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Flashcards in Interest Rates Deck (33)
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How did the Fed respond to the Great Recession?

By lowering the target for the fed funds rate to zero, and then engaging in a process of quantitative easing by purchasing longer-term securities.


How are assets valued?

By determining the future expected cash flow discounted at a rate that reflects the riskiness of the cash flow.


What is Portfolio Theory?

It assumes that a rational investor seeks to minimize risk while maximizing reward.


What is a hurdle rate?

The rate of return an investor requires, above which the investment makes sense and below which it does not.


What does a normal sloping yield curve represent?

An interest rate environment where interest rates in the short term are lower than those in long term.


What does a flat yield curve represent?

An interest rate environment where there is little difference between long-term and short-term interest rates. This means that investors are not rewarded proportionately for holding longer-term assets, in comparison to a normal yield curve environment.


What does an inverted yield curve represent?

Investors are paid a higher return on short-term assets then on long-term assets. This may reflect a negative outlook on the economy.


What are the two components of a long-term interest rate?

1) the spot interest rate that market participants currently expect to prevail at some date in the future and 2) the additional compensation that investors require for the risk of holding longer-term instruments (term premium).


What happens if demand for long-term securities rises?

If the demand rises relative to supply, investors will generally accept less compensation to hold longer-term securities, which means the term premium will decline.


What are the four reasons that demand for long-term issues could increase?

1) LT issues are more stable due to less volatility in the economy. If investors think these market conditions will continue, they may believe that less compensation for is need to justify holding LT issues. 2) Increased intervention in currency markets by governments have put downward pressure on yields. 3) Pension funds are required to be more fully funded because of new financial reforms. 4) Lack of supply.


What are treasury securities?

A debt instrument issued by the Treasury depart that represents direct obligations of the U.S. Government (full faith and credit). Can come in the form of Treasury bills, notes or bonds.


Why are they important?

The treasury yield curve is a benchmark for fixed income securities across the spectrum of debt securities. They are unique because they have virtually nonexistent default risk and tight bid offer spreads.


What are the three goals of the Treasury?

1) Achieve the lowest possible debt service cost, 2) Ensure access to unlimited credit in times of war or emergencies, 3) Promote efficient capital markets.


How are Treasuries used?

1) By the Fed to carry out monetary policy, 2) By foreign currency boards as reserves for dollar-linked currencies, 3) as the default risk-free U.S. Benchmark 4) As the yield determinate for pension funds, 5) By portfolio managers to hedge risk, 6) As a benchmark in determining the required return from riskier investments.


What are primary dealers?

Banks and securities brokerages that trade in U.S. Government securities directly with the Fed. As of 2015, there were 22 primary dealers (TD Securities was added).


What are the obligations of primary dealers?

To 1) participate consistently in open market operations, 2) to provide the Fed with market information and analysis helpful to monetary policy, 3) to participate in all auctions of U.S. Government debt, and 4) to make markets when the NY Fed transacts on behalf of foreign official account holders.


What are the requirements to become a primary dealer?

Must be either a B-D registered with and supervised by the SEC or a U.S. -chartered bank (commercial, thrift, national or state bank) that is subject to bank supervision.


What are the minimum capital requirements for primary dealers?

1) A registered B-D must have at least $150M in regulatory net capital based on the SEC net capital rule. 2) The B-D must be in compliance with all capital and regulatory requirements imposed by the SEC or its SRO. 3) Banks must meet the minimum Tier I and Tier II capital standards under Basel, and have at least $150M of Tier I capital as defined by Basel.


What are Treasury bills?

Negotiable, non-interest bearing securities with original maturities of 3 months, 6 months and 1 year. They are offered at a discount to their face value, and are offered only in book-entry form. “Interest” comes from the difference between the discounted purchase price and the face value of the T-bill.


What are Treasury notes?

A fixed income interest-bearing security with a fixed coupon payable semiannually until maturity. Issued in maturities of 2, 3, 5 and 10 years. They are not callable.


What are Treasury bonds?

This is usually associated with a 30-year fixed income interest-bearing security with a fixed coupon payable semiannually until maturity. It is not callable.


What is the “par value” of a Treasury note or bond?

This is the face amount, which usually differs from the price at which it is trading in the market.


SEC v. Davis et. Al (Youngdahl)

Disruptions in supply. Consultant passed on embargoed information about the suspension of T-bond issuances. They made $3.1M off of the info. Shows the importance of disruptions in supply to the value of existing issuances.


US v. Salomon Brothers

Manipulation of the Auction Process. Civil antitrust complaint which alleged that Salomon Brothers along with other B-Ds has conspired to limit the supply of May 1991 2-year notes available in the secondary market. Then they sold those notes at artificially inflated prices.


What are fixed-rate securities?

Will pay a fixed rate of return for a set period of time. The set coupon is fixed at the time of issuance. Yield s change as interest rates rise and fall, because the price of the underlying changes in accord with the IR market. Coupon remains constant.


What are floating-rate securities?

Issues that have coupons which fluctuate based on terms described by the issuer. Coupon is usually linked to an index or market interest rate. Floating rate notes are often subject to a max or min rate of interest.


What are TIPS?

Treasury Inflation-Protected (Indexed) Securities. Securities whose principal is linked to the Consumer Price Index (CPI). Coupon is fixed, but principal fluctuates with CPI. TIPS are a hedge against inflation—as inflation increases the investor is rewarded with greater principal.


What are STRIPS?

Separate trading of registered interest and principal securities. These are zero coupon bonds created by separating the principal and interest cash flows.


What is coupon stripping?

The ability to separate the principal and coupon payments on an underlying security. All new bond and notes with maturities of 10 years or more are eligible. These securities can also be reassembled into a coupon bond.


What is the Rule of 72?

States that a bond will double in value at a rate of 72 divided by the applicable interest rate.