Chapter 05 - Money Markets

SOLUTIONS MANUAL
Chapter Five
Answers to Chapter 5
Questions:
1. First, money market instruments are generally sold in large denominations (often in units of $1
million to $10 million). Most money market partiipants !ant or need to "orro! large amounts
of ash so that transations osts are lo! relati#e to the interest paid. $he si%e of these initial
transations prohi"its most indi#idual in#estors from in#esting diretly in money market
seurities. &ather, indi#iduals generally only in#est in money market seurities indiretly !ith
the help of finanial institutions suh as money market mutual funds.
'eond, money market seurities ha#e lo! default risk( the risk of late or nonpayment of
prinipal and)or interest is generally small. 'ine ash lent in the money markets must "e
a#aila"le for a *uik return to the lender, money market instruments an generally "e issued only
"y high *uality "orro!ers !ith little risk of default.
Finally, money market seurities must ha#e an original maturity of one year or less. &eall from
Chapter + that the longer the maturity of a de"t seurity, the greater is its interest rate risk and the
higher its re*uired rate of return (the higher its li*uidity risk premium). ,i#en that ad#erse prie
mo#ements resulting from interest rate hanges are smaller for short term seurities, the short
term maturity of money market instruments helps lo!er the risk that interest rate hanges !ill
signifiantly affet the seurity-s market #alue and prie.
.. 'ingle-payment seurities pay interest only one, at maturity. /uoted interest rates on single-
payment seurities assume a +00-day year. $herefore, to ompare single-payment yields !ith
"ond e*ui#alent yields, the *uoted single-payment yield must "e on#erted into a "ond
e*ui#alent rate or yield. $he on#ersion of a single-payment yield to a "ond e*ui#alent rate is
alulated as follo!s1 ibey 2 ispy (+05)+00).
5. $he 3.'. $reasury has a formal proess "y !hih it sells ne! issues of $reasury "ills through
its regular $reasury "ill autions. 4#ery !eek (usually on a $hursday) the amount of ne! 51-day
and 167-day $-"ills the $reasury !ill offer for sale is announed. 8ids may "e su"mitted "y
go#ernment seurities dealers, finanial and nonfinanial orporations, and indi#iduals and must
"e reei#ed "y a Federal &eser#e 8ank "y the 1 pm Monday follo!ing the aution
announement. 9lloations and pries are announed the follo!ing morning ($uesday). :n
addition autions of 57-!eek (1-year) $-"ills are onduted "y the 3.'. $reasury on a monthly
"asis.
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Chapter 05 - Money Markets
Probles:
5. a. $he $-"ill-s *uoted yield is alulated as
i$-"ill, dy 2 $10,000 - $5,505 ; +00 2 1.+70<
$10,000 55
". $he $-"ill-s "ond e*ui#alent yield is alulated as
i$-"ill, "ey 2 $10,000 - $5,505 ; +05 2 1.+.5<
$5,505 55
. $he $-"ill-s "ond 49& is alulated as
49& 2 =1 > .01+.5)(+05)55)?
+05)55
- 1 2 1.+50<
5. 4@C4A Bro"lem1 Cield 2 ..01.<
Cield 2 1.000<
Cield 2 0.60+<
Cield 2 0..01<
Cield 2 0.101<
11. a. $he yield on this repo to the "ank is alulated as follo!s
i&9, spy 2 $75,000,000 - $7.,550,000 ; +00 2 10.+1<
$7.,550,000 D
". $he yield on this repo to the "ank is alulated as follo!s
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Chapter 05 - Money Markets
i&9, spy 2 $75,000,000 - $7.,550,000 ; +00 2 +...<
$7.,550,000 71
17. $he return on the ommerial paper is alulated as
ip, dy 2 $500,000 - $.55,000 ; +00 2 6.00<
$500,000 .5
and
ip, "ey 2 $500,000 - $.55,000 ; +05 2 6.15<
$.55,000 .5
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Chapter 05 - Money Markets
C!APT"# $
1. Capital markets are markets that trade e*uity (stoks) and de"t (notes, "onds, and mortgages)
instruments !ith maturities of more than one year. 8onds are long term de"t o"ligations issued
"y orporations and go#ernment units. Broeeds from a "ond issue are used to raise funds to
support long term operations of the issuer (e.g., for apital e;penditure proEets). :n return for the
in#estor-s funds, "ond issuers promise to pay a speified amount in the future on the maturity of
the "ond (the fae #alue) plus oupon interest on the "orro!ed funds (the oupon rate times the
fae #alue of the "ond). :f the terms of the repayment are not met "y the "ond issuer, the
"ondholder (in#estor) has a laim on the assets of the "ond issuer. 8ond markets are markets in
!hih "onds are issued and trade. $hey are used to assist in the transfer of funds from
indi#iduals, orporations, and go#ernment units !ith e;ess funds to orporations and
go#ernment units in need of long term de"t funding. 8ond markets are traditionally lassified
into three types1 $reasury notes and "onds, muniipal "onds, and orporate "onds.
