Chapter 13 Federal Reserve and General Economics

Question 1

Monetary Policy – The Federal Reserve regulates flow of money and credit in the economy. The Federal Open Market Committee’s(FOMC) chief functions are:

Answer 1

1. Open Market Operations:
   * Buys or sells government securities ( usually treasury bills) including Treasury Bills, Notes and Treasury Bonds and Federal Agency Issues.
   * Buy treasury securities to stimulate the economy, the presumption is that inflation is not a near term threat
   * Sell treasury securities to slow down the economy and fight high or rising inflation
2. Changing the primary reserve requirement maintained by member banks. The federal reserve requires that member banks maintain a certain level of cash reserves.

A. Lowering the reserve requirement would pump more money in the credit system therby stimulating the economy. This presumes that inflation is not a near term threat.

B. Raising the reserve requirement would reduce the amount of funds for loans and credit therby slowing the economy and fighting high or rising inflation.

Question 2

To implement an easy money policy, the Fed would:

Answer 2

1. Buy Treasuries in the open market.
2. Reduce the discount rate
3. Lower the reserve requirement of member banks.
   Note: All the actions above would increase excess reserves.

Question 3

C. To implement a tight money policy, the fed would:

Answer 3

1. Sell Treasuries in the open market.
2. Raise the discount rate.
3. Raise the reserve requirement of member banks.

Question 4

D. Functions of the Federal Reserve system include:

Answer 4

1. Auditing member banks.
2. Landing to commercial banks.
3. Acting as an agent for the U.S. Treasury.
4. Regulating bank credit.
5. Being a lender of last resort.

Question 5

F. Fiscal Policy – of the U.S Government is set by CONGRESS and uses changes in the following to achieve a desired economic effect.

Answer 5

1. Government Spending
2. Taxes
3. Welfare

Note: An increase of tax rates on individual investors or businesses would NOT be effective in turning around a recessionary period due to the amount of income consumers and businesses may be use to spend. By tightening spending a recession could worsen.

Question 6

Prime Rate

Answer 6

is the interest rate charged and set by commercial banks on loans to their creditworthy commercial customers. It is normally the highest rate of all interest rate in this list of interest rates.

Question 7

Federal Funds rate

Answer 7

is the rate that banks charge each other for overnight loans.

Question 8

Discount Rate

Answer 8

is the rate charged by the federal reserve to banks.

Question 9

LIBOR

Answer 9

(London Inter- Bank Offered Rate) is the average rate that international banks charge each other( floating rate) .

Question 10

Broker or Call Loan rate

Answer 10

is the rate at which brokers-dealers borrow from the banks to cover margin loans to customers.

Question 11

Real Interest Rate

Answer 11

is the nominal rate minus the current rate of inflation. The real interest rate is also called the INFLATION -ADJUSTED RETURN

Question 12

Money Market instruments are short term debt instruments with maturities of 12 MONTHS or less and most are highly liquid.

Answer 12

1. Treasury Bills( most liquid)
2. Certificates of Deposit( CDs)
3. Commercial Paper
4. Bankers acceptances( least liquid)
5. Federal Funds
6. Repurchase Agreements
7. Eurodollars
8. Variable Rate Demand Notes

Note: ADRs are capital market instruments, not money market instruments.

Question 13

When interest rates decrease

Answer 13

short term react the quickest
long react the greates

Question 14

Capital Market instruments are long term debt and equity instruments including:

Answer 14

1. Equity Instruments( common and preferred stock)
2. Corporate Bonds
3. Treasury Bonds
4. Municipal Bonds
5. Mortgages
6. ADRs- American depositary Receipts
   Note: The Federal Reserve Board does not issues securities.

Question 15

C. Federal Funds

Answer 15

are excess funds deposited by commercial banks at federal reserve banks, usually funds which are in excess of reserve requirements. Federal Funds are used to settle transactions where there is no float( float is the time between deposit of a check and payment). Member banks may use Federal Funds to:

1.Lend to each other on an overnight basis at the Federal Funds rate.
2. Make same day credit and debit transactions, which are called fed wires.
3. Pay for purchases of government securities when performing Open Market Operations.

