Question

BUS 205 FINALS PART-1 REVIEW

1. ​Indicate the sources of demand for loanable funds and discuss the factors that affect the demand for loanable funds.

​2.​What are the types of marketable obligations issued by the Treasury?

3.​What is discounting? Give an illustration.

4. What is usury, and how does it relate to the cost of consumer credit?

​5.​Explain the difference between the annual percentage rate and the effective annual rate.

6. How does a TIPS bond differ from the typical U.S. Treasury security?

​7.​Describe what is meant by bond covenants.

​8.​Briefly describe the types of bonds that can be issued to provide bondholder security.

9.​Explain what is meant by market stabilization.

​10.​Briefly describe how investment banking is regulated.

​11.​What is meant by the coefficient of variation? How is it used as a measure of risk?

12. What are sources of risk facing a firm which are reflected on its income statement?

Answer 1

Loanable Funds

Bond markets and financial institutions provide a means for those with excess cash to receive compensation for saving their money. In turn, these excess funds provide the financial capital needed for individuals and institutions to invest in a particular asset. For example, a bank will use the money deposited into a savings account by one man for a loanable fund for a woman purchasing a home. Alternately, an investment in an interest bearing bond by one man will help fund the construction of a new factory by the company issuing the bond.

Loanable funds refers to financial capital available to various individual and institutional borrowers. For example, individual borrowers include homeowners taking out a mortgage, while institutional borrowers could be a government issuing bonds or a company borrowing directly from a bank. Banking and financial services rely heavily on loanable funds to lend to borrowers with interest. This interest significantly increases the profit margins of these entities, while also increasing business. Each financial institution has several sources of funding.

Savings

The most common source of loanable funds is from savings of individuals or institutions. When a person opens up a savings account, he is allowing a bank to use his money in exchange for a certain interest rate. The bank will in turn aggregate all of the individual deposits and lend large sums of money to individuals, such as home buyers, and institutions, such as businesses, in exchange for a higher interest rate than it pays its depositors.

Loanable funds refers to financial capital available to various individual and institutional borrowers. For example, individual borrowers include homeowners taking out a mortgage, while institutional borrowers could be a government issuing bonds or a company borrowing directly from a bank. Banking and financial services rely heavily on loanable funds to lend to borrowers with interest. This interest significantly increases the profit margins of these entities, while also increasing business. Each financial institution has several sources of funding.

Newly Created Money

While most economists consider savings to be the primary source of loanable funds in an economy, another important source is newly created money. The Federal Open Market Committee of the Federal Reserve System can introduce money into the American economy by creating money and allowing banks to borrow that money, which they can in turn lend to individuals and institutions, thereby increasing the supply of loanable funds.

Loanable funds refers to financial capital available to various individual and institutional borrowers. For example, individual borrowers include homeowners taking out a mortgage, while institutional borrowers could be a government issuing bonds or a company borrowing directly from a bank. Banking and financial services rely heavily on loanable funds to lend to borrowers with interest. This interest significantly increases the profit margins of these entities, while also increasing business. Each financial institution has several sources of funding

External Sources

External sources outside of the primary economy can also supply loanable funds. For example, a source of loanable funds for the American economy could be Chinese foreign investment. The purchase of American government debt by China increased the amount of capital available in the general economy, although it is particularly beneficial for financial institutions. For example, a Chinese company purchasing American corporate debt in the form of a corporate bond provides an external source of loanable funds that may otherwise be unavailable.   Investment Demand:

The most important factor responsible for the demand for loanable funds is the demand for investment. Investment is expenditure of funds on the building up of new capital goods and inventories. Rate of interest is obviously the cost of borrowing of funds for investment.

Entrepreneurs go on investing in a capital asset up to the point at which the cost of borrowing i.e. the rate of interest equals its expected marginal revenue productivity.

Since marginal revenue productivity of a capital asset falls as more units of it are produced, the businessmen are prepared to invest more only at lower rates of interest. In other words, the demand for loanable funds for investment purposes rises with a fall in the rate of interest, or is interest- elastic. The investment-demand curve is, therefore, shown to be sloping downward to the right. It is the curve L in the diagram.

Dissaving:

Dissaving means consuming more than the income in the current period. It is the excess of expenditure of consumption over income and is thus negative saving. Some people are anxious to purchase such durable goods as houses, automobiles, refrigerators, television sets and air conditioners when they do not have the saving to pay for them.

They get it on installment basis and thus spend more than their current income. Dissaving is more at lower rates of interest and less at higher rates. Therefore, the dissaving curve DS is shown to be sloping from left downward to the right in the diagram.