+. 9 '$&:B is a $reasury seurity in !hih periodi oupon interest payments an "e separated
from eah other and from the final prinipal payment. 9 '$&:B effeti#ely reates t!o
seurities--one for eah interest payment and one for the final prinipal payment. '$&:Bs are
attrati#e in#estments to in#estors !ho !ant to reei#e a ertain amount at a speified time in the
future and are not onerned a"out reei#ing urrent inome. For e;ample, '$&:Bs are used as
in#estment seurities for indi#idual retirement aounts, Feogh Blans, and pension funds.
D. a. su"ordinated de"enture
". mortgage "ond
. su"ordinated de"enture
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Chapter 05 - Money Markets
Probles:
+. a. Guly 15, 7010 to 9ugust 15, 7015 is 5.0D0D17++ years. 9lso, the 9sked prie is 51.1D+<.
$hus,
51.1D+< 2 100<) (1 > 9sked yield)7)
2x5.07671233

'ol#ing for H9sked yield,I !e get 1.6+<
". Guly 15, 7010 to Jo#em"er 15, 7010 is 0.+76D0D17 years. $hus,
K" 2 100<) (1 > 7.7.515<)7)
7;0.+76D0D17
2 60.67+<
5. a. $he inflation-adEusted prinipal at the end of the first si; months Gune +0, 701., is found "y
multiplying the original par #alue ($100,000) "y the semiannual inflation rate. $hus, is adEusted
up!ard "y 0.+ perent (e.g., $100,000 ; 1.00+), or to $100,+00. $herefore, the first oupon
payment, paid on Gune +0, 701., is $.,017 ($100,+00 ; ..0<).
". $he inflation adEusted prinipal at the "eginning of the seond si; months is $100,+00.
. $he prinipal amount used to determine the seond oupon payment is adEusted up!ard "y 1
perent (e.g., $100,+00 ; 1.01), or to $101,+0+. $he oupon payment to the in#estor for the
seond si; month period is the inflation-adEusted prinipal on this oupon payment date
($101,+0.) times the semiannual oupon rate (. perent). Lr on Meem"er +1, 701., the in#estor
reei#es a oupon payment of $.,057.17 ($101,+0+ ; ..0<).
D. a. :f your marginal ta; rate is 76 perent, the after-ta; or e*ui#alent ta; e;empt rate of return on the
ta;a"le "ond is 0.D5<)(1 - .76) 2 5.+D5<
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Chapter 05 - Money Markets
". :f your marginal ta; rate is 71 perent, the after-ta; or e*ui#alent ta; e;empt rate of return on
the ta;a"le "ond is 0.D5<)(1 - .71) 2 6.55.<
10. a. $he losing prie of 8ank of 9meria "onds on Guly 10, 7010 !as 105.700< of the fae
#alue of the "ond.
". $he 'NB "ond rating on Morgan 'tanley 5.500 perent oupon "onds maturing in 7070 on
Guly 10, 7010 !as 9.
. $he losing prie of Co; Communiations D.D50 perent "onds on Guly 15, 7010 !as
101.600< > 0.156< 2 101.556< of the fae #alue of the "ond.
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Chapter 05 - Money Markets
Chapter %
+. 9 lien is a pu"li reord attahed to the title of the property that gi#es the finanial institution
the right to sell the property if the mortgage "orro!er defaults or falls into arrears on his or her
payments. $he mortgage is seured "y the lien. $hat is, until the loan is paid off, no one an "uy
the property and o"tain lear title to it. :f someone tries to purhase the property, the finanial
institution an file notie of the lien at the pu"li reorder-s offie to stop the transation.