Question 16

Federal Funds rate

Answer 16

• is the interest rate charged by banks with excess reserves to banks needing overnight loans to meet reserve requirements.

1. The Federal funds rate is the most volatile rate in the money market.
2. The rate is normally higher than the rate charged at the federal discount window.
3. Leading indicator of interest rates since it is set daily by the market, it is not set by the FED.
4. There is no COLLATERAL required to borrow.
5. The “effective federal funds rate is the daily average rate of interest costs of Federal funds transactions throughout the country.
6. A decline in the Federal Funds rate will expand(increase) the money supply.
7. A rise in the Federal Funds rate will contract(decrease) the money supply.
8. Commercial banks, small regional banks, thrift institutions, and some foreign banks are sources of Federal Funds.

Question 17

when the yield curve is ascending

Answer 17

buy more long term

Question 18

when the the yield curve is descending

Answer 18

buy more short term

Question 19

Repurchase Agreements( REPOs)-

Answer 19

Are short term money market instruments which are generally overnight transactions but can have maturities of up to 3 months. A repo is an agreement to repurchase U.S. Government or other securities at a fixed price, usually on an overnight transaction.

1. Most sellers are government securities dealers.
2. Most buyers are corporations with surplus funds.
3. The difference between the purchase and re-purchase prices is the interest.
4. When the Fed participates in the Repo market and buys repos, it increases the money supply, if it sells Repos, it decreases the money supply.
5. Repos usually trade in denominations of $1,000,000
6. Interest Paid on repos is competitive with the Federal funds Rate .
   7.Repo rates are negotiated between two parties
7. Banks and thrifts often use repos to raise temporary capital.
8. Has an active secondary market.
9. Repos are not riskless transactions.
10. Some Repos are issued as CALLABLE.

Question 20

Bankers Acceptances are:

Answer 20

1. Used to finance foreign trade and are considered to be safe.
2. Drafts or bills of exchange which become money market instruments when payment is guaranteed by a bank or other financial institution. Also called “two name paper”
   Because if the issuer cannot pay the bank or institution will pay.
3. Issued on a discount basis so that exporters can receive immediate payment.
4. Most mature within 9 months.
5. Trade in the OTC market primarily by institutional investors.
6. Dealers in Bankers Acceptances profit from the spread between the price at which they are bought and sold( discount).

Question 21

Commercial paper:

Answer 21

1. Normally has a maximum maturity of 270 days or 9 months.
2. Represents an unsecured promissory note of corporations and is one of the best ways for a corporation to raise short term funds.
3. The proceeds may be used in any way by the issuer and are generally repaid with incoming accounts receivables.
4. Normally issued for a specific amount at a discount and redeemed at face value on a specific date, but can be issued as interest bearing certificates.
5. “Prime commercial paper” are notes issued by MAJOR corporations.
6. Usually yields more than Treasury bills for the same maturity.
7. Does not pay semi-annual interest
8. Not guaranteed by the FDIC.
9. Is NOT issued as callable.
10. May be sold directly by the issuer.
11. The quality of commercial paper is rated by Standard & Poor’s, Moody’s and Fitch but is not rated by A.M. Best.
12. Has an active secondary market, very liquid.
13. Exempt from the SEC
14. Is normally issued in book entry form.

Question 22

Eurodollars

Answer 22

are deposits in U.S. Dollars that have been deposited with banks outside of the U.S. and are frequently used to settle international transactions. The Fed generally is not a major participant in the Eurodollar market.

Question 23

Eurodollar Bonds

Answer 23

are bonds issued outside of the U.S. by either foreign or domestic corporations.