Hoarding:

Loanable funds are also demanded for hoarding purposes that is for the satisfaction of the desire of people to hold money. People like to hold money in idle cash balances when they feel that the current rate of interest on lending is not sufficiently high to induce them to part with their money and that in the near future they will be able to make better use of their hoarded balances.

2) There are four types of marketable treasury securities: Treasury bills, Treasury notes, Treasury bonds, and Treasury InflationProtected Securities (TIPS). N. 3) Discounting is the process of determining the present value of a payment or a stream of payments that is to be received in the future. Given the time value of money, a dollar is worth more today than it would be worth tomorrow. Discounting is the primary factor used in pricing a stream of tomorrow's cash flows.

For example, the coupon payments found in a regular bond are discounted by a certain interest rate and added together with the discounted par value to determine the bond's current value.

From a business perspective, an asset has no value unless it can produce cash flows in the future. Stocks pay dividends. Bonds pay interest, and projects provide investors with incremental future cash flows. The value of those future cash flows in today's terms is calculated by applying a discount factor to future cash flows. 4)Usury is the practice of making unethical or immoral monetary loans that unfairly enrich the lender. The term may be used in a moral sense—condemning, taking advantage of others' misfortunes—or in a legal sense, where an interest rate is charged in excess of the maximum rate that is allowed by law.   Society's interest lies not necessarily in control of any of these indi- vidual consumer transactions, but rather in controlling the aggregate of them. Society's interest is complicated by the fact that debt is nec- essary for economic growth, but irresponsible growth can lead to so- cial factors which undermine long term stability. Usury laws are a useful and reasonable tool for limiting consumer debt in society's best interest by balancing the need for economic development with the risk of destabilizing effects on society. Uniform and effective usury laws could be an important counterweight to the forces of oversupply. Deregulation and competition only contribute to the dangers to society from irresponsible growth. Indeed, the legal criti- cism of usury as anticompetitive ignores the broad trends of our present economic condition which have caused the consumer debt to balloon in the last forty years. Anticompetitiveness alone does not mean that usury is mismatched to its protective task. While econo- mists discount the relationship of consumer debt to recession by not ing that consumer debt will not lead to recession,there is little doubt that in a recession all consumers suffer, overleveraged con- sumers suffer most, and the more overleveraged our population is, the more our society will suffer. The forces which contribute to the oversupply and overleveraging of consumers in our economy make our population as a whole more vulnerable to hardship.
Usury is a recognized tool of national economic policy, not simply the domain of state police power. Modern European nations rely on usury laws as a tool of national policy, not intended merely for the
As a value moderating the supply of consumer credit in society, national usury laws can moderate the competing interests in indebtedness and offer consumers and society protection in a time of diminished employment or recession which is the major problem of post-industrial development. 5)

The most common and comparable interest rate is the APR (annual percentage rate), also called nominal APR, an annualized rate which does not include compounding. The United States Truth in Lending Act requires disclosure using the APR, and it is used as a standard rate in many other countries.

The APR can be calculated by multiplying the periodic interest rate (say 2 percent per month) times the number of periods per year (in this case 12). Where n equals the number of periods per year and i equals the periodic (in this case, monthly) interest rate, then APR can be calculated as:

APR = i * n; or, using our example: 2% * 12 = 24%

The EIR, or effective interest rate, also known as effective APR, effective annual rate (EAR), or annual equivalent rate (AER), takes into account the effect of compounding.

EIR is the standard method of interest calculation in the European Union, and interest rates on all consumer loans in the EU must be disclosed in this format.

The EIR calculation is used in cases where interest is compounded, i.e. when interest is charged upon interest. Compound interest is used to calculate payments on credit card debt, where interest can be charged on existing interest, or other types of revolving credit facilities where outstanding interest not paid on time is added to the amount of principal owed and interest is subsequently charged on the new total. Because the EIR takes compounding into account it will always be greater than APR for a given loan, provided that the compounding occurs more frequently than once per year.
In microfinance, EIR is a less useful calculation than APR when calculating the cash cost of borrowing (it overstates cash costs for traditional loans with constant installments). The EIR, however, assigns a time value to money, regardless of whether it is charged in cash, and is therefore conceptually more complete.

Where n equals the number of compounding periods per year and i equals the periodic interest rate, EIR can be calculated as:

EIR = (1+i)n – 1

Using our previous example, where the quoted interest rate is 2 percent per month:

EIR = (1+.02)12 – 1 = .268242 or 26.8%

Note that the EIR is higher than the APR calculated using the same periodic interest rate and number of periods per year because the EIR takes into account the effect of compounding.

EIR can be calculated using the above formula with a financial calculator (or any calculator which has an exponent (yx) function) or using a basic spreadsheet program like Excel.