Explain the main difference between a bond and a common stock

Revision: monetary and financial theories.

1. Main differences between a bond and a common stock:
- Bond is a debt security that promises to make payments periodically for a
specified period, it means you provide a loan to finance the activity of
corporations. You can earn interest rate- cost of borrowing.
- Common stock represents a share of ownership in a corporation, it is a
security that is a claim on the earnings and assets of the corporation.
- Risk: stock > bond but higher risk can come higher returns. If the
corporation will go bankrupt, you will receive money for bond first because
it has responsibility to pay the loan.
2. If you suspect that a company will go bankrupt next year, which would
you instead hold,
bonds issued by the company or equities issued by the company? Why?
In the event of bankruptcy, bondholders are higher up in the hierarchy of
claims compared to equity holders. When a company goes bankrupt and its
assets are liquidated, bondholders have a higher chance of recovering some
or all of their investment before equity holders receive anything.
3. How does risk-sharing benefit both financial intermediaries and
private investors?
Financial intermediaries benefit by carrying risk at relatively low transaction costs.
Since higher risk assets on average earn a higher return, financial intermediaries
can earn a profit on a diversified portfolio of risky assets. Individual investors
benefit by earning returns on a pooled collection of assets issued by financial
intermediaries at lower risk. Risk to individual investors is lowered through the
pooling of assets by the financial intermediary.
7. How can the adverse selection problem explain why you are more likely to
make a loan to
a family member than to a stranger? If you are an employer, what kinds of
moral hazard
problems might you worry about about your employees?
4. Because you know your family member better than a stranger, you know
more about the borrower’s honesty, propensity for risk taking, and other
traits. There is less asymmetric information than with a stranger and less
 likelihood of an adverse selection problem, with the result that you are
more likely to lend to the family member.
In any organization moral hazard problems to worry about with employees
always exist. Moral hazards differ from one institution to another as the
businesses are different. If I am an employer some of the moral hazard’s
problems I might worry about are, my employees committing fraud because
this will have a negative impact on my business operations. Another thing is
employees stealing from my business as this would be a loss on my part.
8. In ancient Greece, why was gold a more likely candidate for use as money
than wine?
5. Gold will not need special storage and can even be buried for later use. It
also can be divided into small piece and mold into other products like
coins and jewelry and used for different purposes. Wine is hard to hold it
value ( specially in the past) over longer period of time.
9. Why would a government choose to issue a perpetuity, which
requires payments forever,
instead of a terminal loan, such as a fixed-payment loan, discount bond,
or coupon bond?
It is easy to calculate. Perpetuity is a perpetual bond with no maturity
date and no payment of principle that make coupon payment of C$
forever, you can see that ic increases and price of the bond falls. The
near-term costs to maintaining a given size loan are much smaller for a
perpetuity than for a similar fixed payment loan, discount, or coupon
bond. For instance, assuming 5% interest rate over 10 years, on a $1,000
loan, a perpetuity costs $50 a year (or $500 in payments over 10 years).
for a fixed payment loan, this would be $129.50 per year (or $1295) in
payments over the same 10-year period). For a discount loan, this loan
would require a lump sum payment of $1628.89 in 10 years. For a
coupon bond, assuming the same $50 coupon payments as the perpetuity
implies a $1,000 face value. Thus, for the coupon bond, the total
payments at the end of 10 years will be $1,500.
6. Conditions that a discount bond have a nominal negative interest
rate:
 Whenever the current price P is greater than face value F of a discount bond, the
yield to maturity will be negative, means that the price of discount bond has
risen. It is possible for a coupon bond to have a negative nominal interest rate,
as long as the coupon payment and face value are low relative to the current
price. As an example, with a one-year coupon bond, the yield to maturity is
given as i = ( F - P)/P; in this case whenever C + F < P, i will be negative. It is
impossible for a perpetuity to have a negative nominal interest rate, since this
would require either the coupon payment or the price to be negative. (chapter 4)
11. With a discount bond, the return on the bond is equal to the capital gain
rate:
True. The return on a bond is the current yield iC plus the rate of capital gain, g. A
discount bond, by definition, has no coupon payments, thus the current yield is
always zero (the coupon payment of zero divided by current price) for a discount
bond.
Coupon bond
12. You would rather be holding long-term bonds because their price would
increase more than the price of the short-term bonds, giving them a higher return.
Longer-term bonds are more susceptible to higher price fluctuations than shorter-
term bonds, and hence have greater interest-rate risk.
15.
a. because gold become acceptable as a medium of exchange, gold liquidity is high
so I will buy more gold to serve my transactions.
b. price in the gold market become more volatile, risk of the asset also higher, buy
less
c. gold price tend to move with the aggregate price level, you have tendency to
buy more because more expected return.
d. buy more, because rise in the interest rate lead to fall in the price of gold, it
increase demand for gold.
16. Raphael observes that at the current level of interest rates, there is an excess
supply of bonds, and therefore, he anticipates an increase in the price of bonds. Is
Raphael correct? Incorrect
If at the current level of interest rates there is an excess supply of bonds,
the bond's price will fall and the interest rate will rise to the
equilibrium level.