1. Eurodollars bond interest and principal payments can only be made in U.S. dollars(Eurodollars).
2. Eurodollars bonds are normally sold at rates lower than U.S. interest rates because there is less regulation.
3. They offer diversification to investors and are offered for sale to investors in foreign countries.
4. The SEC does not have jurisdiction of the Eurodollar bondmarket; therefore, it provides less legal protections than domestic bond market.

Question 24

The Interbank Market

Answer 24

is an unregulated, decentralized global market which trades currencies( and debt obligations such as Eurobonds). It is free from government regulation. Governments may take actions which would affect their own currencies . Trading is generally conducted in units of $50,000,000 to $100,000,000. Trading is done between institutions only. Interbank transactions risks include:

1. Economic changes in countries whose currencies are being traded.
2. Changes in government policies.
3. No last sale information.
4. 24 hour market

Question 25

Individual CDs

Answer 25

a. Are issued and guaranteed by banks in return for time deposits
b. Are issued in denomination of $100 to $100,000 ( or more).
c. Generally have maturities of 1 year or less.
d. Interest is accrued and paid at maturity.
e. Penalties may be incurred if cashed in prior to maturity.
f. Are not liquid.
g. Are offered primarily by banks to their customers but can be offered by broker-dealers.

Question 26

Negotiable CDs- Jumbo CDs- Brokered CDs

Answer 26

a. Are issued and guaranteed by banks in return for time deposits
b. Have a $100,000 minimum deposit
c. generally have fixed maturities of 1 year or less but some are issued with longer term maturities of several years.
d. Usually trade “plus interest”( with accrued interest) which is paid to the seller on settlement date and are issued in register form.
e. Penalties may be incurred if cashed in prior to maturity.
f. Have a liquid Secondary market as compared to the market for individual CDs but overall are not liquid as other securities.
g. Jumbo CDs can be issued as callable.
h. Are FDIC insured.

Question 27

In FOREX

Answer 27

cannot trade in US dollar, need to be the Yen, Peso, etc.

Question 28

Foreign Trade

Answer 28

1. When discussing appreciation and deprecation of currencies, we must also consider the floating exchange rate. The floating exchange rate is the ratio at which currencies are currently trading and is representation of how many units of one currency are needed in order to buy one unit of another currency . It is determined by supply and demand and is influenced by market forces and intervention by central banks.

For example:
If the exchange rate between the US dollar and the EURO is $1.20 US dolars to one British pound, this means that is takes $1.20 US dollars to buy 1 British Pound. Conversely, this also means that it takes 1 British pound to buy $1.20 US Dollars.

2. When viewing exchange rate, the perspective is always important:

Are we looking at from a US Citizen view

Are we looking at from a foreign view

Question 29

In foreign trade, depreciation of the US Dollar( weakening dollar). In relation to the currencies of other nation causes

Answer 29

US Exports become more competitive

Question 30

In foreign trade, an appreciation of the US Dollar( a strengthening dollar) in relation to currencies of other nations:

Answer 30

US exports become less competitive in world markets

Foreign imports become more competitive in domestic markets.

Question 31

As interest rates rise, the US dollar usually rises, foreign currency values decline. However, higher interest rates in the USA relative to rates of foreign nations would attract more investors to US bonds because they would offer a higher return.

Question 32

A U.S. balance of payment deficit would increase due to:

Answer 32

a. An increase in US investments abroad.
b. U.S Tourist spending abroad.
c. US loans to other countries
d. Raising dividends and interest payments on foreign-owned securities of US issuers
e. Money going out of the US would increase the deficit.
5. A US Balance of Payments would improve with:

A. New Foreign investment in the US
B. Commodity exports.
C. Spending by foreign tourists in the US.
D. increased dividends and interest earned on foreign investments.
E. Money coming into the US would reduce the deficit.

Question 33

International Monetary Fund(IMF)

Answer 33

This organization is funded by industrialized nations and its purpose are to promote monetary and exchange stability and international trade.

