
Decisions to spend affect the amount saved (supply of funds)
and the amount borrowed (demand for funds).
EXAMPLE
Assume the U.S. inflation rate is expected to increase.
Households that supply funds may reduce their savings at any
interest rate level so that they can make more purchases now
before prices rise. This shift in behavior is reflected by an
inward shift (to the left) in the supply curve of loanable funds.
In addition, households and businesses may be willing to
borrow more funds at any interest rate level so that they can
purchase products now before prices increase. This is reflected
by an outward shift (to the right) in the demand curve for
loanable funds. These shifts are illustrated in Exhibit 2.10. The
new equilibrium interest rate is higher because of these shifts in
saving and borrowing behavior.
Exhibit 2.9 Impact of an Economic Slowdown
Exhibit 2.10 Impact of an Increase in Inflationary Expectations
on Interest Rates
Fisher Effect More than 70 years ago, Irving Fisher proposed a
theory of interest rate determination that is still widely used
today. It does not contradict the loanable funds theory but
simply offers an additional explanation for interest rate
movements. Fisher proposed that nominal interest payments

compensate savers in two ways. First, they compensate for a
saver's reduced purchasing power. Second, they provide an
additional premium to savers for forgoing present consumption.
Savers are willing to forgo consumption only if they receive a
premium on their savings above the anticipated rate of inflation,
as shown in the following equation:
i = E(INF) + iR
where
· i= nominal or quoted rate of interest
· E(INF)= expected inflation rate
· iR= real interest rate
This relationship between interest rates and expected inflation
is often referred to as the Fisher effect. The difference between
the nominal interest rate and the expected inflation rate is the
real return to a saver after adjusting for the reduced purchasing
power over the time period of concern. It is referred to as
the real interest rate because, unlike the nominal rate of
interest, it adjusts for the expected rate of inflation. The
preceding equation can be rearranged to express the real interest
rate as
iR = i − E(INF)
When the inflation rate is higher than anticipated, the real
interest rate is relatively low. Borrowers benefit because they
were able to borrow at a lower nominal interest rate than would
have been offered if inflation had been accurately forecasted.
When the inflation rate is lower than anticipated, the real
interest rate is relatively high and borrowers are adversely
affected.
WEB
www.federalreserve.gov/monetarypolicy/fomc.htm
Information on how the Fed controls the money supply.
Throughout the text, the term “interest rate” will be used to
represent the nominal, or quoted, rate of interest. Keep in mind,
however, that inflation may prevent purchasing power from
increasing during periods of rising interest rates.
2-2c Impact of Monetary Policy on Interest Rates

The Federal Reserve can affect the supply of loanable funds by
increasing or reducing the total amount of deposits held at
commercial banks or other depository institutions. The process
by which the Fed adjusts the money supply is described
in Chapter 4. When the Fed increases the money supply, it
increases the supply of loanable funds and this places downward
pressure on interest rates.
EXAMPLE
The credit crisis intensified during the fall of 2008, and
economic conditions weakened. The Fed increased the money
supply in the banking system as a means of ensuring that funds
were available for households or businesses that wanted to
borrow funds. Consequently, financial institutions had more
funds available that they could lend. The increase in the supply
of loanable funds placed downward pressure on interest rates.
Because the demand for loanable funds decreased during this
period (as explained previously), the downward pressure on
interest rates was even more pronounced. Interest rates declined
substantially in the fall of 2008 in response to these two forces.
Since the economy remained weak even after the credit crisis,
the Fed continued its policy of injecting funds into the banking
system during the 2009–2013 period in order to keep interest
rates (the cost of borrowing) low. Its policy was intended to
encourage corporations and households to borrow and spend
money, in order to stimulate the economy.
If the Fed reduces the money supply, it reduces the supply of
loanable funds. Assuming no change in demand, this action
places upward pressure on interest rates.
2-2d Impact of the Budget Deficit on Interest Rates
When the federal government enacts fiscal policies that result in
more expenditures than tax revenue, the budget deficit is
increased. Because of large budget deficits in recent years, the
U.S. government is a major participant in the demand for
loanable funds. A higher federal government deficit increases
the quantity of loanable funds demanded at any prevailing
interest rate, which causes an outward shift in the demand

curve. Assuming that all other factors are held constant, interest
rates will rise. Given a finite amount of loanable funds supplied
to the market (through savings), excessive government demand
for these funds tends to “crowd out” the private demand (by
consumers and corporations) for funds. The federal government
may be willing to pay whatever is necessary to borrow these
funds, but the private sector may not. This impact is known as
the crowding-out effect. Exhibit 2.11 illustrates the flow of
funds between the federal government and the private sector.
There is a counterargument that the supply curve might shift
outward if the government creates more jobs by spending more
funds than it collects from the public (this is what causes the
deficit in the first place). If this were to occur, then the deficit
might not place upward pressure on interest rates. Much
research has investigated this issue and has generally shown
that, when holding other factors constant, higher budget deficits
place upward pressure on interest rates.
2-2e Impact of Foreign Flows of Funds on Interest Rates
The interest rate for a specific currency is determined by the
demand for funds denominated in that currency and the supply
of funds available in that currency.
EXAMPLE
The supply and demand curves for the U.S. dollar and for
Brazil's currency, the real, are compared for a given point in
time in Exhibit 2.12. Although the demand curve for loanable
funds should be downward sloping for every currency and the
supply schedule should be upward sloping, the actual positions
of these curves vary among currencies. First, notice that the
demand and supply curves are farther to the right for the dollar
than for the Brazilian real. The amount of U.S. dollar-
denominated loanable funds supplied and demanded is much
greater than the amount of Brazilian real-denominated loanable
funds because the U.S. economy is much larger than Brazil's
economy.
Exhibit 2.11 Flow of Funds between the Federal Government

and the Private Sector
Exhibit 2.12 Demand and Supply Curves for Loanable Funds
Denominated in U.S. Dollars and Brazilian Real
Observe also that the positions of the demand and supply
curves for loanable funds are much higher for the Brazilian real
than for the dollar. The supply schedule for loanable funds
denominated in Brazilian real shows that hardly any amount of
savings would be supplied at low interest rate levels because the
relatively high inflation in Brazil encourages households to
spend more of their disposable income before prices increase.
This discourages households from saving unless the interest rate
is sufficiently high. In addition, the demand for loanable funds
denominated in Brazilian real shows that borrowers are willing
to borrow even at relatively high rates of interest because they
want to make purchases now before prices increase. Firms are
willing to pay 15 percent interest on a loan to purchase
machines whose prices may increase 20 percent by the
following year.
Because of the different positions of the demand and supply
curves for the two currencies shown in Exhibit 2.12, the
equilibrium interest rate is much higher for the Brazilian real
than for the dollar. As the demand and supply schedules change
over time for a specific currency, so will the equilibrium
interest rate. For example, if Brazil's government could
substantially reduce local inflation, then the supply curve of
loanable funds denominated in the Brazilian real would shift out
(to the right) while the demand schedule of loanable funds
would shift in (to the left). The result would be a lower
equilibrium interest rate.
In recent years, massive flows of funds have shifted between
countries, causing abrupt adjustments in the supply of funds
available in each country and thereby affecting interest rates. In
general, the shifts are driven by large institutional investors
seeking a high return on their investments. These investors

commonly attempt to invest funds in debt securities in countries
where interest rates are high. However, many countries that
typically have relatively high interest rates also tend to have
high inflation, which can weaken their local currencies. Since
the depreciation (decline in value) of a currency can more than
offset a high interest rate in some cases, investors tend to avoid
investing in countries with high interest rates if the threat of
inflation is very high.
2-2f Summary of Forces That Affect Interest Rates
In general, economic conditions are the primary forces behind a
change in the supply of savings provided by households or a
change in the demand for funds by households, businesses, or
the government. The saving behavior of the households that
supply funds in the United States is partially influenced by U.S.
fiscal policy, which determines the taxes paid by U.S.
households and thus determines the level of disposable income.
The Federal Reserve's monetary policy also affects the supply
of funds in the United States because it determines the U.S.
money supply. The supply of funds provided to the United
States by foreign investors is influenced by foreign economic
conditions, including foreign interest rates.
WEB
http://research.stlouisfed.org/fred2
Time series of various interest rates provided by the Federal
Reserve Economic Databank.
The demand for funds in the United States is indirectly
affected by U.S. monetary and fiscal policies because these
policies influence economic growth and inflation, which in turn
affect business demand for funds. Fiscal policy determines the
budget deficit and therefore determines the federal government
demand for funds.
EXAMPLE
Exhibit 2.13 plots U.S. interest rates over recent decades and
illustrates how they are affected by the forces of monetary and
fiscal policy. From 2000 to the beginning of 2003, the U.S.
economy was very weak, which reduced the business and

household demand for loanable funds and caused interest rates
to decline. During the period 2005-2007, U.S. economic growth
increased and interest rates rose.
However, the credit crisis that began in 2008 caused the
economy to weaken substantially, and interest rates declined to
extremely low levels. During the crisis, the federal government
experienced a huge budget deficit as it bailed out some firms
and increased its spending in various ways to stimulate the
economy. Although the large government demand for funds
placed upward pressure on interest rates, this pressure was
offset by a weak demand for funds by firms (as businesses
canceled their plans to expand). In addition, the Federal Reserve
increased the money supply at this time in order to push interest
rates lower in an attempt to encourage businesses and
households to borrow and spend money. The weak economy and
the Fed's monetary policy continued during the next four years,
which allowed interest rates to remain at very low levels. The
Fed's monetary policy had more influence on U.S. interest rates
than any other factor during the 2008-2013 period. In some
other periods, the monetary policy is not as pronounced, and
other factors have more influence on interest rates.
Exhibit 2.13 Interest Rate Movements over Time
Exhibit 2.14 Framework for Forecasting Interest Rates
This summary does not cover every possible interaction
among the forces that can affect interest rate movements, but it
does illustrate how some key factors have an influence on
interest rates over time. Because the prices of some securities
are influenced by interest rate movements, those prices are
affected by the factors discussed here, as explained more fully
in subsequent chapters.
2-3 FORECASTING INTEREST RATES
WEB
http://research.stlouisfed.org/fred2
Quotations of current interest rates and trends of historical