17. Using the supply and demand analysis for the bond market, answer the
following questions:
a. What will happen in the bond market if the government limits the amount of
daily
transactions? Which characteristic of an asset would be affected?
Liquidity of bonds related to other asset will decrease, increasing the interest rate
and lowering bond’s price.
b. How might a sudden increase in people’s expectations of future real estate prices
affect interest rates?
People’s expectations of future real estate price increase, demand of asset also
increase, and the demand for bond decrease, then bond price decreases and
interest rate increases
c. Suppose that many big corporations decide not to issue bonds since it is now too
costly to comply with new financial market regulations. Can you describe the
expected effect on interest rates?
It affect supply curve, it will lead to a shift in the supply curve to the left, so the
price of bond become higher,it means that interest rate lower
d. Will there be an effect on interest rates if brokerage commissions on stocks fall?
Explain your answer.
Brokage commissions on stocks fall, people have tendency to buy more stocks, it
means that demand for bond falls. Demand curve shift left, price of bond decrease
and interest rate rise
18. Using the supply and demand analysis for the bond market, answer the
following
questions:
 a. The president of the United States announced in a press conference that he
would fight the higher inflation rate with a new anti-inflation program.
Predict what will happen to interest rates if the public believes him.
If the publics believes him, their expectation of inflation will false, so demand for
bond become higher, it lead to a shift in demand curve to the right. However, it
also make supply falls because high cost, which cause the supply curve shift to the
left, it make equilibrium to move lower than the initial one, interest rate increase.
b. Suppose you are in charge of your company's financial department, and you
have to decide whether to borrow short- or long-term. Checking the news,
you realize that the government is about to engage in a major infrastructure
plan in the near future. Predict what will happen to interest rates. Will you
advise borrowing short or long-term?
the government engage in major infrastructure plan, they will issue more bond to
get money, so the supply curve shifts right-> price of bond become lower, interest
rate higher.
You should borrow long term because if you borrow shot term, to the maturity, you
will receive higher interest rate.
19. What are the transaction costs problems facing financial organizations? Explain
how financial intermediaries can help reduce these problems.
Transaction costs problem facing higher commission fee, your investment is not
diversify (higher risk)
Usually transaction costs increase the expense of investors. This is
especially notable for households and private investors. Since they have limited
funds available for investment, high transaction costs cause people to invest in
only a small share of all available options, making their investments riskier. One
solution for high transaction cost is to bundle investors' funds and take advantage
of economies of scale. This led to the making of financial intermediaries like
mutual funds which sell shares to individuals and invest the proceeds in bonds and
stocks. Since many transactions occur together, transaction costs for each of
them become lower. Additionally, financial intermediaries also provide the
expertise that can be used to lower transaction costs.
Financial intermediaries can help reduce these problems: they bundle the funds
of many investors together so they can take advantage of economy scale, the
reduction in transaction costs per dollar of investment at the size of transaction
increases. Bundling investor’s funds together reduce transaction costs for each
individual investors.
Expertise: Their expertise in computer technology enables them to offer customers
convenient services like being able to call a toll-free number for information on
how well their investments are doing and to write checks on their accounts.
An important outcome of a financial intermediary’s low transaction costs is the
ability to provide its customers with liquidity services, services that make it easier
for customers to conduct transactions.
19. Explain why dating can be considered a method to solve the adverse selection
problem
When we date, we can extract information about the others. At the same time, we
also share information about themselves. This information helps us to have better
understandings, better decision about a probable future life together. There is no
difference from the one in which the loan officer tries the right borrower.]
21. Why are financial intermediaries willing to engage in information collection
activities when investors in financial instruments may be unwilling to do so?
Due to free-rider problem, investors in financial instrument don’t have incentive to
gather information about borrowers who issue securities. However, financial
intermediaries can avoid free-rider problems because they can make private loan,
these information collection activities can be profitable. Thus, they have incentives
to collect more information.
22. Would you be more willing to lend to a friend if she had put all her life savings
into her business than you would be if she had not done so? Why?
You would be more willing because putting her life savings into her business
provides you protection against the problem of moral hazard.
23. What steps can the government take to reduce asymmetric information
problems and help the financial system function more smoothly and efficiently?
The government can produce information about borrowers and provide it to
investors free of charge, it can require borrowers to report honest information
about themselves to investors, and it can set and enforce rules that govern the
behavior of financial institutions so they do not take on too much risk. These
prudential regulations for banks include banning certain activities and asset
categories considered too risky, establishing minimum capital requirements, and
requiring disclosure of financial information to regulators and investor.
24. Which problem of asymmetric information are prospective employers trying to
solve when they ask applicants to go through a job interview? Is that the end of the
information asymmetry?
Adverse selection. Prospective employers want to know more about potential
workers, like the way loan officers want to know more about potential borrowers.
As it is the case with a loan transaction, the information asymmetric does not end
here, they also need to solve moral hazard problem. Usually, employers try to solve
this problem with paying schemes that encourage workers to provide more effort.
25. What are the benefits and costs for a bank when it decides to increase the
amount of its bank capital? If a bank doubles the amount of its capital and ROA
stays constant, what will happen to ROE? Why do equity holders care more about
ROE than about ROA?
If the bank decide to increase the amount of bank capital, it less likely to broke if
there are losses on its loans or other assets. The cost is that for the same ROA, it
will have lower ROE.
ROE will fall in half. ROA= ROE. EM
They care about ROE than ROA because ROE is the return of the equity, show
stock holders how much they will receive on equity investments, while ROA –
return of asset only show how much the bank has- the assets are being managed.
26. Suppose your bank has the following balance sheet:
What would happen to bank profits if the interest rates in the economy go down?
What actions could you take to reduce the bank’s interest-rate risk?