Question 34

The World Bank

Answer 34

its purpose is to assist developing nations by providing them with loans.

Question 35

Forex Market

Answer 35

the forex market is a worldwide decentralized marketplace established for the trading and conversion of various currencies that exist in the world. It facilitates international trade and provides a market for foreign and US currencies. Speculation by investors in the Forex market increases liquidity by providing more investors who are buying and selling base and counter currencies. The spot or cash price of each currency is used to determine the value of each currency being traded.

Question 36

Recession is defined as:

Answer 36

A mild consecutive six month decline in stock prices, business activity and employment.
Two consecutive quarters of negative( declining) growth in GDP.

B. Recovery period would show as an increase in the GDP for at least 2 consecutive quarters.

C. Inflationary period we generally see too much money chasing too few goods, which causes rising prices and interest rates. In an attempt to end an inflationary period, the Federal Reserve would tighten the money supply ( sell government securities and raise the discount rate).

NOTE: full employment and high consumer spending contribute to increasing inflationary pressure.

Question 37

Effect of Inflation/Deflation:

Answer 37

Periods of Inflation , interest rates increase and bond prices decline.
2. Periods of deflation, interest rates decline and the bonds prices appreciate.

An investor would buy short-term bonds if he anticipates rising interest rates

An investor would buy long term bonds if he anticipates declining interest rates

Question 38

Keynesian Economic Theory

Answer 38

believes in active government intervention in the marketplace. This theory believes that the government should, manipulate government expenditures and taxation( to avoid a depression, increase government spending- Fiscal Policy.

Question 39

Monetarist Theory

Answer 39

believes that controlling the money supply has a greater impact on the economy than Federal spending. Monetarists advocate a slow but steady growth in the money supply.

Question 40

Supply side Economics Theory

Answer 40

believes that drastic reductions in tax rates and size of government will stimulate the economy.

Question 41

Classical Economic Theory

Answer 41

is a monthly measure of the change in the price of the average goods and services bought by wage earners in selected U.S. cities. The CPI measures inflation. The CPI is also called The Cost of Living index.

Question 42

economic cycle

Answer 42

1. Expansion- indicates a recovery period( interest rates rise)
2. Peak indicates top of expansion period.
3. Contraction indicates a recessionary period( interest rates decline)
4. Trough indicates the bottom of a recessionary period.

Interest rates usually follow the movement of the Business cycle.

During expansionary periods, the demand for Goods, production, employment, and profits would be expected to increase.

Question 43

Elasticity of Demand

Answer 43

is an economic concept that measure how consumers respond to changes in price of a service or product.

1. Elastic demand- is when consumers respond significantly to a price change. This demand is considered elastic. Examples are changes in movie tickets, air travel, and restaurant meals.
2. Inelastic demand- is when consumers do NOT respond significantly to a price change. Examples are prices in coffee, utilities and cigarettes.
3. Unitary elastic demand- is when the change in consumer demand equals the change in the price. Example would be prices in homes increase 20%, but consumer demand for homes drops 20%.

Question 44

Bankruptcy

Answer 44

1. Chapter 7- if a person files for bankruptcy, any excess funds would be paid to the creditors
2. Chapter 11- generally used by business rather than an individual and allows business to reorganize and repay its creditors.
3. Chapter 13- usually occurs when an individual files for bankruptcy, and agrees to repay all or some of the debt to its creditors.

Question 45

Treasury Bills

Answer 45

Are always sold at a Discount, do not pay interest, therefore no coupon
Issued in minimum denominations of $100. 1,3,6, and 12 month maturities

1 and 2 month auctioned every Thursday and settle on the following Tuesday( T+3),
3 and 6 month auctioned every Monday settle Thursday (T+3)
1 year auctioned on Tuesday and settled on Thursday
Regular Way in the secondary Market is T+1
Quotes on BID and ASK are backwards

BID ASK
5.95 5.80
1,000 1,000
- 59.50 - 58.00
940.50(BID) 942.00( ASK)

Basis points for T-Bills / minimum denomination
$100- 12 month
$50 -180 day( 6 month)
$25- 3 month

Considered a Risk- Free Investment, guaranteed by the Government

Question 46

TIPS

Answer 46

Treasury inflation- Protected Securities rate based off of CPI
Interest is paid semi-annually at a fixed rate and applied to the inflation adjusted principal value of the bond.
Principal is adjusted to CPI semi-annually.
Final payment on a TIP cannot be less than what the investor originally paid for.