interest rates for various debt securities.
Exhibit 2.14 summarizes the key factors that are evaluated when
forecasting interest rates. With an understanding of how each
factor affects interest rates, it is possible to forecast how
interest rates may change in the future. When forecasting
household demand for loanable funds, it may be necessary to
assess consumer credit data to determine the borrowing capacity
of households. The potential supply of loanable funds provided
by households may be determined in a similar manner by
assessing factors that affect the earning power of households.
Business demand for loanable funds can be forecast by
assessing future plans for corporate expansion and the future
state of the economy. Federal government demand for loanable
funds could be influenced by the economy's future state because
it affects tax revenues to be received and the amount of
unemployment compensation to be paid out, factors that affect
the size of the government deficit. The Federal Reserve
System's money supply targets may be assessed by reviewing
public statements about the Fed's future objectives, although
those statements are rather vague.
To forecast future interest rates, the net demand for funds
(ND) should be forecast:
ND = DA − SA = (Dh + Db + Dg + Dm + Df) −
(Sh + Sb + Sg + Sm + Sf)
If the forecasted level of ND is positive or negative, then a
disequilibrium will exist temporarily. If ND is positive, the
disequilibrium will be corrected by an upward adjustment in
interest rates; if ND is negative, the disequilibrium will be
corrected by a downward adjustment. The larger the forecasted
magnitude of ND, the larger the adjustment in interest rates.
Some analysts focus more on changes in DA and SA than on
estimating their aggregate levels. For example, assume that
today the equilibrium interest rate is 7 percent. This interest
rate will change only if DA and SA change to create a
temporary disequilibrium. If the government demand for funds
(Dg) is expected to increase substantially and if no other

components are expected to change, DA will exceed SA, placing
upward pressure on interest rates. Thus the forecast of future
interest rates can be derived without estimating every
component comprised by DA and SA.
SUMMARY
· ▪ The loanable funds framework shows how the equilibrium
interest rate depends on the aggregate supply of available funds
and the aggregate demand for funds. As conditions cause the
aggregate supply or demand schedules to change, interest rates
gravitate toward a new equilibrium.
· ▪ The relevant factors that affect interest rate movements
include changes in economic growth, inflation, the budget
deficit, foreign interest rates, and the money supply. These
factors can have a strong impact on the aggregate supply of
funds and/or the aggregate demand for funds and can thereby
affect the equilibrium interest rate. In particular, economic
growth has a strong influence on the demand for loanable funds,
and changes in the money supply have a strong impact on the
supply of loanable funds.
· ▪ Given that the equilibrium interest rate is determined by
supply and demand conditions, changes in the interest rate can
be forecasted by forecasting changes in the supply of and the
demand for loanable funds. Thus, the factors that influence the
supply of funds and the demand for funds must be forecast in
order to forecast interest rates.
POINT COUNTER-POINT
Does a Large Fiscal Budget Deficit Result in Higher Interest
Rates?
Point No. In some years (such as 2008), the fiscal budget deficit
was large but interest rates were very low.
Counter-Point Yes. When the federal government borrows large
amounts of funds, it can crowd out other potential borrowers,
and the interest rates are bid up by the deficit units.

· 1.Interest Rate Movements Explain why interest rates changed
as they did over the past year.
· 2.Interest Elasticity Explain what is meant by interest
elasticity. Would you expect the federal government's demand
for loanable funds to be more or less interest-elastic than
household demand for loanable funds? Why?
· 3.Impact of Government Spending If the federal government
planned to expand the space program, how might this affect
interest rates?
· 4.Impact of a Recession Explain why interest rates tend to
decrease during recessionary periods. Review historical interest
rates to determine how they reacted to recessionary periods.
Explain this reaction.
· 5.Impact of the Economy Explain how the expected interest
rate in one year depends on your expectation of economic
growth and inflation.
· 6.Impact of the Money Supply Should increasing money
supply growth place upward or downward pressure on interest
rates?
· 7.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.
· 8.Nominal versus Real Interest Rate What is the difference
between the nominal interest rate and the real interest rate?
What is the logic behind the implied positive relationship
between expected inflation and nominal interest rates?
· 9.Real Interest Rate Estimate the real interest rate over the last
year. If financial market participants overestimate inflation in a
particular period, will real interest rates be relatively high or
low? Explain.
· 10.Forecasting Interest Rates Why do forecasts of interest
rates differ among experts?

Advanced Questions
· 11.Impact of Stock Market Crises During periods when
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 also 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.
· 12.Impact of Expected Inflation How might expectations of
higher oil prices affect the demand for loanable funds, the
supply of loanable funds, and interest rates in the United
States? Will the interest rates of other countries be affected in
the same way? Explain.
· 13.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?
· 14.Impact of War 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?
· 15.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 that attack could have placed upward
pressure on U.S. interest rates.
· 16.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 expected 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
effects of other factors, so it forecast interest rates to increase
by 2 percentage points. Comment on Jayhawk's logic.
· 17.Decomposing Interest Rate Movements The interest rate on

a one-year loan can be decomposed into a one-year, risk-free
(free from default risk) component and a risk premium that
reflects the potential for default on the loan in that year. A
change in economic conditions can affect the risk-free rate and
the risk premium. The risk-free rate is normally affected by
changing economic conditions to a greater degree than is the
risk premium. Explain how a weaker economy will likely affect
the risk-free component, the risk premium, and the overall cost
of a one-year loan obtained by (a) the Treasury and (b) a
corporation. Will the change in the cost of borrowing be more
pronounced for the Treasury or for the corporation? Why?
· 18.Forecasting Interest Rates Based on Prevailing
Conditions Consider the prevailing conditions for inflation
(including oil prices), the economy, the budget deficit, and the
Fed's monetary policy that could affect interest rates. Based on
these conditions, do you think interest rates will likely increase
or decrease during this semester? Offer some logic to support
your answer. Which factor do you think will have the greatest
impact on interest rates?
· 19.Impact of Economic Crises on Interest Rates When
economic crises in countries are due to a weak economy, local
interest rates tend to be very low. However, if the crisis was
caused by an unusually high rate of inflation, interest rates tend
to be very high. Explain why.
· 20.U.S. Interest Rates during the Credit Crisis During the
credit crisis, U.S. interest rates were extremely low, which
enabled businesses to borrow at a low cost. Holding other
factors constant, this should result in a higher number of
feasible projects, which should encourage businesses to borrow
more money and expand. Yet many businesses that had access
to loanable funds were unwilling to borrow during the credit
crisis. What other factor changed during this period that more
than offset the potentially favorable effect of the low interest
rates on project feasibility, thereby discouraging businesses
from expanding?
· 21.Political Influence on Interest Rates Offer an argument for

why a political regime that favors a large government will cause
interest rates to be higher. Offer at least one example of why a
political regime that favors a large government will cause
interest rates to be lower. [Hint: Recognize that the government
intervention in the economy can influence other factors that
affect interstates.]
· 22.Impact of Stock Market Uncertainty Consider a period in
which stock prices are very high, such that investors begin to
think that stocks are overvalued and their valuations are very
uncertain. If investors decide to move their money into much
safer investments, how do you think this would affect general
interest rate levels? In your answer, use the loanable funds
framework by explaining how the supply or demand for
loanable funds would be affected by the investor actions, and
how this force would affect interest rates.
· 23.Impact of the European Economy In 2012, some economists
suggested that U.S. interest rates are dictated by the weak
economic conditions in Europe. Use the loanable funds
framework to explain how European economic conditions might
affect U.S. interest rates.
Interpret the following comments made by Wall Street analysts
and portfolio managers.
· a. “The flight of funds from bank deposits to U.S. stocks will
pressure interest rates.”
· b. “Since Japanese interest rates have recently declined to very
low levels, expect a reduction in 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.”
Forecasting Interest Rates As the treasurer of a manufacturing
company, your task is to forecast the direction of interest rates.
You plan to borrow funds and may use the forecast of interest
rates to determine whether you should obtain a loan with a fixed
interest rate or a floating interest rate. The following

information can be considered when assessing the future
direction of interest rates.
· ▪ Economic growth has been high over the last two years, but
you expect that it will be stagnant over the next year.
· ▪ Inflation has been 3 percent over each of the last few years,
and you expect that it will be about the same over the next year.
· ▪ The federal government has announced major cuts in its
spending, which should have a major impact on the budget
deficit.
· ▪ The Federal Reserve is not expected to affect the existing
supply of loanable funds over the next year.
· ▪ The overall level of savings by households is not expected to
change.
· a. Given the preceding information, assess how the demand for
and the supply of loanable funds would be affected, if at all,
and predict the future direction of interest rates.
· b. You can obtain a one-year loan at a fixed rate of 8 percent
or a floating-rate loan that is currently at 8 percent but would be
revised every month in accordance with general interest rate
movements. Which type of loan is more appropriate based on
the information provided?
· c. Assume that Canadian interest rates have abruptly risen just
as you have completed your forecast of future U.S. interest
rates. Consequently, Canadian interest rates are now 2
percentage points above U.S. interest rates. How might this
specific situation place pressure on U.S. interest rates?
Considering this situation along with the other information
provided, would you change your forecast of the future
direction of U.S. interest rates?
PROBLEMS
· 1.Nominal Rate of Interest Suppose the real interest rate is 6
percent and the expected inflation rate is 2 percent. What would
you expect the nominal rate of interest to be?
· 2.Real Interest Rate Suppose that Treasury bills are currently
paying 9 percent and the expected inflation rate is 3 percent.
What is the real interest rate?

How the Flow of Funds Affects Interest Rates
Recall that Carson Company has obtained substantial loans from
finance companies and commercial banks. The interest rate on
the loans is tied to market interest rates and is adjusted every
six months. Thus, Carson's cost of obtaining funds is sensitive
to interest rate movements. Given its expectations that the U.S.
economy will strengthen, Carson plans to grow in the future by
expanding and by making acquisitions. Carson expects that it
will need substantial long-term financing to pay for this growth,
and it plans to borrow additional funds either through existing
loans or by issuing bonds. The company is also considering the
possibility of issuing stock to raise funds in the next year.
· a. Explain why Carson should be very interested in future
interest rate movements.
· b. Given Carson's expectations, do you think the company
anticipates that interest rates will increase or decrease in the
future? Explain.
· c. If Carson's expectations of future interest rates are correct,
how would this affect its cost of borrowing on its existing loans
and on its future loans?
· d. Explain why Carson's expectations about future interest
rates may affect its decision about when to borrow funds and
whether to obtain floating-rate or fixed-rate loans.
· 1. Go to http://research.stlouisfed.org/fred2. Under
“Categories,” select “Interest rates” and then select the three-
month Treasury-bill series (secondary market). Describe how
this rate has changed in recent months. Using the information in
this chapter, explain why the interest rate changed as it did.
· 2. Using the same website, retrieve data at the beginning of
the last 20 quarters for interest rates (based on the three-month
Treasury-bill rate) and the producer price index for all
commodities and place the data in two columns of an Excel
spreadsheet. Derive the change in interest rates on a quarterly
basis. Then derive the percentage change in the producer price

index on a quarterly basis, which serves as a measure of
inflation. Apply regression analysis in which the change in
interest rates is the dependent variable and inflation is the
independent variable (see Appendix B for information about
applying regression analysis). Explain the relationship that you
find. Does it appear that inflation and interest rate movements
are positively related?
WSJ EXERCISE
Forecasting Interest Rates
Review information about the credit markets in a recent issue of
the Wall Street Journal. Identify the factors that are given
attention because they may affect future interest rate
movements. Then create your own forecasts as to whether
interest rates will increase or decrease from now until the end of
the school term, based on your assessment of any factors that
affect interest rates. Explain your forecast.
this chapter.
· 1. budget deficit AND interest rate
· 2. flow of funds AND interest rate
· 3. Federal Reserve AND interest rate
· 4. economic growth AND interest rate