5. 9 fi;ed rate mortgage loks in the "orro!er-s interest rate and thus re*uired monthly
payments o#er the life of the mortgage, regardless of ho! market rates hange. :n ontrast, the
interest rate on an adEusta"le rate mortgage (9&M) is tied to some market interest rate or interest
rate inde;. $hus, the re*uired monthly payments an hange o#er the life of the mortgage. 9&Ms
generally limit the hange in the interest rate allo!ed eah year and during the life of the
mortgage
Mortgage "orro!ers generally prefer fi;ed rate loans to 9&Ms, partiularly !hen interest
rates in the eonomy are lo!. :n fat if interest rates rise, 9&Ms may ause "orro!ers to "e
una"le to meet the promised payments on the mortgage. :n ontrast, most mortgage lenders
prefer 9&Ms !hen interest rates are lo!. Ohen interest rates e#entually rise, 9&M payments on
their mortgage assets !ill rise. 'ine deposit rates and other lia"ility rates too !ill "e rising, it
!ill "e easier for finanial institutions to pay the higher interest rates to their depositors !hen
they issue 9&Ms. Po!e#er, higher interest payments mean mortgage "orro!ers may ha#e
trou"le making their payments. $hus, default risk inreases. 9s a result, !hile 9&Ms redue a
finanial institutions interest rate risk, they also inrease their default risk.
D. 'u"prime mortgages are mortgages to "orro!ers that do not *ualify for prime mortgages
"eause of !eakened redit histories inluding payment delin*uenies, and possi"ly more se#ere
pro"lems suh as harge-offs, Eudgments, and "ankrupties. 'u"prime "orro!ers may also
display redued repayment apaity as measured "y redit sores, de"t-to-inome ratios, or other
riteria that may enompass "orro!ers !ith inomplete redit histories. 'u"prime mortgages
ha#e a higher rate of default than prime mortgage loans and are thus, riskier loans for the
mortgage lender and. 9s a result, these mortgages ha#e higher interest rates than prime
mortgages. $he maEority of home loans are not su"prime mortgages, ho!e#er their num"ers
rapidly gre! in the mid-7000s. 'u"prime mortgages aounted for 5 perent of all mortgage
originations from 1550 through 700. and rose to a"out 71 perent from 700. through 7000.
:t !as su"prime mortgages and the huge gro!th in them that !as a maEor instigator of the
finanial risis. $he lo! interest rate en#ironment in the early and mid-7000s led to a dramati
inrease in the demand for residential mortgages, espeially among those !ho had pre#iously
"een e;luded from partiipating in the market "eause of their poor redit ratings, i.e., su"prime
"orro!ers. $o "oost their earnings, F:s "egan lo!ering their redit *uality ut-off points. :n the
su"prime market, "anks and other mortgage lenders often offered relati#ely lo! HteaserI rates on
adEusta"le rate mortgages (9&Ms). 4#entually, housing pries started to fall and interest rates
started to rise. 'ine many su"prime mortgages had floating rates, meeting mortgage payments
"eame impossi"le for many lo! inome households. $he results !ere a !a#e of mortgage
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Chapter 05 - Money Markets
defaults in the su"prime market and forelosures that only reinfored the do!n!ard trend in
house pries. 9s this happened, the poor *uality of the ollateral and redit *uality underlying
su"prime mortgage pools "eame apparent. 'u"prime mortgage-"aked seurities plummeted in
#alue and the finanial risis "egan.
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Chapter 05 - Money Markets
Probles:
7. Cou !ill make a do!n payment of 70 perent of the purhase prie, or you !ill make a do!n
payment of $+5,000 (.70 ; $1D5,000) at losing and "orro! $1.0,000 through the mortgage.
a. For your mortgage1$1.0,000 2 BM$Q=1-(1)(1>.0DD5)17)
15(17)
)?)(.0DD5)17)R
or BM$ 2 $1.0,000)Q=1-(1)(1>.0DD5)17)
15(17)
)?)(.0DD5)17)R
therefore BM$ 2 $1.0,000)100.7+66 2 $1,+1D
$hus, your monthly payment is $1,+1D.D5.
