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39 Cards in this Set
- Front
- Back
Price that equates supply and demand for loanable funds
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Interest rate
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Interest rates are determined by the supply and demand for loanable funds in financial markets
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Role of financial markets
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1982-present (generally declining prices and interest rates)
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The current trend in interest rates
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States that interest rates are a function of the supply of and demand for loanable funds
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Loanable funds theory
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Current savings and expansion of deposits by depository institutions
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Basic sources of loanable funds
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Major factor is the level of national income
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Volume of savings
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Amount of short-term credit available depends on lending policies of depository institutions and the Fed
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Expansion of Deposits by Depository Institutions
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Refers to how lenders see the future
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Liquidity Attitude
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Interest rate that is observed in the marketplace
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Nominal interest rate (r)
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r = RR + IP + DRP
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Nominal interest rate equation
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Interest rate on a risk-free debt instrument when no inflation is expected
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Real Rate of Interest (RR)
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Average inflation rate expected over the life of the security
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Inflation Premium (IP)
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Compensation for the possibility of the borrower’s failure to pay interest and/or principal when due
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Default Risk Premium (DRP)
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r = RR + IP + DRP + MRP + LP
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Longer nominal interest rate
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Compensation for securities that cannot easily be converted to cash without major price discounts
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Liquidity Premium (LP)
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Possible price fluctuations in fixed-rate debt instruments associated with changes in market interest rates
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Interest rate risk
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An inverse relationship exists between debt instrument values or prices and nominal interest rates in the marketplace
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Reason for interest rate risk
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Interest rate on a debt instrument with no default, maturity, or liquidity risks (Treasury securities are the closest example)
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Risk-free rate of interest
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Risk-Free Rate (rf) = Real Rate (RR) + Inflation Premium (IP)
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Risk-free rate of interest equation
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Securities that may be bought and sold through the usual market channels
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Marketable Government Securities
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Issues that cannot be transferred between persons or institutions but must be redeemed with the U.S. government
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Nonmarketable Government Securities
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Obligations that bear the shortest (up to one year) original maturities
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Treasury Bills
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Obligations issued with maturities of two to ten years
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Treasury Notes
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Obligations issued with maturities usually over five years and up to thirty years
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Treasury Bonds
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Relationship between interest rates or yields and the time to maturity for debt instruments of comparable quality
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Maturity (Term) structure of interest rates
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Graphic presentation of the term structure of interest rates at a given point in time
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Yield Curve
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Shape of the yield curve indicates investor expectations about future inflation rates
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Expectations Theory
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Investors are willing to accept lower interest rates on short-term debt securities which provide greater liquidity and less interest rate risk
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Liquidity Preference Theory
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Interest rates may differ because securities of different maturities are not perfect substitutes for each other
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Market Segmentation Theory
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Occurs when an increase in the price of goods or services is not offset by an increase in quality
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Inflation
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Changes in the money supply or in the amount of metal in the money unit have influenced prices since the earliest records of civilization
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Historical Price Movements
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Occurs when prices are raised to cover rising production costs, such as wages
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Cost-Push Inflation
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Occurs during economic expansions when demand for goods and services is greater than supply
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Demand-Pull Inflation
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Caused by the expectation that prices will continue to rise, resulting in increased buying to avoid even higher future prices
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Speculative Inflation
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The tendency of prices, aided by union-corporation contracts, to rise during economic expansion and to resist declines during recessions
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Administrative Inflation
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Risk that a borrower will not pay interest and/or repay the principal on a loan according to the agreed contractual terms
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Default Risk
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DRP = r - RR - IP - MRP - LP
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Default risk equation
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Ratings of Baa or higher (Aaa, Aa, or A) that meet financial institution investment standards
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Investment Grade Bonds
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High-yield or junk bonds that have a substantial probability of default
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High-Yield Bonds
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