ECO 3223 SU 2015 EVANS STUDY GUIDE FOR EXAM 2 Note This is intended to direct you to the relevant topics that will be covered on the exam Questions will be worded differently so don t MEMORIZE this content use it to help you understand the concepts CHAPTER 5 Understand the following 1 the significance of the bond market to the U S economy why interest rates in capital markets fluctuate the Theory of Asset Demand and factors that will shift the Demand Curve for bonds know in which direction an increase decrease will shift the curve 2 a b factors that will shift the Supply Curve for bonds and in which direction with 3 an increase decrease 1 Expected profitability of investment opportunities right 2 Expected inflation 3 Government budget deficits the impact upon bond prices and interest rates of any shift in Demand or 4 Supply especially an increase in expected inflation an increase in the expected rate of inflation lowers the expected return for bonds causing their demand to decline and the demand curve to shift to the left a business cycle expansion In a business cycle expansions with growing wealth the demand for bonds and the demand curve for bonds shifts to the right 5 6 factors that determine and shift the supply and demand for money what is meant by stating that the interest rate is the opportunity cost of holding money The quantity of money demanded and the interest rate should be negatively related by using the concept of opportunity cost the amount of interest sacrificed by not holding the alternative asset As the interest rate in bonds rise the opp Cost of holding money rises thus money is less desirable and the quantity of money demanded must fall the model of supply and demand for money and indicate how a shift in either demand or supply will affect short term interest rates 1 7 8 9 the secondary and undesirable economic effect of a decrease in short term interest rates which results from an increase in the supply of money Why do we say that the Fed can target either inflation or interest rates but not both If the fed reserve wants to increase the supply of money to bring interest rates down supply will shift to the right This stimulates the economy however price level will rise causing inflation Expansionary policy inflation Contracting falling price level the Fisher Effect and its impact upon the effects of monetary policy When expected inflation rises interest rates will rise Inflation is associated with rising interest rates Ir iN pie Ir 4 2 Ir 2 real return Keynes liquidity preference framework in terms of the income and price level effects Income effect as an economy expands and income rises wealth increases and people will want to hold more money as a store of value Second as the economy expands and income rises people will want to carry out more transaction using money as a medium of exchange with the result that they will also want to hold more money A higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right Price level effect people care about the money they hold in real terms what they can buy When the price level rises the same nominal quantity of money is no longer as valuable A rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right Main idea People prefer to hold money and as the interest rate falls people will hold more money CHAPTER 6 1 Understand how default risk liquidity and income tax considerations affect bond prices and interest rates on bonds Default risk demand will fall shifting left Prices and interest rates move in the opposite direction Liquidity risk wouldn t be able to get rid of a greek bond not liquid would have to sell very low giving them a higher yield to maturity 2 Income tax and municipal bonds demand shifts right if youre in a higher tax bracket 2 Know how to calculate tax equivalent yield on a bond Municipal tax free Ex municipal with C 7 U S Gov bond 9 tax 35 Convert municipal to tax equivalent yield TEY C 1 t 7 1 0 35 7 65 TEY 10 8 Better off with municipal because you are tax free and 7 is less than 10 8 Know how to identify the area of risk premium on the supply demand models for corporate bonds and U S Treasury securities Know how to determine the risk of default on bonds against what standard is 3 4 this risk measured 5 fall as much in the future rise in the future Yield curves the macroeconomic interpretation of origin and slope of a an upward sloping yield curve short term interest rates are not expected to rise or b a steeply upward sloping yield curve short term interest rates are expected to c a relatively flat yield curve short term rates are expected to fall moderately in the future d an inverted yield curve downward sloping short term interest rates are expected to fall sharply in the future 6 Which of the following Expectations Segmented Markets and Liquidity Premium Preferred Habitat theories best explains why yield curves are generally upward sloping Liquidity premium CHAPTER 7 1 What rights do stockholders have with respect to the corporation in which they own stock Own an interest in the corporation proportional to the percentage of outstanding shares they own The rights include being able to vote and to be the residual claimant of all funds flowing into the firm cash flows 2 What are stocks cash flows Funds flowing into the firm stockholders may receive whatever remains after all other claims against the firms assets have been satisfied into the formula Be able to calculate the price of a stock From the resulting 3 Understand stock valuation formula and why holding period is not incorporated 3 price you calculate explain how k and g help interpret investors beliefs and how they may differ P D 1 g k g Ex P 3 1 02 05 02 102 With a coupon bond you know what C will be for every year with a stock you do not know Therefore if you were using the coupon bond formula you would have to estimate C C 1 i coupon bond You cant estimate the exact FV of a cash flow for a stock K the required return it represents their beliefs about the future economy its consumer preference future direction of interest rates in the economy G corporate profits 4 What role does information play in determining stock prices Monetary policy can affect stock prices in two ways First when the Fed lowers interest rates the return on bonds decline and investors are likely to accept a lower required rate of