· 5. inflation AND interest rate
· 6. monetary policy AND interest rate
· 7. supply of savings AND interest rate
· 8. business expansion AND interest rate
· 9. demand for credit AND interest rate
· 10. interest rate AND forecast
1 Role of Financial Markets and Institutions
CHAPTER OBJECTIVES
· ▪ describe the types of financial markets that facilitate the
flow of funds,
· ▪ describe the types of securities traded within financial
markets,
· ▪ describe the role of financial institutions within financial
markets, and
· ▪ explain how financial institutions were exposed to the credit
crisis.
A financial market is a market in which financial assets
(securities) such as stocks and bonds can be purchased or sold.
Funds are transferred in financial markets when one party
purchases financial assets previously held by another party.
Financial markets facilitate the flow of funds and thereby allow
financing and investing by households, firms, and government
agencies. This chapter provides some background on financial
markets and on the financial institutions that participate in
them.
1-1 ROLE OF FINANCIAL MARKETS
Financial markets transfer funds from those who have excess
funds to those who need funds. They enable college students to
obtain student loans, families to obtain mortgages, businesses to
finance their growth, and governments to finance many of their
expenditures. Many households and businesses with excess
funds are willing to supply funds to financial markets because
they earn a return on their investment. If funds were not

supplied, the financial markets would not be able to transfer
funds to those who need them.
Those participants who receive more money than they spend
are referred to as surplus units (or investors). They provide
their net savings to the financial markets. Those participants
who spend more money than they receive are referred to
as deficit units. They access funds from financial markets so
that they can spend more money than they receive. Many
individuals provide funds to financial markets in some periods
and access funds in other periods.
EXAMPLE
College students are typically deficit units, as they often borrow
from financial markets to support their education. After they
obtain their degree, they earn more income than they spend and
thus become surplus units by investing their excess funds. A
few years later, they may become deficit units again by
purchasing a home. At this stage, they may provide funds to and
access funds from financial markets simultaneously. That is,
they may periodically deposit savings in a financial institution
while also borrowing a large amount of money from a financial
institution to buy a home.
Many deficit units such as firms and government agencies
access funds from financial markets by issuing securities, which
represent a claim on the issuer. Debt securities represent debt
(also called credit, or borrowed funds) incurred by the issuer.
Deficit units that issue the debt securities are borrowers. The
surplus units that purchase debt securities are creditors, and
they receive interest on a periodic basis (such as every six
months). Debt securities have a maturity date, at which time the
surplus units can redeem the securities in order to receive the
principal (face value) from the deficit units that issued them.
Equity securities (also called stocks) represent equity or
ownership in the firm. Some large businesses prefer to issue
equity securities rather than debt securities when they need
funds but might not be financially capable of making the
periodic interest payments required for debt securities.

1-1a Accommodating Corporate Finance Needs
A key role of financial markets is to accommodate corporate
finance activity. Corporate finance (also called financial
management) involves corporate decisions such as how much
funding to obtain and what types of securities to issue when
financing operations. The financial markets serve as the
mechanism whereby corporations (acting as deficit units) can
obtain funds from investors (acting as surplus units).
1-1b Accommodating Investment Needs
Another key role of financial markets is accommodating surplus
units who want to invest in either debt or equity securities.
Investment management involves decisions by investors
regarding how to invest their funds. The financial markets offer
investors access to a wide variety of investment opportunities,
including securities issued by the U.S. Treasury and government
agencies as well as securities issued by corporations.
Financial institutions (discussed later in this chapter) serve as
intermediaries within the financial markets. They channel funds
from surplus units to deficit units. For example, they channel
funds received from individuals to corporations. Thus they
connect the investment management activity with the corporate
finance activity, as shown in Exhibit 1.1. They also commonly
serve as investors and channel their own funds to corporations.
WEB
www.nyse.com
New York Stock Exchange market summary, quotes, financial
statistics, and more.
www.nasdaq.com
Comprehensive historic and current data on all Nasdaq
transactions.
1-1c Primary versus Secondary Markets
Primary markets facilitate the issuance of new
securities. Secondary markets facilitate the trading of existing
securities, which allows for a change in the ownership of the
securities. Many types of debt securities have a secondary
market, so that investors who initially purchased them in the

primary market do not have to hold them until maturity. Primary
market transactions provide funds to the initial issuer of
securities; secondary market transactions do not.
EXAMPLE
Last year, Riverto Co. had excess funds and invested in newly
issued Treasury debt securities with a 10-year maturity. This
year, it will need $15 million to expand its operations. The
company decided to sell its holdings of Treasury debt securities
in the secondary market even though those securities will not
mature for nine more years. It received $5 million from the sale.
In also issued its own debt securities in the primary market
today in order to obtain an additional $10 million. Riverto's
debt securities have a 10-year maturity, so investors that
purchase them can redeem them at maturity (in 10 years) or sell
them before that time to other investors in the secondary
market.
Exhibit 1.1 How Financial Markets Facilitate Corporate Finance
and Investment Management
An important characteristic of securities that are traded in
secondary markets is liquidity, which is the degree to which
securities can easily be liquidated (sold) without a loss of value.
Some securities have an active secondary market, meaning that
there are many willing buyers and sellers of the security at a
given moment in time. Investors prefer liquid securities so that
they can easily sell the securities whenever they want (without a
loss in value). If a security is illiquid, investors may not be able
to find a willing buyer for it in the secondary market and may
have to sell the security at a large discount just to attract a
buyer.
Treasury securities are liquid because they are frequently
issued by the Treasury, and there are many investors at any
point in time who want to invest in them. Conversely, debt
securities issued by a small firm may be illiquid, as there are
not many investors who may want to invest in them. Thus
investors who purchase these securities in the primary market

may not be able to easily sell them in the secondary market.
1-2 SECURITIES TRADED IN FINANCIAL MARKETS
Securities can be classified as money market securities, capital
market securities, or derivative securities.
1-2a Money Market Securities
Money markets facilitate the sale of short-term debt securities
by deficit units to surplus units. The securities traded in this
market are referred to as money market securities, which are
debt securities that have a maturity of one year or less. These
generally have a relatively high degree of liquidity, not only
because of their short-term maturity but also because they are
desirable to many investors and therefore commonly have an
active secondary market. Money market securities tend to have
a low expected return but also a low degree of credit (default)
risk. Common types of money market securities include
Treasury bills (issued by the U.S. Treasury), commercial paper
(issued by corporations), and negotiable certificates of deposit
(issued by depository institutions).
1-2b Capital Market Securities
Capital markets facilitate the sale of long-term securities by
deficit units to surplus units. The securities traded in this
market are referred to as capital market securities. Capital
market securities are commonly issued to finance the purchase
of capital assets, such as buildings, equipment, or machinery.
Three common types of capital market securities are bonds,
mortgages, and stocks, which are described in turn.
WEB
www.investinginbonds.com
Data and other information about bonds.
Bonds Bonds are long-term debt securities issued by the
Treasury, government agencies, and corporations to finance
their operations. They provide a return to investors in the form
of interest income (coupon payments) every six months. Since
bonds represent debt, they specify the amount and timing of
interest and principal payments to investors who purchase them.
At maturity, investors holding the debt securities are paid the

principal. Bonds commonly have maturities of between 10 and
20 years.
Treasury bonds are perceived to be free from default risk
because they are issued by the U.S. Treasury. In contrast, bonds
issued by corporations are subject to default risk because the
issuer could default on its obligation to repay the debt. These
bonds must offer a higher expected return than Treasury bonds
in order to compensate investors for that default risk.
Bonds can be sold in the secondary market if investors do not
want to hold them until maturity. Because the prices of debt
securities change over time, they may be worthless when sold in
the secondary market than when they were purchased.
Mortgages Mortgages are long-term debt obligations created to
finance the purchase of real estate. Residential mortgages are
obtained by individuals and families to purchase homes.
Financial institutions serve as lenders by providing residential
mortgages in their role as a financial intermediary. They can
pool deposits received from surplus units, and lend those funds
to an individual who wants to purchase a home. Before granting
mortgages, they assess the likelihood that the borrower will
repay the loan based on certain criteria such as the borrower's
income level relative to the value of the home. They offer prime
mortgages to borrowers who qualify based on these criteria. The
home serves as collateral in the event that the borrower is not
able to make the mortgage payments.
Subprime mortgages are offered to some borrowers who do
not have sufficient income to qualify for prime mortgages or
who are unable to make a down payment. Subprime mortgages
exhibit a higher risk of default, thus the lenders providing these
mortgages charge a higher interest rate (and additional up-front
fees) to compensate. Subprime mortgages received much
attention in 2008 because of their high default rates, which led
to the credit crisis. Many lenders are no longer willing to
provide subprime mortgages, and recent regulations (described
later in this chapter) raise the minimum qualifications necessary
to obtain a mortgage.

