Comparing Financial Institutions Chapter Questions Order Instructions: Chapter 1
16. Comparing Financial Institutions classify the types of financial institutions mentioned in this chapter as either depository or non-depository.
Explain the general difference between depository and non-depository 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?
1. Interest Rate Movements Explain why interest rates changed as they did over the past year.
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?
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?
1. Characteristics That Affect Security Yields Identify the relevant characteristics of any security that can affect its yield.
3. Impact of Liquidity on Yield Discuss the relationship between the yield and liquidity of securities.
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 bias be avoided?
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?
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.
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.
Comparing Financial Institutions Chapter Questions Sample Answer
Financial Chapter Questions
Depository institutions are the financial companies such as banks, savings and credit unions, which receive money from clients and led them to the borrowers. Non-depository institutions are finance companies which depend on sources of funding from the commercial paper market. They include insurance companies, mutual funds, pension funds, and money market funds. The main difference between depository and non-depository financial institutions is that the former accepts deposits from the customers whereas the later does not.
It is widely acknowledged that financial institutions are becoming more similar. However, these institutions differ distinctly in terms of performs due to various factors. Different financial institutions have adopted different policies and regulations which influence their operations and this explains why firms offering similar services perform differently. Another factor which creates this disparity is that is that these financial institutions rely on different sources of funds and use funds in different projects.
If a financial institution acts an intermediary, it stands the chance of earning fees or commissions as income. However, this income will significantly affect the asset portfolio of the institution. This means that the true financial position of the company is not reflected in the balance sheet. As indicated above, the company will receive immediate income from the transaction but this does not affect the balance sheet. According to Hill and Jones (2007), borrowers are the ultimate users of these funds while the ultimate savers are the sources of funds. In this case, sources of funds are suppliers of funds who are mainly those who save their money in anticipation of specified interest. Those borrowing funds, who are referred to as ultimate users in this chapter are also investors. The financial institutions lend money to investors who use to finance their investment projects.
The interest rates changes as they did over the years simply because they are affected by numerous factors which control supply and demand of funds which are loaned by the financial institution or government. Generally speaking, there is an inverse relationship between the number of funds that can be offered as loan demanded by the customers and the interest (Hermanson & Edwards, 2012). When the demand for the funds is high, interest rates are expected to be high and vice versa is true. The changes in interest rates are also influenced by the government monetary policies. When the government pumps in more money into the economy, interest rates reduces and the vice versa is true. This is because government policies have far-reaching impacts on the forces of demand and supply in the money markets. However, the bottom line is that the number of funds demanded greatly influence changes interest rates.
Nominal interest rate refers to the actual quoted interest rate whereas real interest rate describes the nominal interest minus the forecasted rate of inflation. According to Proctor (2012), customers or investors are always interested in positive real return. Therefore, they are willing to invest their funds if the nominal interest rate is more than inflation. As such, the purchasing power of the funds invested by the customers will grow over time. With the rise of inflation, the nominal rise is expected to rise owing to the fact that investors would expect or require nominal return which is more than the inflation rate.
Increase in oil prices is expected to cause an increase in inflation, and this will cause expectation of higher interest rates in the global market. Therefore, firms and the US government will have to borrow more funds before an increase in oil prices and before an increase in interest rates. In the event of this situation, consumers are compelled to use their savings to buy products before the increase in its prices. As such, the demand for funds that can be offered as a loan is expected to increase, while supply is expected to decrease. This would lead to an increase in interest rates.
Interest rates among countries are expected to be closely related in the recent past owing to the fact that financial institutions and markets have become more geographically integrated. This means that more international financial flows will definitely occur so as to make use of higher interest rates in foreign markets. This, in turn, affects the supply and demand conditions in every foreign market.
Some of the common relevant characteristics of any security are default risk, tax status, maturity and liquidity
The higher the liquidity of a security, the lower is the yield provided other things are equal.
The forward rate refers to the expected interest rate at a future date. In the events that forward rates are determined without taking into account liquidity premium, there is a likelihood that the future interest rates will be overestimated. In the event that liquidity premium is considered when determining the forward rate, it is possible to eliminate bias.
Yield curve indicates no expected change in interest rates as indicated in pure expectations theory. As such, flat yield curve which indicates the existence of liquidity premium, then this would have downward slope if liquidity premium is removed. This suggests anticipation of a slight decrease in future interest rates.
The weak economy often leads to an expectation in a reduction of interest rates and this would create a downward-sloping yield curve. The liquidity premiums would lead to a slight upward slope of the yield curve. The preference of treasury gives rise to a downward sloping of the demand yield curve provided that other constants are held constant.
Default risk occurs when the borrower fails to make interest or principals payments on loan borrowed. In most cases, defaulters tend to make interest or principal payments when the economic conditions are favorable hence minimal default risks. However, default risk widens in times of economic downturns. This is because investors are ready to take an additional risk during times of economic prosperity hence it requires lower fields from low-rated bonds. During the times of economic crisis, investors are keen on security hence they require significant yields from riskier bonds. Currently, the country is experiencing some economic challenges. This means that investors are not ready to take additional risks thus require fewer yields from low-rated bonds. This would definitely lead to an increase in the default risk premium. Yield curve actually tells how interest rates are likely to change in the future (Neale & McElroy 2014). It is used by economist and financial analysts to get an idea changes in economic activities that are likely to lead to changes in interest rate. Due to economic conditions, interest rates will increase. This has an effect on the yield curve as it will steepen. These changes are based on risk premiums and expected changes in interest rates in the near future.
Comparing Financial Institutions Chapter Questions References
Hermanson, R.G & Edwards. J.D., (2012), Accounting Principles Volume II. Dow Jones-Irwin. New York.
Hill, C.L. &Jones, G.R., (2007), Strategic Management Theory: An Integrated Approach. Houghton Mifflin. Boston.
Neale, B. & McElroy T. (2014), Business Finance: A Value-Based Approach. Prentice Hall. Harlow, Essex.
Proctor, R. (2012), Managerial Accounting: Decision Making and Performance Improvement. Prentice Hall. Harlow, Essex.