TIPS are auctioned three times a year- July, October, January

Regular Way settlement is T+1
Auction is T +3

Question 47

How to Read a Treasury BOND

Answer 47

Quotes BID- 103.08 = 103 8/32 = 1,032.50 8/32 = .25 or 2.50

32nds not 8ths

Question 48

on a treasury bond

Answer 48

YTM is always calculated from the asking price

Question 49

Repurchase Agreement- also called Repo’s.

Answer 49

Interest Rate on repos is comparable to the Fed Funds Rates.

Repo’s are usually overnight transactions traded between large companies or institutions

Question 50

Treasury Notes

Answer 50

Sold with fixed coupon rates, pay interest semi-annually, issued in minimum of denominations of $100, 2-10 years maturities NEVER CALLABLE

Question 51

Treasury Bonds

Answer 51

Sold with fixed coupon rates, pay interest semi-annually, issued in minimum of denominations of $100, 20-30 years maturities CAN BE CALLABLE
Accrued Interest on U.S. Government Notes and Bonds

Use a 365 day
Example: Assume an investor buys a Treasury Bond regular way on Tuesday June 3 and interest was paid last March 15. How many days of accrued interest is the seller entitled to?

March 15-31= 17
April = 30
May =31
June =3 (settles next business day)
81 days

use the date of purchase (june 3rd in this case)

Question 52

Calculate the following price on the bond.

99.24

Answer 52

99 x 10= 990
24/32. X 10= 7.50
997.50 is total value of par 1,000

Question 53

Federal Agency Issues

Answer 53

Federal Home Loan Banks
Federal Farm Credit Bank
Fannie Mae-Buys mortgages from lenders( VA and FHA)
Ginnie Mae- backed from the government , issued in minimum of 1,000 denominations
Freddie Mac- issued in minimum of 25,000 denominations

Have higher yields than direct obligations of the US Government

Question 54

FANNIE MAE

Answer 54

Not guaranteed by the US Government

Question 55

Ginnie Mae

Answer 55

Guaranteed by the US Government
Pass through securities pass through investors monthly
Issued in denomination of $1,000

ggg

Question 56

Freddie Mac

Answer 56

Pass through securities pass through investors monthly from conventional mortgage payments
Issued in denomination of $25,000

Question 57

Sallie Mae

Answer 57

Purchases student loans from qualifying colleges, banks, etc
Less credit risk than corporate debt and municipal revenue

Question 58

Federal Farm Credit System Notes and Bonds:

Answer 58

Interest is exempt from state and local taxes, subject to Federal tax.
Not guaranteed by the US Government
Bonds are more actively traded in the secondary market than the notes.

Bonds with long and short term maturities in 5,000 increments. ( bond are not callable. )
Not guaranteed by the US government.

Federal Home Loan Banks(FHLB) are considered to be safe investment.

Question 59

Other Types Of Government Securities

Answer 59

STRIPS- Separate Trading of Registered Interest and Principal Securities

Treasury Receipts(TR’s)

Zero Coupon Treasury Bonds or Stripped Treasuries
All above are the same, just different names

Interest is paid at maturity.
Sold at a discount.

Question 60

Series EE Bonds

Answer 60

are NON-MARKETABLE Federal Government Debt.
Taxable when redeemed
Denominations of $25 to $10,000 per calendar year.
Redeemable before maturity after 1 year
Not eligible to be used as collateral for a loan due to they are not marketable.