Commercial mortgages are long-term debt obligations created
to finance the purchase of commercial property. Real estate
developers rely on commercial mortgages so they can build
shopping centers, office buildings, or other facilities. Financial
institutions serve as lenders by providing commercial
mortgages. By channeling funds from surplus units (depositors)
to real estate developers, they serve as a financial intermediary
and facilitate the development of commercial real estate.
Mortgage-Backed Securities Mortgage-backed securities are
debt obligations representing claims on a package of mortgages.
There are many forms of mortgage-backed securities. In their
simplest form, the investors who purchase these securities
receive monthly payments that are made by the homeowners on
the mortgages backing the securities.
EXAMPLE
Mountain Savings Bank originates 100 residential mortgages for
home buyers and will service the mortgages by processing the
monthly payments. However, the bank does not want to use its
own funds to finance the mortgages. It issues mortgage-backed
securities that represent this package of mortgages to eight
financial institutions that are willing to purchase all of these
securities. Each month, when Mountain Savings Bank receives
interest and principal payments on the mortgages, it passes
those payments on to the eight financial institutions that
purchased the mortgage-backed securities and thereby provided
the financing to the homeowners. If some of the homeowners
default on their payments, the payments, and thus the return on
investment earned by the financial institutions that purchased
the mortgage-backed securities, will be reduced. The securities
they purchased are backed (collateralized) by the mortgages.
In many cases, the financial institution that originates the
mortgage is not accustomed to the process of issuing mortgage-
backed securities. If Mountain Savings Bank is unfamiliar with
the process, another financial institution may participate by
bundling Mountain's 100 mortgages with mortgages originated
by other institutions. Then the financial institution issues

mortgage-backed securities that represent all the mortgages in
the bundle. Thus any investor that purchases these mortgage-
backed securities is partially financing the 100 mortgages at
Mountain Savings Bank and all the other mortgages in the
bundle that are backing these securities.
As housing prices increased in the 2004–2006 period, many
financial institutions used their funds to purchase mortgage-
backed securities, some of which represented bundles of
subprime mortgages. These financial institutions incorrectly
presumed that the homes would serve as sufficient collateral if
the mortgages defaulted. In 2008, many subprime mortgages
defaulted and home prices plummeted, which meant that the
collateral was not adequate to cover the credit provided.
Consequently, the values of mortgage-backed securities also
plummeted, and the financial institutions holding these
securities experienced major losses.
Stocks Stocks (or equity securities) represent partial ownership
in the corporations that issue them. They are classified as
capital market securities because they have no maturity and
therefore serve as a long-term source of funds. Investors who
purchase stocks (referred to as stockholders) issued by a
corporation in the primary market can sell the stocks to other
investors at any time in the secondary market. However, stocks
of some corporations are more liquid than stocks of others.
More than a million shares of stocks of large corporations are
traded in the secondary market on any given day, as there are
many investors who are willing to buy them. Stocks of small
corporations are less liquid, because the secondary market is not
as active.
Some corporations provide income to their stockholders by
distributing a portion of their quarterly earnings in the form of
dividends. Other corporations retain and reinvest all of their
earnings in their operations, which increase their growth
potential.
As corporations grow and increase in value, the value of their
stock increases; investors can then earn a capital gain from

selling the stock for a higher price than they paid for it. Thus,
investors can earn a return from stocks in the form of periodic
dividends (if there are any) and in the form a capital gain when
they sell the stock. However, stocks are subject to risk because
their future prices are uncertain. Their prices commonly decline
when the firm performs poorly, resulting in negative returns to
investors.
1-2c Derivative Securities
In addition to money market and capital market securities,
derivative securities are also traded in financial
markets. Derivative securities are financial contracts whose
values are derived from the values of underlying assets (such as
debt securities or equity securities). Many derivative securities
enable investors to engage in speculation and risk management.
WEB
www.cboe.com
Information about derivative securities.
Speculation Derivative securities allow an investor to speculate
on movements in the value of the underlying assets without
having to purchase those assets. Some derivative securities
allow investors to benefit from an increase in the value of the
underlying assets, whereas others allow investors to benefit
from a decrease in the assets' value. Investors who speculate in
derivative contracts can achieve higher returns than if they had
speculated in the underlying assets, but they are also exposed to
higher risk.
Risk Management Derivative securities can be used in a manner
that will generate gains if the value of the underlying assets
declines. Consequently, financial institutions and other firms
can use derivative securities to adjust the risk of their existing
investments in securities. If a firm maintains investments in
bonds, it can take specific positions in derivative securities that
will generate gains if bond values decline. In this
way, derivative securities can be used to reduce a firm's risk.
The loss on the bonds is offset by the gains on these derivative
securities.

1-2d Valuation of Securities
Each type of security generates a unique stream of expected
cash flows to investors. The valuation of a security is measured
as the present value of its expected cash flows, discounted at a
rate that reflects the uncertainty surrounding the cash flows.
Debt securities are easier to value because they promise to
investors specific payments (interest and principal) until they
mature. The stream of cash flows generated by stocks is more
difficult to estimate because some stocks do not pay dividends,
and so investors receive cash flow only when they sell the
stock. All investors sell the stock at different times. Thus some
investors choose to value a stock by valuing the company and
then dividing that value by the number of shares of stock.
Impact of Information on Valuation Investors can attempt to
estimate the future cash flows that they will receive by
obtaining information that may influence a security's future
cash flows. The valuation process is illustrated in Exhibit 1.2.
Some investors rely mostly on economic or industry
information to value a security, whereas others rely more on
published opinions about the firm's management. When
investors receive new information about a security that clearly
indicates the likelihood of higher cash flows or less uncertainty
surrounding the cash flows, they revise their valuations of that
security upward. As a result, investors increase the demand for
the security. In addition, investors that previously purchased
that security and were planning to sell the security in the
secondary market may decide not to sell. This results in a
smaller supply of that security for sale (by investors who had
previously purchased it) in the secondary market. Thus the
market price of the security rises to a new equilibrium level.
Conversely, when investors receive unfavorable information,
they reduce the expected cash flows or increase the discount
rate used in valuation. The valuations of the security are revised
downward, which results in a lower demand and an increase in
the supply of that security for sale in the secondary market.
Consequently, there is a decline in the equilibrium price.

Exhibit 1.2 Use of Information to Make Investment Decisions
In an efficient market, securities are rationally priced. If a
security is clearly undervalued based on public information,
some investors will capitalize on the discrepancy by purchasing
that security. This strong demand for the security will push the
security's price higher until the discrepancy no longer exists.
The investors who recognized the discrepancy will be rewarded
with higher returns on their investment. Their actions to
capitalize on valuation discrepancies typically push security
prices toward their proper price levels, based on the information
that is available.
Impact of the Internet on Valuation The Internet has improved
the valuation of securities in several ways. Prices of securities
are quoted online and can be obtained at any given moment by
investors. For some securities, investors can track the actual
sequence of transactions. Because much more information about
the firms that issue securities is available online, securities can
be priced more accurately. Furthermore, orders to buy or sell
many types of securities can be submitted online, which
expedites the adjustment in security prices to new information.
WEB
finance.yahoo.com
Market quotations and overview of financial market activity.
Impact of Behavioral Finance on Valuation In some cases, a
security may be mispriced because of the psychology involved
in the decision making. Behavioral finance is the application of
psychology to make financial decisions. It offers a reason why
markets are not always efficient.
EXAMPLE
When Facebook issued stock to the public in May 2012, many
critics suggested that the initial high stock price was influenced
by market hype rather than fundamentals (such as its expected
cash flows). Some of Facebook's customers may invest in
Facebook's stock because they commonly use Facebook's
services, without really considering whether the stock price was

appropriate. Facebook's stock price declined by about 50
percent in a few months as the hype in the stock market wore
off.
Behavioral finance can sometimes explain the movements of a
security's price or even of the entire stock market. In some
periods, investors seem to be excessively optimistic, and their
stock-buying frenzy can push the prices of the entire stock
market higher. This leads to a stock price bubble that bursts
once investors consider fundamental characteristics (such as a
firm's cash flows) rather than hype when valuing a stock.
Uncertainty Surrounding Valuation of Securities Even if
markets are efficient, the valuation of a firm's security is
subject to much uncertainty because investors have limited
information available to value that security. Furthermore, the
return from investing in a security over a particular period is
typically uncertain because the cash flows to be received by
investors over that period is uncertain. The higher the degree of
uncertainty, the higher is the risk from investing in that
security. From the perspective of an investor who purchases a
security, risk represents the potential deviation of the security's
actual return from what was expected. For any given type of
security, risk levels among the issuers of that security can vary.
EXAMPLE
Nike stock provides cash flows to investors in the form of
quarterly dividends and when an investor sells the stock. Both
the future dividends and the future stock price are uncertain.
Thus the cash flows that Nike stock will provide to investors
over a future period are uncertain, which means that the return
from investing in Nike stock over that period is uncertain.
Yet the cash flow provided by Nike's stock is less uncertain
than that provided by a small, young, publicly traded
technology company. Because the return on the technology
stock over a particular period is more uncertain than the return
on Nike stock, the technology stock has more risk.
1-2e Securities Regulations
Much of the information that investors use to value securities

issued by firms is provided in the form of financial statements
by those firms. In particular, investors rely on accounting
reports of a firm's revenue and expenses as a basis for
estimating its future cash flows. Although firms with publicly
traded stock are required to disclose financial information and
financial statements, a firm's managers still possess information
about its financial condition that is not necessarily available to
investors. This situation is referred to as asymmetric
information. Even when information is disclosed, an asymmetric
information problem may still exist if some of the information
provided by the firm's managers is intentionally misleading in
order to exaggerate the firm's performance.
Required Disclosure Many regulations exist that attempt to
ensure that businesses disclose accurate financial information.
Similarly, when information is disclosed to only a small set of
investors, those investors have a major advantage over other
investors. Thus another regulatory goal is to provide all
investors with equal access to disclosures by firms. The
Securities Act of 1933 was intended to ensure complete
disclosure of relevant financial information on publicly offered
securities and to prevent fraudulent practices in selling these
securities.
WEB
www.sec.gov
Background on the Securities and Exchange Commission, and
news releases about financial regulations.
The Securities Exchange Act of 1934 extended the disclosure
requirements to secondary market issues. It also declared illegal
a variety of deceptive practices, such as misleading financial
statements and trading strategies designed to manipulate the
market price. In addition, it established the Securities and
Exchange Commission (SEC) to oversee the securities markets,
and the SEC has implemented additional regulations over time.
Securities laws do not prevent investors from making poor
investment decisions; they seek only to ensure full disclosure of
information and thereby protect against fraud.

