zaheerswati@ciit.net.

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COMSATS Institute of Information Technology Abbottabad

Department of Management Sciences

First Sessional: Spring 2014

Class: BBA 8 (A) Date: 11-04-14
Subject: Financial Institutions Instructor: Zaheer A. Swati
Total Time Allowed: 80 Minutes Max Marks:
Registration #



SECTION-A
(Time allowed: 20 Minutes) (Marks: 20)

A. Encircle the most appropriate choice (MCQs). (Marks: 20)
1. Which of the following is not a theory of the termstructure of interest rates?
(a) Expectations hypothesis (b) Permanent income hypothesis
(c) Liquidity premiumtheory (d) Market segmentation hypothesis
2. The theme of liquidity premium theory of the termstructure of interest rates is that?
(a) Short-termand long-term bonds are perfect substitutes
(b) Short-termbonds are relatively less liquid (less marketable) than long-termbonds
(c) Long-term bonds are relatively less liquid (less marketable) than short-term bonds
(d) Short-termand long-termbonds are perfect complements
3. The yield that one can expect to receive on loanable funds without taking significant risk is called the?
(a) Risk premium (b) Pure interest yield (c) Inflationary premium (d) Nominal interest yield
4. The real rate of interest is the?
(a) Nominal rate of interest plus the inflationary premium
(b) Risk component associated with the ownership of real assets
(c) Yield one can expect to receive on loanable funds without taking significant risk
(d) Nominal rate of interest minus the inflationary premium
5. The termstructure of interest rates is the structure of interest rates on bonds that differ only in terms of?
(a) Purchase price (b) Income risk (c) Term to maturity (d) Liquidity
6. When yield curves are steeply upward-sloping?
(a) Long-term interest rates are above short-term interest rates
(b) Short-terminterest rates are above long-terminterest rates
(c) Short-terminterest rates are about the same as long-term interest rates
(d) Medium-terminterest rates are above both short-termand long-terminterest rates
7. A checking deposit in a bank is considered __________ of that bank
(a) Capital (b) Net worth (c) An asset (d) A liability
8. If the expected inflation rate is 4% and the real rate of return is 5%, what is the nominal interest rate?
(a) 1% (b) 9% (c) 6% (d) 5%
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9. According to the expectations hypothesis the yield on?
(a) A short-termbond is an average of the expected yields on long-termbonds
(b) A long-term bond is the average of expected yields on short-term bonds
(c) A short-termbond is the difference between the long-termyield and the inflation rate
(d) A long-termbond is the sumof the short-termyield and the risk premium
10. If the expected path of one-year interest rates over the next four years is 5 percent, 4 percent, 2 percent, and 1 percent, then
the pure expectations theory predicts that todays interest rate on the four-year bond is?
(a) 1 percent (b) 2 percent (c) 4 percent (d) None of the above
11. The present value of Rs. 100, delivered one year fromnow, would?
(a) Fall if the rate of interest increased (b) Fall if the rate of interest decreased
(c) Rise if the rate of interest increased (d) Not change if the interest rate changed
12. An increase in the Consumer Price Index is commonly referred to as?
(a) Economic growth (b) Inflation (c) Unemployment (d) Deflation
13. The Fisher Effect assumes that the?
(a) Real interest rate is equal to the nominal interest rate
(b) Nominal interest rate is equal to the real interest rate plus the inflation rate
(c) Inflation rate is equal to the real interest rate (d) Nominal interest rate is equal to the inflation rate
14. According to the market segmentation hypothesis, short-term and long-term bonds?
(a) Are perfect substitutes (b) Are complementary to each other
(c) Are not substitutes for each other (d) All of above are correct
15. The liquidity premiumtheory of the termstructure?
(a) Indicates that todays long-terminterest rate equals the average of short-terminterest rates that people expect to occur
over the life of the long-term (b) Assumes that claims of different maturities are perfect substitutes
(c) Suggests that markets for bonds of different maturities are completely separate (d) None of the above
16. Typically, increasing interest rates?
(a) Discourage corporate investments (b) Discourage individuals fromsaving
(c) Encourage corporate expansion (d) Encourage corporate borrowing
17. The price of one countrys currency in terms of anothers is called?
(a) The exchange rate (b) The interest rate (c) Industrial average (d) None
18. If your nominal income rises 4 percent and your real income falls 1 percent, by how much did the price level change?
(a) 5 percent decrease (b) 3 percent increase (c) 3 percent decrease (d) 5 percent increase
19. Which of the following is not a determinant of market interest rates?
(a) r
rf
(b) Liability risk premium (c) Default risk premium (d) Maturity risk premium
20. According to the expectations hypothesis, the expectation of falling short-terminterest rates results in?
(a) A downward-sloping yield curve (b) An upward-sloping yield curve
(c) A flat (horizontal) yield curve (d) A hump-shaped yield curve