If the interest rate in the economy go down, bank profits will decrease because
rate-sensitive of asset > rate sensitive of liabilities.
Reduce the bank’s interest rate risk:
If the bank rate- sensitive asset < rs liabilities, if the interest rate will fall, do
nothing, you will benefit from the expected interest rate decline.
If the interest rate falls, shorten the duration of the banks assets to increase the
rate sensitive, or could lengthen the duration of the liabilities. They also use
financial
derivatives such as interest-rate swaps, options, or futures
lower the discount rate
27. Suppose your bank has the following balance sheet:
If the required reserve ratio is 10%, what actions should the bank manager take if
there is an unexpected deposit outflow of $50 million?
ASSET LIABILITIES
Reserve 50 Checkable deposits 200
Securities 50 Bank capital 50
Loans 150
If an unexpected outflow of 50$ million, it means that reserve falls by 50$ to 0 and
Checkable deposits falls by 50$ to 150$. Then bank need to acquire 15$ ( 10%)
They can call or sell off 15$ of loans. Borrowing money from other banks, discount
loan from FED, selling more 15$ securities, ...
28. Predict what will happen to interest rates on a corporation’s bonds if the federal
government guarantees today that it will pay creditors if the corporation goes
bankrupt in the future. What will happen to the interest rates on Treasury
securities?
There is guarantee from government, they will buy more Corporation bond,
demand increases, higher prices=> Interest rate decreases.
Then Demand for treasury securities decreases, prices also decrease then interest
rat increase.

29. Predict what would happen to the risk premiums of municipal bonds if the
federal
government guarantees today that it will pay creditors if municipal governments
default on their payments. Do you think that it will then make sense for municipal
bonds to be exempt from income taxes?
Risk premium decrease, because bond’s default risk decrease.
Municipal bonds have lower interest rate than Treasury bonds
Municipal bonds will be exempt from income tax because eliminating income tax
raises the taxable equivalent yield. It means that if you don't pay your state income
tax, you won't have to pay your federal income tax.
Once the municipal bonds are given a tax advantage that raises their after-tax
expected return relative to Treasury bonds and makes them more desirable,
demand for them rises, and their demand curve shifts to the right.
If a bond has a favorable tax treatment, as do municipal bonds, whose interest
payments are exempt from federal income taxes, its interest rate will be lower.
Hợp lí bởi vì họ có thể tăng lợi tức, trở nên hấp hấp dẫn hơn, đường cầu dịch
chuyển sang phải,
30. If a yield curve looks like the one shown in the figure below, what is the market
predicting about the movement of future short-term interest rates? What might the
yield curve indicate about the market’s predictions for the inflation rate in the
future?
It shows that short-term interest rates will remain constant but increase in the
future, then the inflation will increase
31. If a yield curve looks like the one shown in the figure below, what is the market
predicting about the movement of future short-term interest rates? What might the
yield curve indicate
about the market’s predictions for the inflation rate in the future?
It shows that short-term interest rates increase in the near future, it is above the
current short-term interest rate. The downward interest rate slope for longer
maturity indicates that short-term interest rates are expected to fall sharply. Since
interest rate and inflation move together, the yield curve suggest that the market
inflation to rise in the future but it fall later on.