Regulatory Response to Financial Reporting Scandals Financial
scandals that occurred in the 2001–2002 period proved that the
existing regulations were not sufficient to prevent fraud.
Several well-known companies such as Enron and WorldCom
misled investors by exaggerating their earnings. They also
failed to disclose relevant information that would have
adversely affected the prices of their stock and debt securities.
Firms that have issued stock and debt securities must hire
independent auditors to verify that their financial information is
accurate. However, in some cases, the auditors who were hired
to ensure accuracy were not meeting their responsibility.
In response to the financial scandals, the Sarbanes-Oxley Act
(discussed throughout this text) was passed to require that firms
provide more complete and accurate financial information. It
also imposed restrictions to ensure proper auditing by auditors
and proper oversight by the firm's board of directors. These
rules were intended to regain the trust of investors who supply
the funds to the financial markets. Through these measures,
regulators tried to eliminate or at least reduce the asymmetric
information problem.
However, the Sarbanes-Oxley Act did not completely
eliminate questionable accounting methods. In 2011 and 2012,
Groupon Inc. used accounting methods that inflated its reported
earnings. As these accounting methods were criticized by the
financial media during 2012, the stock price of Groupon
declined by about 85 percent.
1-2f International Securities Transactions
Financial markets are continuously being developed throughout
the world to improve the transfer of securities between surplus
units and deficit units. The financial markets are much more
developed in some countries than in others, and they also vary
in terms of the volumes of funds transferred from surplus to
deficit units. Some countries have more developed financial
markets for specific securities, and other countries (in Eastern
Europe and Asia, for example) have established financial

markets recently.
Under favorable economic conditions, the international
integration of securities markets allows governments and
corporations easier access to funding from creditors or investors
in other countries to support their growth. In addition, investors
and creditors in any country can benefit from the investment
opportunities in other countries. Yet, under unfavorable
economic conditions, the international integration of securities
markets allows one country's financial problems to adversely
affect other countries. The U.S. financial markets allow foreign
investors to pursue investment opportunities in the United
States, but during the U.S. financial crisis, many foreign
investors who invested in U.S. securities experienced severe
losses. Thus the U.S. financial crisis spread beyond the United
States.
Many European governments borrow funds from creditors in
many different countries, but as the governments of Greece,
Portugal, and Spain struggled to repay their loans, they caused
financial problems for some creditors in other countries.
Economic conditions are more closely connected because of the
international integration of securities markets, and this causes
each country to be more exposed to the economic conditions of
other countries.
Foreign Exchange Market International financial transactions
normally require the exchange of currencies. The foreign
exchange market facilitates this exchange. Many commercial
banks and other financial institutions serve as intermediaries in
the foreign exchange market by matching up participants who
want to exchange one currency for another. Some of these
financial institutions also serve as dealers by taking positions in
currencies to accommodate foreign exchange requests.
Like securities, most currencies have a market-determined
price (exchange rate) that changes in response to supply and
demand. If there is a sudden shift in the aggregate demand by
corporations, government agencies, and individuals for a given
currency, or a shift in the aggregate supply of that currency for

sale (to be exchanged for another currency), the price of the
currency (exchange rate) will change.
1-2g Government Intervention in Financial Markets
In recent years, the government has increased its role in
financial markets. Consider the following examples.
· 1. During the credit crisis, the Federal Reserve purchased
various types of debt securities. The intervention was intended
to ensure more liquidity in the debt securities markets, and
therefore encourage investors to purchase debt securities.
· 2. New government regulations changed the manner by which
the credit risk of bonds were assessed. The new regulations
occurred because of criticisms about the previous process used
for rating bonds that did not effectively warn investors about
the credit risk of bonds during the credit crisis.
· 3. The government increased its monitoring of stock trading,
and prosecuted cases in which investors traded based on inside
information about firms that was not available to other
investors. The increased government efforts were intended to
ensure that no investor had an unfair advantage when trading in
financial markets.
These examples illustrate how the government has increased its
efforts to ensure fair and orderly financial markets, which could
encourage more investors to participate in the markets, and
therefore could increase liquidity.
1-3 ROLE OF FINANCIAL INSTITUTIONS
Because financial markets are imperfect, securities buyers and
sellers do not have full access to information. Individuals with
available funds are not normally capable of identifying credit
worthy borrowers to whom they could lend those funds. In
addition, they do not have the expertise to assess the
creditworthiness of potential borrowers. Financial institutions
are needed to resolve the limitations caused by market
imperfections. They accept funds from surplus units and
channel the funds to deficit units. Without financial institutions,
the information and transaction costs of financial market
transactions would be excessive. Financial institutions can be

classified as depository and nondepository institutions.
1-3a Role of Depository Institutions
Depository institutions accept deposits from surplus units and
provide credit to deficit units through loans and purchases of
securities. They are popular financial institutions for the
following reasons.
· ▪ They offer deposit accounts that can accommodate the
amount and liquidity characteristics desired by most surplus
units.
· ▪ They repackage funds received from deposits to provide
loans of the size and maturity desired by deficit units.
· ▪ They accept the risk on loans provided.
· ▪ They have more expertise than individual surplus units in
evaluating the creditworthiness of deficit units.
· ▪ They diversify their loans among numerous deficit units and
therefore can absorb defaulted loans better than individual
surplus units could.
To appreciate these advantages, consider the flow of funds
from surplus units to deficit units if depository institutions did
not exist. Each surplus unit would have to identify a deficit unit
desiring to borrow the precise amount of funds available for the
precise time period in which funds would be available.
Furthermore, each surplus unit would have to perform the credit
evaluation and incur the risk of default. Under these conditions,
many surplus units would likely hold their funds rather than
channel them to deficit units. Hence, the flow of funds from
surplus units to deficit units would be disrupted.
When a depository institution offers a loan, it is acting as a
creditor, just as if it had purchased a debt security. The more
personalized loan agreement is less marketable in the secondary
market than a debt security, however, because the loan
agreement contains detailed provisions that can differ
significantly among loans. Potential investors would need to
review all provisions before purchasing loans in the secondary
market.
A more specific description of each depository institution's

role in the financial markets follows.
Commercial Banks In aggregate, commercial banks are the most
dominant depository institution. They serve surplus units by
offering a wide variety of deposit accounts, and they transfer
deposited funds to deficit units by providing direct loans or
purchasing debt securities. Commercial bank operations are
exposed to risk because their loans and many of their
investments in debt securities are subject to the risk of default
by the borrowers.
Commercial banks serve both the private and public sectors;
their deposit and lending services are utilized by households,
businesses, and government agencies. Some commercial banks
(including Bank of America, J.P. Morgan Chase, Citigroup, and
Sun Trust Banks) have more than $100 billion in assets.
Some commercial banks receive more funds from deposits
than they need to make loans or invest in securities. Other
commercial banks need more funds to accommodate customer
requests than the amount of funds that they receive from
deposits. The federal funds market facilitates the flow of funds
between depository institutions (including banks). A bank that
has excess funds can lend to a bank with deficient funds for a
short-term period, such as one to five days. In this way, the
federal funds market facilitates the flow of funds from banks
that have excess funds to banks that are in need of funds.
WEB
www.fdic.gov
Information and news about banks and savings institutions.
Commercial banks are subject to regulations that are intended
to limit their exposure to the risk of failure. In particular, banks
are required to maintain a minimum level of capital, relative to
their size, so that they have a cushion to absorb possible losses
from defaults on some loans provided to households or
businesses. The Federal Reserve (“the Fed”) serves as a
regulator of banks.
Savings Institutions Savings institutions, which are sometimes
referred to as thrift institutions, are another type of depository

institution. Savings institutions include savings and loan
associations (S&Ls) and savings banks. Like commercial banks,
savings institutions offer deposit accounts to surplus units and
then channel these deposits to deficit units. Savings banks are
similar to S&Ls except that they have more diversified uses of
funds. Over time, however, this difference has narrowed.
Savings institutions can be owned by shareholders, but most are
mutual (depositor owned). Like commercial banks, savings
institutions rely on the federal funds market to lend their excess
funds or to borrow funds on a short-term basis.
Whereas commercial banks concentrate on commercial
(business) loans, savings institutions concentrate on residential
mortgage loans. Normally, mortgage loans are perceived to
exhibit a relatively low level of risk, but many mortgages
defaulted in 2008 and 2009. This led to the credit crisis and
caused financial problems for many savings institutions.
Credit Unions Credit unions differ from commercial banks and
savings institutions in that they (1) are nonprofit and (2) restrict
their business to credit union members, who share a common
bond (such as a common employer or union). Like savings
institutions, they are sometimes classified as thrift institutions
in order to distinguish them from commercial banks. Because of
the “common bond” characteristic, credit unions tend to be
much smaller than other depository institutions. They use most
of their funds to provide loans to their members. Some of the
largest credit unions (e.g., the Navy Federal Credit Union, the
State Employees Credit Union of North Carolina, the Pentagon
Federal Credit Union) have assets of more than $5 billion.
1-3b Role of Nondepository Financial Institutions
Nondepository institutions generate funds from sources other
than deposits but also play a major role in financial
intermediation. These institutions are briefly described here and
are covered in more detail in Part 7.
Finance Companies Most finance companies obtain funds by
issuing securities and then lend the funds to individuals and
small businesses. The functions of finance companies and

depository institutions overlap, although each type of institution
concentrates on a particular segment of the financial markets
(explained in the chapters devoted to these institutions).
Mutual Funds Mutual funds sell shares to surplus units and use
the funds received to purchase a portfolio of securities. They
are the dominant nondepository financial institution when
measured in total assets. Some mutual funds concentrate their
investment in capital market securities, such as stocks or bonds.
Others, known as money market mutual funds, concentrate in
money market securities. Typically, mutual funds purchase
securities in minimum denominations that are larger than the
savings of an individual surplus unit. By purchasing shares of
mutual funds and money market mutual funds, small savers are
able to invest in a diversified portfolio of securities with a
relatively small amount of funds.
WEB
finance.yahoo.com/funds
Information about mutual funds.
Securities Firms Securities firms provide a wide variety of
functions in financial markets. Some securities firms act as
a broker, executing securities transactions between two parties.
The broker fee for executing a transaction is reflected in the
difference (or spread) between the bid quote and the ask quote.
The markup as a percentage of the transaction amount will
likely be higher for less common transactions, since more time
is needed to match up buyers and sellers. The markup will also
likely be higher for transactions involving relatively small
amounts so that the broker will be adequately compensated for
the time required to execute the transaction.
Furthermore, securities firms often act as dealers, making a
market in specific securities by maintaining an inventory of
securities. Although a broker's income is mostly based on the
markup, the dealer's income is influenced by the performance of
the security portfolio maintained. Some dealers also provide
brokerage services and therefore earn income from both types of
activities.