". $he 00th payment of $1,+1D.D5 is split as follo!s1 $D1+.0D to interest and $00..D7 to
prinipal.
. $he 160th payment of $1,+1D.D5 is split as follo!s1 $6..0 to interest and $1,+05.++ to
prinipal.
d. $he total payments o#er the life of the mortgage amount to payments of $7+D,701..6
($1,+1D.D60 ; 15 ; 17)1 $1.0,000 to the repayment of prinipal and $5D,701..6 to the payment
of interest.
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Chapter 05 - Money Markets
5. Cou !ill make a do!n payment of 70 perent of the purhase prie, or you !ill make a do!n
payment of $.0,000 (.70 ; $700,000) at losing and "orro! $100,000 through the mortgage.
a. For your mortgage1$100,000 2 BM$Q=1-(1)(1>.0050)17)
+0(17)
)?)(.0050)17)R
or BM$ 2 $100,000)Q=1-(1)(1>.0050)17)
+0(17)
)?)(.0050)17)R
therefore BM$ 2 $100,000)156.7106 2 $1,011.+1
$hus, your monthly payment is $1,011.+1.
". 9morti%ation 'hedule for first 0 payments (months)

8eginning 4nding
Aoan Aoan
Month 8alane Bayment :nterest Brinipal 8alane
1 $100,000.00 $1,011.+1 $600.0D $1...0. $155,655.+0
7 155,655.+0 1,011.+1 605.66 1.5..+ 155,D05.5+
+ 155,D05.5+ 1,011.+1 605.10 1.0.71 155,50+.D7
. 155,50+.D7 1,011.+1 60..+0 1.D.01 155,.10.D1
5 155,.10.D1 1,011.+1 60+.51 1.D.60 155,706.51
0 155,706.51 1,011.+1 607.D1 1.6.00 155,170.+1

10. Cou !ill make a do!n payment of 75 perent of the purhase prie, or you !ill make a do!n
payment of $.+,D50 (.75 ; $1D5,000) at losing and "orro! $1+1,750 through the mortgage.
a. :f Lption 7 is hosen you pay $1+1,750 ; .07 2 $7,075 in points and reei#e $176,075 at
losing ($1+1,750 - $7,075), although the mortgage prinipal is $1+1,750. $o determine the "est
option, !e first alulate the monthly payments for "oth options as follo!s
Lption 11 $1+1,750 2 BM$ Q=1-(1)(1>.0500)17)
15(17)
)?)(.0500)17)R 2S BM$ 2
$1,0+D.57
Lption 71 $1+1,750 2 BM$ Q=1-(1)(1>.0.D5)17)
15(17)
)?)(.0.D5)17)R 2S BM$ 2
$1,070.50
:n e;hange for $7,075 up front, Lption 7 redues your monthly mortgage payments "y $1D.017.
$he present #alue of these sa#ings (e#aluated at ..D5 perent) o#er the 15 years is
BK 2 $5.50 Q=1-(1)(1>.0.D5)17)
15(17)
)?)(.0.D5)17)R 2 $7,16D.1.
Lption 1 is the "etter hoie. $he present #alue of the monthly sa#ings, $7,16D.1., is less than
the points paid up front, $7,075.
". :f Lption 1 is hosen you pay $1+1,750 ; .07 2 $7,075 in points and reei#e $176,075 at
losing ($1+1,750 - $7,075), although the mortgage prinipal is $1+1,750. :f Lption 7 is hosen
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Chapter 05 - Money Markets
you pay $1+1,750 ; .0+ 2 $+,5+D.5 in points and reei#e $17D,+17.5 at losing ($1+1,750 -
$+,5+D.5). $he differene in sa#ings on the points is $1,+17.5.
$o determine the "est option, !e alulate the monthly payments for "oth options as follo!s
Lption 11 $1+1,750 2 BM$ Q=1-(1)(1>.0.65)17)
15(17)
)?)(.0.65)17)R 2S BM$ 2
$1,07D.05
Lption 71 $1+1,750 2 BM$ Q=1-(1)(1>.0.06)17)
15(17)
)?)(.0.06)17)R 2S BM$ 2
$1,010.1D
:n e;hange for $1,+17.5 up front, Lption 7 redues your monthly mortgage payments "y
$11.57.
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