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SECTION-B
(Time allowed: 60 Minutes) (Marks:10)
Q1: r
rf

=real risk-free rate =2%
Constant inflation premium =3%
Maturity risk premium =(t-1)*0.1%,
Default risk premium =1%
Liquidity premium =1%

Requirement (A): What should be the nominal risk-free rate for 3-month T-bills? (1 Mark)
Solution:
2% +3% =5%
(Since MRP =DRP =LP =0 for T-bills)

Requirement (B): What should be the rate on a 20 year T-bond? (2 Marks)
Solution:
2% +3% +(20 - 1)*0.1% =6.9%
(Since DRP =LP =0 for T-bonds)

Requirement (C): What should be the rate on a 20 year XYZ bond? (2 Marks)
Solution:
2% +3% +(20 - 1)*0.1% +1% +1% =8.9%
(Since it is a corporate bond)

Q2. Assume the following set of rates: (3 Marks)




Requirement: What are the forward rates over each of the four years (2 to 4)? (3 Marks)



Putting the values


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Q 3: The real risk-free rate of interest, r
rf
, is 4 percent, and it is expected to remain constant over time. Inflation is expected to be
2 percent per year for the next three years, after which time inflation is expected to remain at a constant rate of 5 percent per year.
The maturity risk premiumis equal to 0.1(t - 1) %, what is the yield on a 10-year Treasury bond? (2 Marks)
Solution:
r
d
=r
rf
+IP +DRP +MRP
r
d
=4% +(2% (3) +5% (7))/10 +0.1(10.1)
r
d
=4% +4.1% +0.9%
r
d
= 9%


SECTION-C
(Marks: 15)
Q1: How does the liquidity premiumtheory of the term structure of interest rates differ fromun-biased expected theory? Your
argument should be based on suitable examples and graphs. (10 Marks)
Solution:
The Expectations Theory
This theory state that the shape and slope of the yield curve are determined by investors expectation about future short-term
interest rate movements and that changes in these expectations about future interest rate will change the shape of the yield
curve
The Theory assumes that
Investors are profit maximizers, and that
Investors have no preference between holding long and short-termsecurities. That is they are indifferent towards interest
rate risk
According to the expectations hypothesis, the yield on a long-termsecurity (say bond) is the average of expected short-term
interest rates
Suppose one-year interest rate over the next five years are expected to be: 5%, 6%, 7%, 8% and 9%
Then, interest rate on the two-year bond:
(5% +6%)/2 =5. 5%


1 2
Yield Curve
2
4
Maturity (years)
Yield to maturity (%)
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Liquidity Premiums Theory
This theory is extension of the unbiased expectation theory
The borrowers who seek long-term funds to finance capital projects must pay lenders a liquidity premium (an additional
yield for accepting lower liquidity, also called premium)
This premiumincreases as maturity increases. This is because risk increases as maturity increases. Thus the yield curve
must have liquidity premiumadded to it. The following graph illustrates this:


The interest rate on a long-term bond will equal the average of short-term interest rates expected to occur over the life of
the long-term bond plus a liquidity premium
Suppose one-year interest rate over the next five years are 5%, 6%, 7%, 8%, 9%, liquidity premiums for one to five-year
are 0%, 0.25%, 0.5%, 0.75%, 1.0%


Q2: Discuss factors affecting supply of loanable funds other than interest rate with diagram(5 Marks)
Solution:


IR
r
0
SL
1
DL
0

SL
0
r
1
LF
Maturity
Expectation theory Y.C
Observed Y.C
Liquidity Premium
Yield
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a. Changes in the quantity of money:
If quantity of money increases ( M is +), supply of loanable funds increases (people have more money to save), the SL curve
shifts to the right (or downwards), resulting in a new equilibriumwith lower interest rate and higher equilibriumquantity.
b. Change in the income tax:
A decrease in income tax increase saving. Thus, the supply of loanable funds increases, shifting the SL curve to the right,
decreasing r
0
and increasing Q
0
.
c. Changes in government budget from deficit to surplus position:
Reduced government expenditure increases government savings, thus shifts the SL curve to the right.
d. Expected inflation:
If lower rates of inflation are expected in the future, saving increase (current consumption decreases waiting for the expected
reduction in prices), and supply of loanable fund will increases, which shift the SL curve to the right.
e. Change in saving rate or public desire to hold money balances:
An increase in saving rate (the percentage of income saved) will increase the supply of loanable funds, shifting the SL curve shift
to the right.
f. Changes in business saving:
An increase in business saving of course increases supply of loanable funds and SL curve shift to the right.