In addition to brokerage and dealer services, securities firms
also provide underwriting and advising services. The
underwriting and advising services are commonly referred to
as investment banking, and the securities firms that specialize
in these services are sometimes referred to as investment banks.
Some securities firms place newly issued securities for
corporations and government agencies; this task differs from
traditional brokerage activities because it involves the primary
market. When securities firms underwrite newly issued
securities, they may sell the securities for a client at a
guaranteed price or may simply sell the securities at the best
price they can get for their client.
Some securities firms offer advisory services on mergers and
other forms of corporate restructuring. In addition to helping a
company plan its restructuring, the securities firm also executes
the change in the client's capital structure by placing the
securities issued by the company.
Insurance Companies Insurance companies provide individuals
and firms with insurance policies that reduce the financial
burden associated with death, illness, and damage to property.
These companies charge premiums in exchange for the
insurance that they provide. They invest the funds received in
the form of premiums until the funds are needed to cover
insurance claims. Insurance companies commonly invest these
funds in stocks or bonds issued by corporations or in bonds
issued by the government. In this way, they finance the needs of
deficit units and thus serve as important financial
intermediaries. Their overall performance is linked to the
performance of the stocks and bonds in which they invest. Large
insurance companies include State Farm Group, Allstate
Insurance, Travelers Group, CNA Insurance, and Liberty
Mutual.
Pension Funds Many corporations and government agencies
offer pension plans to their employees. The employees and their
employers (or both) periodically contribute funds to the plan.
Pension funds provide an efficient way for individuals to save

for their retirement. The pension funds manage the money until
the individuals with draw the funds from their retirement
accounts. The money that is contributed to individual retirement
accounts is commonly invested by the pension funds in stocks
or bonds issued by corporations or in bonds issued by the
government. Thus pension funds are important financial
intermediaries that finance the needs of deficit units.
1-3c Comparison of Roles among Financial Institutions
The role of financial institutions in facilitating the flow of
funds from individual surplus units (investors) to deficit units is
illustrated in Exhibit 1.3. Surplus units are shown on the left
side of the exhibit, and deficit units are shown on the right.
Three different flows of funds from surplus units to deficit units
are shown in the exhibit. One set of flows represents deposits
from surplus units that are transformed by depository
institutions into loans for deficit units. A second set of flows
represents purchases of securities (commercial paper) issued by
finance companies that are transformed into finance company
loans for deficit units. A third set of flows reflects the
purchases of shares issued by mutual funds, which are used by
the mutual funds to purchase debt and equity securities of
deficit units.
The deficit units also receive funding from insurance
companies and pension funds. Because insurance companies and
pension funds purchase massive amounts of stocks and bonds,
they finance much of the expenditures made by large deficit
units, such as corporations and government agencies. Financial
institutions such as commercial banks, insurance companies,
mutual funds, and pension funds serve the role of investing
funds that they have received from surplus units, so they are
often referred to as institutional investors.
Securities firms are not shown in Exhibit 1.3, but they play an
important role in facilitating the flow of funds. Many of the
transactions between the financial institutions and deficit units
are executed by securities firms. Furthermore, some funds flow
directly from surplus units to deficit units as a result of security

transactions, with securities firms serving as brokers.
Exhibit 1.3 Comparison of Roles among Financial Institutions
Institutional Role as a Monitor of Publicly Traded Firms In
addition to the roles of financial institutions described
in Exhibit 1.3, financial institutions also serve as monitors of
publicly traded firms. Because insurance companies, pension
funds, and some mutual funds are major investors in stocks,
they can influence the management of publicly traded firms. In
recent years, many large institutional investors have publicly
criticized the management of specific firms, which has resulted
in corporate restructuring or even the firing of executives in
some cases. Thus institutional investors not only provide
financial support to companies but also exercise some degree of
corporate control over them. By serving as activist
shareholders, they can help ensure that managers of publicly
held corporations are making decisions that are in the best
interests of the shareholders.
1-3d How the Internet Facilitates Roles of Financial Institutions
The Internet has also enabled financial institutions to perform
their roles more efficiently. Some commercial banks have been
created solely as online entities. Because they have lower costs,
they can offer higher interest rates on deposits and lower rates
on loans. Other banks and depository institutions also offer
online services, which can reduce costs, increase efficiency, and
intensify competition. Many mutual funds allow their
shareholders to execute buy or sell transactions online. Some
insurance companies conduct much of their business online,
which reduces their operating costs and forces other insurance
companies to price their services competitively. Some brokerage
firms conduct much of their business online, which reduces
their operating costs; because these firms can lower the fees
they charge, they force other brokerage firms to price their
services competitively.
1-3e Relative Importance of Financial Institutions
Together, all of these financial institutions hold assets equal to

about $45 trillion. Commercial banks hold the most assets of
any depository institution, with about $12 trillion in aggregate.
Mutual funds hold the largest amount of assets of any
nondepository institution, with about $11 trillion in aggregate.
Exhibit 1.4 summarizes the main sources and uses of funds for
each type of financial institution. Households with savings are
served by depository institutions. Households with deficient
funds are served by depository institutions and finance
companies. Large corporations and governments that issue
securities obtain financing from all types of financial
institutions. Several agencies regulate the various types of
financial institutions, and the various regulations may give
some financial institutions a comparative advantage over others.
1-3f Consolidation of Financial Institutions
In recent years, commercial banks have acquired other
commercial banks so that a given infrastructure can generate
and support a higher volume of business. By increasing the
volume of services produced, the average cost of providing the
services (such as loans) can be reduced. Savings institutions
have consolidated to achieve economies of scale for their
mortgage lending business. Insurance companies have
consolidated so that they can reduce the average cost of
providing insurance services.
Exhibit 1.4 Summary of Institutional Sources and Uses of Funds
FINANCIAL INSTITUTIONS
MAIN SOURCES OF FUNDS
MAIN USES OF FUNDS
Commercial banks
Deposits from households, businesses, and government agencies
Purchases of government and corporate securities; loans to
businesses and households
Savings institutions
Deposits from households, businesses, and government agencies
Purchases of government and corporate securities; mortgages
and other loans to households; some loans to businesses
Credit unions

Deposits from credit union members
Loans to credit union members
Finance companies
Securities sold to households and businesses
Loans to households and businesses
Mutual funds
Shares sold to households, businesses, and government agencies
Purchases of long-term government and corporate securities
Money market funds
Shares sold to households, businesses, and government agencies
Purchases of short-term government and corporate securities
Insurance companies
Insurance premiums and earnings from investments
Pension funds
Employer/employee contributions
During the last 10 years, different types of financial
institutions were allowed by regulators to expand the types of
services they offer and capitalize on economies of scope.
Commercial banks merged with savings institutions, securities
firms, finance companies, mutual funds, and insurance
companies. Although the operations of each type of financial
institution are commonly managed separately, a financial
conglomerate offers advantages to customers who prefer to
obtain all of their financial services from a single financial
institution. Because a financial conglomerate is more
diversified, it may be less exposed to a possible decline in
customer demand for any single financial service.
EXAMPLE
Wells Fargo is a classic example of the evolution in financial
services. It originally focused on commercial banking but has
expanded its nonbank services to include mortgages, small
business loans, consumer loans, real estate, brokerage,
investment banking, online financial services, and insurance. In
a recent annual report, Wells Fargo stated: “Our diversity in

businesses makes us much more than a bank. We're a diversified
financial services company. We're competing in a highly
fragmented and fast growing industry: Financial Services. This
helps us weather downturns that inevitably affect anyone
segment of our industry.”
Typical Structure of a Financial Conglomerate A typical
organizational structure of a financial conglomerate is shown
in Exhibit 1.5. Historically, each of the financial services (such
as banking, mortgages, brokerage, and insurance) had
significant barriers to entry, so only a limited number of firms
competed in that industry. The barriers prevented most firms
from offering a wide variety of these services. In recent years,
the barriers to entry have been reduced, allowing firms that had
specialized in one service to expand more easily into other
financial services. Many firms expanded by acquiring other
financial services firms. Thus many financial conglomerates are
composed of various financial institutions that were originally
independent but are now units (or subsidiaries) of the
conglomerate.
Exhibit 1.5 Organizational Structure of a Financial
Conglomerate
Impact of Consolidation on Competition As financial
institutions spread into other financial services, the competition
for customers desiring the various types of financial services
increased. Prices of financial services declined in response to
the competition. In addition, consolidation has provided more
convenience. Individual customers can rely on the financial
conglomerate for convenient access to life and health insurance,
brokerage, mutual funds, investment advice and financial
planning, bank deposits, and personal loans. A corporate
customer can turn to the financial conglomerate for property
and casualty insurance, health insurance plans for employees,
business loans, advice on restructuring its businesses, issuing
new debt or equity securities, and management of its pension
plan.

Global Consolidation of Financial Institutions Many financial
institutions have expanded internationally to capitalize on their
expertise. Commercial banks, insurance companies, and
securities firms have expanded through international mergers.
An international merger between financial institutions enables
the merged company to offer the services of both entities to its
entire customer base. For example, a U.S. commercial bank may
specialize in lending while a European securities firm
specializes in services such as underwriting securities. A merger
between the two entities allows the U.S. bank to provide its
services to the European customer base (clients of the European
securities firm) and allows the European securities firm to offer
its services to the U.S. customer base. By combining specialized
skills and customer bases, the merged financial institutions can
offer more services to clients and have an international
customer base.
The adoption of the euro by 17 European countries has
increased business between those countries and created a more
competitive environment in Europe. European financial
institutions, which had primarily competed with other financial
institutions based in their own country, recognized that they
would now face more competition from financial institutions in
other countries.
Many financial institutions have attempted to benefit from
opportunities in emerging markets. For example, some large
securities firms have expanded into many countries to offer
underwriting services for firms and government agencies. The
need for this service has increased most dramatically in
countries where businesses have been privatized. In addition,
commercial banks have expanded into emerging markets to
provide loans. Although this allows them to capitalize on
opportunities in these countries, it also exposes them to
financial problems in these countries.
1-4 CREDIT CRISIS FOR FINANCIAL INSTITUTIONS
Following the abrupt increase in home prices in the 2004–2006

period, many financial institutions increased their holdings of
mortgages and mortgage-backed securities, whose performance
was based on the timely mortgage payments made by
homeowners. Some financial institutions (especially commercial
banks and savings institutions) aggressively attempted to
expand their mortgage business in order to capitalize on the
strong housing market. They commonly applied liberal
standards when originating new mortgages and often failed to
verify the applicant's job status, income level, or credit history.
Home prices were expected to continue rising over time, so
financial institutions presumed (incorrectly) that the underlying
value of the homes would provide adequate collateral to back
the mortgage if homeowners could not make their mortgage
payments.
In the 2007–2009 period, mortgage defaults increased, and
there was an excess of unoccupied homes as homeowners who
could not pay the mortgage left their homes. As a result, home
prices plummeted, and the value of the property collateral
backing many mortgages was less than the outstanding mortgage
amount. By January 2009, at least 10 percent of all American
homeowners were either behind on their mortgage payments or
had defaulted on their mortgage. Many of the financial
institutions that originated mortgages suffered major losses.
1-4a Systemic Risk during the Credit Crisis
The credit crisis illustrated how financial problems of some
financial institutions spread to others. Systemic risk is defined
as the spread of financial problems among financial institutions
and across financial markets that could cause a collapse in the
financial system. It exists because financial institutions invest
their funds in similar types of securities and therefore have
similar exposure to large declines in the prices of these
securities. In this case, mortgage defaults affected financial
institutions in several ways. First, many financial institutions
that originated mortgages shortly before the crisis sold them to
other financial institutions (i.e., commercial banks, savings
institutions, mutual funds, insurance companies, securities

firms, and pension funds); hence even financial institutions that
were not involved in the mortgage origination process
experienced large losses because they purchased the mortgages
originated by other financial institutions.
Second, many other financial institutions that invested in
mortgage-backed securities and promised payments on
mortgages were exposed to the crisis. Third, some financial
institutions (especially securities firms) relied heavily on short-
term debt to finance their operations and used their holdings of
mortgage-backed securities as collateral. But when the prices of
mortgage-backed securities plummeted, large securities firms
such as Bear Stearns and Lehman Brothers could not issue new
short-term debt to pay off the principal on maturing debt.
Furthermore, the decline in home building activity caused a
decrease in the demand for many related businesses, such as air-
conditioning services, roofing, and landscaping. In addition, the
loss of income by workers in these industries caused a decline
in spending in a wide variety of industries. The weak economy
also created more concerns about the potential default on debt
securities, causing further declines in bond prices. The financial
markets were filled with sellers who wanted to dump debt
securities, but there were not many buyers willing to buy
securities. Consequently, the prices of debt securities plunged.
Systemic risk was a major concern during the credit crisis
because the prices of most equity securities declined
substantially, since the operating performance of most firms
declined when the economy weakened. Thus most financial
institutions experienced large losses on their investments during
the credit crisis even if they invested solely inequity securities.
1-4b Government Response to the Credit Crisis
The government intervened in order to correct some of the
economic problems caused by the credit crisis.
Emergency Economic Stabilization Act On October 3, 2008,
Congress enacted the Emergency Economic Stabilization Act of
2008 (also referred to as the bailout act), which was intended to
resolve the liquidity problems of financial institutions and to

restore the confidence of the investors who invest in them. The
act directed the Treasury to inject $700 billion into the financial
system, primarily by investing money into the banking system
by purchasing the preferred stock of financial institutions. In
this way, the Treasury provided large commercial banks with
capital to cushion their losses, thereby reducing the likelihood
that the banks would fail.
Federal Reserve Actions In 2008, some large securities firms
such as Bear Stearns and Lehman Brothers experienced severe
financial problems. The Federal Reserve rescued Bear Stearns
by financing its acquisition by a commercial bank (J.P. Morgan
Chase) in order to calm the financial markets. However, when
Lehman Brothers was failing six months later, it was not
rescued by the government, and this caused much paranoia in
financial markets.
At this time, the Fed also provided emergency loans to many
other securities firms that were not subject to its regulation.
Some major securities firms (such as Merrill Lynch) were
acquired by commercial banks, while others (Goldman Sachs
and Morgan Stanley) were converted into commercial banks.
These actions resulted in the consolidation of financial
institutions and also subjected more financial institutions to
Federal Reserve regulations.
Financial Reform Act of 2010 On July 21, 2010, President
Obama signed the Financial Reform Act (also referred to as the
Wall Street Reform Act or Consumer Protection Act), which
was intended to prevent some of the problems that caused the
credit crisis. The provisions of the act are frequently discussed
in this text when they apply to specific financial markets or
financial institutions.
One of the key provisions of the Financial Reform Act of
2010 is that mortgage lenders verify the income, job status, and
credit history of mortgage applicants before approving mortgage
applications. This provision is intended to prevent applicants
from receiving mortgages unless they are creditworthy.

In addition, the Financial Reform Act called for the creation
of the Financial Stability Oversight Council, which is
responsible for identifying risks to financial stability in the
United States and makes regulatory recommendations that could
reduce any risks to the financial system. The council consists of
10 members who represent the heads of regulatory agencies that
regulate key components of the financial system, including
the housing industry, securities trading, depository institutions,
mutual funds, and insurance companies.
Furthermore, the act established the Consumer Financial
Protection Bureau (housed within the Federal Reserve) to
regulate specific financial services for consumers, including
online banking, checking accounts, credit cards, and student
loans. This bureau can set rules to ensure that information
regarding endorsements of specific financial products is
accurate and to prevent deceptive practices.
1-4c Conclusion about Government Response to the Credit
Crisis
In general, the government response to the credit crisis was
intended to enhance the safety of financial institutions. Since
financial institutions serve as intermediaries for financial
markets, the tougher regulations on financial institutions can
stabilize the financial markets and encourage more participation
by surplus and deficit units in these markets.
SUMMARY
· ▪ Financial markets facilitate the transfer of funds from
surplus units to deficit units. Because funding needs vary
among deficit units, various financial markets have been
established. The primary market allows for the issuance of new
securities, and the secondary market allows for the sale of
existing securities.
· ▪ Securities can be classified as money market (short-term)
securities or capital market (long-term) securities. Common
capital market securities include bonds, mortgages, mortgage-
backed securities, and stocks. The valuation of a security
represents the present value of future cash flows that it is

expected to generate. New information that indicates a change
in expected cash flows or degree of uncertainty affects prices of
securities in financial markets.
· ▪ Depository and nondepository institutions help to finance the
needs of deficit units. The main depository institutions are
commercial banks, savings institutions, and credit unions. The
main nondepository institutions are finance companies, mutual
funds, pension funds, and insurance companies. Many financial
institutions have been consolidated (due to mergers) into
financial conglomerates, where they serve as subsidiaries of the
conglomerate while conducting their specialized services. Thus,
some financial conglomerates are able to provide all types of
financial services. Consolidation allows for economies of scale
and scope, which can enhance cash flows and increase the
financial institution's value. In addition, consolidation can
diversify the institution's services and increase its value through
the reduction in risk.
· ▪ The credit crisis in 2008 and 2009 had a profound effect on
financial institutions. Those institutions that were heavily
involved in originating or investing in mortgages suffered major
losses. Many investors were concerned that the institutions
might fail and therefore avoided them, which disrupted the
ability of financial institutions to facilitate the flow of funds.
The credit crisis led to concerns about systemic risk, as
financial problems spread among financial institutions that were
heavily exposed to mortgages.
POINT COUNTER-POINT
Will Computer Technology Cause Financial Intermediaries to
Become Extinct?
Point Yes. Financial intermediaries benefit from access to
information. As information becomes more accessible,
individuals will have the information they need before investing
or borrowing funds. They will not need financial intermediaries
to make their decisions.
Counter-Point No. Individuals rely not only on information but
also on expertise. Some financial intermediaries specialize in

credit analysis so that they can make loans. Surplus units will
continue to provide funds to financial intermediaries, rather
than make direct loans, because they are not capable of credit
analysis even if more information about prospective borrowers
is available. Some financial intermediaries no longer have
physical buildings for customer service, but they still require
agents who have the expertise to assess the creditworthiness of
prospective borrowers.
· 1.Surplus and Deficit Units Explain the meaning of surplus
units and deficit units. Provide an example of each. Which types
of financial institutions do you deal with? Explain whether you
are acting as a surplus unit or a deficit unit in your relationship
with each financial institution.
· 2.Types of Markets Distinguish between primary and
secondary markets. Distinguish between money and capital
markets.
· 3.Imperfect Markets Distinguish between perfect and
imperfect security markets. Explain why the existence of
imperfect markets creates a need for financial intermediaries.
· 4.Efficient Markets Explain the meaning of efficient markets.
Why might we expect markets to be efficient most of the time?
In recent years, several securities firms have been guilty of
using inside information when purchasing securities, thereby
achieving returns well above the norm (even when accounting
for risk). Does this suggest that the security markets are not
efficient? Explain.
· 5.Securities Laws What was the purpose of the Securities Act
of 1933? What was the purpose of the Securities Exchange Act
of 1934? Do these laws prevent investors from making poor
investment decisions? Explain.
· 6.International Barriers If barriers to international securities
markets are reduced, will a country's interest rate be more or
less susceptible to foreign lending and borrowing activities?

Explain.
· 7.International Flow of Funds In what way could the
international flow of funds cause a decline in interest rates?
· 8.Securities Firms What are the functions of securities firms?
Many securities firms employ brokers and dealers. Distinguish
between the functions of a broker and those of a dealer, and
explain how each is compensated.
· 9.Standardized Securities Why do you think securities are
commonly standardized? Explain why some financial flows of
funds cannot occur through the sale of standardized securities.
If securities were not standardized, how would this affect the
volume of financial transactions conducted by brokers?
· 10.Marketability Commercial banks use some funds to
purchase securities and other funds to make loans. Why are the
securities more marketable than loans in the secondary market?
· 11.Depository Institutions Explain the primary use of funds by
commercial banks versus savings institutions.
· 12.Credit Unions With regard to the profit motive, how are
credit unions different from other financial institutions?
· 13.Nondepository Institutions Compare the main sources and
uses of funds for finance companies, insurance companies, and
pension funds.
· 14.Mutual Funds What is the function of a mutual fund? Why
are mutual funds popular among investors? How does a money
market mutual fund differ from a stock or bond mutual fund?
· 15.Impact of Privatization on Financial Markets Explain how
the privatization of companies in Europe can lead to the
development of new securities markets.
Advanced Questions
· 16.Comparing Financial Institutions Classify the types of
financial institutions mentioned in this chapter as either
depository or nondepository. Explain the general difference
between depository and nondepository institution sources of
funds. It is often said that all types of financial institutions have
begun to offer services that were previously offered only by
certain types. Consequently, the operations of many financial

institutions are becoming more similar. Nevertheless,
performance levels still differ significantly among types of
financial institutions. Why?
· 17.Financial Intermediation Look in a business periodical for
news about a recent financial transaction involving two
financial institutions. For this transaction, determine the
following:
· a. How will each institution's balance sheet be affected?
· b. Will either institution receive immediate income from the
transaction?
· c. Who is the ultimate user of funds?
· d. Who is the ultimate source of funds?
· 18.Role of Accounting in Financial Markets Integrate the roles
of accounting, regulation, and financial market participation.
That is, explain how financial market participants rely on
accounting and why regulatory oversight of the accounting
process is necessary.
· 19.Impact of Credit Crisis on Liquidity Explain why the credit
crisis caused a lack of liquidity in the secondary markets for
many types of debt securities. Explain how such a lack of
liquidity would affect the prices of the debt securities in the
secondary markets.
· 20.Impact of Credit Crisis on Institutions Explain why
mortgage defaults during the credit crisis adversely affected
financial institutions that did not originate the mortgages. What
role did these institutions play in financing the mortgages?
· 21.Regulation of Financial Institutions Financial institutions
are subject to regulation to ensure that they do not take
excessive risk and can safely facilitate the flow of funds
through financial markets. Nevertheless, during the credit crisis,
individuals were concerned about using financial institutions to
facilitate their financial transactions. Why do you think the
existing regulations were ineffective at ensuring a safe financial
system?
· 22.Impact of the Greece Debt Crisis European debt markets
have become integrated over time, so that institutional investors

(such as commercial banks) commonly purchase debt issued in
other European countries. When the government of Greece
experienced problems in meeting its debt obligations in 2010,
some investors became concerned that the crisis would spread to
other European countries. Explain why integrated European
financial markets might allow a debt crisis in one European
country to spread to other countries in Europe.
· 23.Global Financial Market Regulations Assume that countries
A and B are of similar size, that they have similar economies,
and that the government debt levels of both countries are within
reasonable limits. Assume that the regulations in country A
require complete disclosure of financial reporting by issuers of
debt in that country but that regulations in country B do not
require much disclosure of financial reporting. Explain why the
government of country A is able to issue debt at a lower cost
than the government of country B.
· 24.Influence of Financial Markets Some countries do not have
well-established markets for debt securities or equity securities.
Why do you think this can limit the development of the country,
business expansion, and growth in national income in these
countries?
· 25.Impact of Systemic Risk Different types of financial
institutions commonly interact. They provide loans to each
other, and take opposite positions on many different types of
financial agreements, whereby one will owe the other based on
a specific financial outcome. Explain why their relationships
cause concerns about systemic risk.
“Interpreting Financial News” tests your ability to comprehend
common statements made by Wall Street analysts and portfolio
managers who participate in the financial markets. Interpret the
following statements.
· a. “The price of IBM stock will not be affected by the
announcement that its earnings have increased as expected.”
· b. “The lending operations at Bank of America should benefit
from strong economic growth.”

· c. “The brokerage and underwriting performance at Goldman
Sachs should benefit from strong economic growth.”
Utilizing Financial Markets As a financial manager of a large
firm, you plan to borrow $70 million over the next year.
· a. What are the most likely ways in which you can borrow $70
million?
· b. Assuming that you decide to issue debt securities, describe
the types of financial institutions that may purchase these
securities.
· c. How do individuals indirectly provide the financing for
your firm when they maintain deposits at depository
institutions, invest in mutual funds, purchase insurance policies,
or invest in pensions?
Roles of Financial Markets and Institutions
This continuing exercise focuses on the interactions of a single
manufacturing firm (Carson Company) in the financial markets.
It illustrates how financial markets and institutions are
integrated and facilitate the flow of funds in the business and
financial environment. At the end of every chapter, this exercise
provides a list of questions about Carson Company that requires
the application of concepts presented in the chapter as they
relate to the flow of funds.
Carson Company is a large manufacturing firm in California
that was created 20 years ago by the Carson family. It was
initially financed with an equity investment by the Carson
family and 10 other individuals. Over time, Carson Company
obtained substantial loans from finance companies and
commercial banks. The interest rate on the loans is tied to
market interest rates and is adjusted every six months. Thus
Carson's cost of obtaining funds is sensitive to interest rate
movements. It has a credit line with a bank in case it suddenly
needs additional funds for a temporary period. It has purchased
Treasury securities that it could sell if it experiences any
liquidity problems.

Carson Company has assets valued at about $50 million and
generates sales of about $100 million per year. Some of its
growth is attributed to its acquisitions of other firms. Because
of its expectations of a strong U.S. economy, Carson plans to
grow in the future by expanding its business and by making
more acquisitions. It expects that it will need substantial long-
term financing and plans to borrow additional funds either
through loans or by issuing bonds. It is also considering issuing
stock to raise funds in the next year. Carson closely monitors
conditions in financial markets that could affect its cash inflows
and cash outflows and thereby affect its value.
· a. In what way is Carson a surplus unit?
· b. In what way is Carson a deficit unit?
· c. How might finance companies facilitate Carson's
expansion?
· d. How might commercial banks facilitate Carson's expansion?
· e. Why might Carson have limited access to additional debt
financing during its growth phase?
· f. How might securities firms facilitate Carson's expansion?
· g. How might Carson use the primary market to facilitate its
expansion?
· h. How might it use the secondary market?
· i. If financial markets were perfect, how might this have
allowed Carson to avoid financial institutions?
· j. The loans that Carson has obtained from commercial banks
stipulate that Carson must receive the bank's approval before
pursuing any large projects. What is the purpose of this
condition? Does this condition benefit the owners of the
company?
· 1. Review the information for the common stock of IBM,
using the website finance.yahoo.com. Insert the ticker symbol
“IBM” in the box and click on “Get Quotes.” The main goal at
this point is to become familiar with the information that you
can obtain at this website. Review the data that are shown for
IBM stock. Compare the price of IBM based on its last trade

with the price range for the year. Is the price near its high or
low price? What is the total value of IBM stock (market
capitalization)? What is the average daily trading volume (Avg
Vol) of IBM stock? Click on “5y”just below the stock price
chart to see IBM's stock price movements over the last five
years. Describe the trend in IBM's stock over this period. At
what points was the stock price the highest and lowest?
· 2. Repeat the questions in exercise 1 for the Children's Place
Retail Stores (symbol PLCE). Explain how the market
capitalization and trading volume for PLCE differ from that for
IBM.
WSJ EXERCISE
Differentiating between Primary and Secondary Markets
Review the different tables relating to stock markets and bond
markets that appear in Section C of the Wall Street Journal.
Explain whether each of these tables is focused on the primary
or secondary markets.
this chapter.
· 1. secondary market AND liquidity
· 2. secondary market AND offering
· 3. money market

· 4. bond offering
· 5. stock offering
· 6. valuation AND stock
· 7. market efficiency
· 8. financial AND regulation
· 9. financial institution AND operations
· 10. financial institution AND governance
Term Paper on the Credit Crisis
Write a term paper on one of the following topics or on a topic
assigned by your professor. Details such as the due date and the
length of the paper will be provided by your professor.
Each of the topics listed below can be easily researched
because considerable media attention has been devoted to the
subject. Although this text offers a brief summary of each topic,
much more information is available at online sources that you
can find by using a search engine and inserting a few key terms
or phrases.
· 1.Impact of Lehman Brothers' Bankruptcy on Individual
Wealth Explain how the bankruptcy of Lehman Brothers (the
largest bankruptcy ever) affected the wealth and income of
many different types of individuals whose money was invested
by institutional investors (such as pension funds) in Lehman
Brothers' debt.
· 2.Impact of the Credit Crisis on Financial Market
Liquidity Explain the link between the credit crisis and the lack
of liquidity in the debt markets. Offer some insight as to why
the debt markets became inactive. How were interest rates
affected? What happened to initial public offering (IPO)
activity during the credit crisis? Why?
· 3.Transparency of Financial Institutions during the Credit
Crisis Select a financial institution that had serious financial
problems as a result of the credit crisis. Review the media
stories about this institution during the six months before its
financial problems were publicized. Were there any clues that
the financial institution was having problems? At what point do
you think that the institution recognized that it was having

financial difficulties? Did its previous annual report indicate
serious problems? Did it announce its problems, or did another
media source reveal the problems?
· 4.Cause of Problems for Financial Institutions during the
Credit Crisis Select a financial institution that had serious
financial problems as a result of the credit crisis. Determine the
main underlying causes of the problems experienced by that
financial institution. Explain how these problems might have
been avoided.
· 5.Mortgage-Backed Securities and Risk Taking by Financial
Institutions Do you think that institutional investors that
purchased mortgage-backed securities containing subprime
mortgages were following reasonable investment guidelines?
Address this issue for various types of financial institutions
such as pension funds, commercial banks, insurance companies,
and mutual funds (your answer might differ with the type of
institutional investor). If financial institutions are taking on too
much risk, how should regulations be changed to limit such
excessive risk taking?
· 6.Pension Fund Investments in Lehman Brothers' Debt At the
time that Lehman Brothers filed for bankruptcy, financial
institutions serving municipalities in California were holding
more than $300 billion in debt issued by Lehman. Do you think
that municipal pension funds that purchased commercial paper
and other debt securities issued by Lehman Brothers were
following reasonable investment guidelines? If a pension fund
is taking on too much risk, how should regulations be changed
to limit such excessive risk taking?
· 7.Future Valuation of Mortgage-Backed
Securities Commercial banks must periodically “mark to
market” their assets in order to determine the capital they need.
Identify some advantages and disadvantages of this method, and
propose a solution that would be fair to both commercial banks
and regulators.
· 8.Future Structure of Fannie Mae Fannie Mae plays an
important role in the mortgage market, but it suffered major

problems during the credit crisis. Discuss the underlying causes
of the problems at Fannie Mae beyond what has been discussed
in the text. Should Fannie Mae be owned completely by the
government? Should it be privatized? Offer your opinion on a
structure for Fannie Mae that would avoid its previous problems
and enable it to serve the mortgage market.
· 9.Future Structure of Ratings Agencies Rating agencies rated
the so-called tranches of mortgage-backed securities that were
sold to institutional investors. Explain why the performance of
these agencies was criticized, and then defend against this
criticism on behalf of the agencies. Was the criticism of the
agencies justified? How could rating agencies be structured or
regulated in a different manner in order to prevent the problems
that occurred during the credit crisis?
· 10.Future Structure of Credit Default Swaps Explain how
credit default swaps maybe partially responsible for the credit
crisis. Offer a proposal for how they could be structured in the
future to ensure that they are used to enhance the safety of the
financial system.
· 11.Sale of Bear Stearns Review the arguments that have been
made for the government-orchestrated sale of Bear Stearns. If
Bear Stearns had been allowed to fail, what types of financial
institutions would have been adversely affected? In other words,
who benefited from the government's action to prevent the
failure of Bear Stearns? Do you think Bear Stearns should have
been allowed to fail? Explain your opinion.
· 12.Bailout of AIG Review the arguments that have been made
for the bailout of American International Group (AIG). If AIG
had been allowed to fail, what types of financial institutions
would have been adversely affected? That is, who benefited
from the bailout of AIG? Do you think AIG should have been
allowed to fail? Explain your opinion.
· 13.Executive Compensation at Financial Institutions Discuss
the compensation received by executives at some financial
institutions that experienced financial problems (e.g., AIG, Bear
Stearns, Lehman Brothers, Merrill Lynch, Washington Mutual).

Should these executives be allowed to retain the bonuses that
they received in the 2007-2008 period? Should executive
compensation at financial institutions be capped?
· 14.Impact of the Credit Crisis on Commercial Banks versus
Securities Firms Both commercial banks and securities firms
were adversely affected by the credit crisis, but for different
reasons. Discuss the reasons for the adverse effects on
commercial banks and securities firms and explain why the
reasons were different.
· 15.Role of the Treasury and the Fed in the Credit
Crisis Summarize the various ways in which the U.S. Treasury
and the Federal Reserve intervened to resolve the credit crisis.
Discuss the pros and cons of their interventions. Offer your own
opinion regarding whether they should have intervened.
Assignment Content
1.
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Write a 525- to 700-word brief paper.
Choose a concept that stood out to you from your textbook or
Electronic Reserve Readings this week.
Apply this concept to your current or future job. How can this
knowledge assist you in your professional success?
Format your paper consistent with APA guidelines.
Submit your assignment.
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