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Answers to Chapter 2
Questions:
1. The household sector (consumers) is the largest supplier of loanable funds. Households supply funds when they
have excess income or want to reinvest a part of their wealth. For example, during times of high growth households
Higher interest rates will also result in higher supplies of funds from the business sector. When businesses
Loanable funds are also supplied by some government units that temporarily generate more cash inflows
(e.g., taxes) than they have budgeted to spend. These funds are invested until they are needed by the governmental
Finally, foreign investors increasingly view U.S. financial markets as alternatives to their domestic financial
markets. When expected risk-adjusted returns are higher on U.S. financial securities than on comparable securities in
their home countries, foreign investors increase the supply of funds to U.S. markets. Indeed the high savings rates of
2. Households (although they are net suppliers of funds) borrow funds in financial markets. The demand for loanable
funds by households comes from their purchases of homes, durable goods (e.g., cars, appliances), and nondurable
Businesses often finance investments in long-term (fixed) assets (e.g., plant and equipment) and in
short-term assets (e.g., inventory and accounts receivable) with debt market instruments. Higher borrowing costs
Governments also borrow heavily in financial markets. State and local governments often issue debt to
finance temporary imbalances between operating revenues (e.g., taxes) and budgeted expenditures (e.g., road
Finally, foreign participants might also borrow in U.S. financial markets. Foreign borrowers look for the
cheapest source of funds globally. Most foreign borrowing in U.S. financial markets comes from the business
3. Factors that affect the supply of funds include total wealth risk of the financial security, future spending needs,
monetary policy objectives, and foreign economic conditions.
Wealth. As the total wealth of financial market participants (households, business, etc.) increases the absolute dollar
value available for investment purposes increases. Accordingly, at every interest rate the supply of loanable funds
increases, or the supply curve shifts down and to the right. The shift in the supply curve creates a disequilibrium in
this financial market. As competitive forces adjust, and holding all other factors constant, the increase in the supply
Risk. As the risk of a financial security increases, it becomes less attractive to supplier of funds. Accordingly, at
every interest rate the supply of loanable funds decreases, or the supply curve shifts up and to the left. The shift in
the supply curve creates a disequilibrium in this financial market. As competitive forces adjust, and holding all other
Near-term Spending Needs. When financial market participants have few near-term spending needs, the absolute
dollar value of funds available to invest increases. Accordingly, at every interest rate the supply of loanable funds
increases, or the supply curve shifts down and to the right. The financial market, holding all other factors constant,
Monetary Expansion. One method used by the Federal Reserve to implement monetary policy is to alter the
availability of credit and thus, the growth in the money supply. When monetary policy objectives are to enhance
growth in the economy, the Federal Reserve increases the supply of funds available in the financial markets. At
Economic Conditions. Finally, as economic conditions improve in a country relative to other countries, the flow of
funds to that country increases. The inflow of foreign funds to U.S. financial markets increases the supply of
4. Factors that affect the demand for funds utility derived from the asset purchased with borrowed funds,
restrictiveness of nonprice conditions of borrowing, domestic economic conditions, and foreign economic
conditions.
Utility Derived from Asset Purchased With Borrowed Funds. As the utility derived from an asset purchased with
borrowed funds increases the willingness of market participants (households, business, etc.) to borrow increases and
Restrictiveness on Nonprice Conditions on Borrowed Funds. As the nonprice restrictions put on borrowers as a
condition of borrowing increase the willingness of market participants to borrow decreases and the absolute dollar
value borrowed decreases. Accordingly, at every interest rate the demand of loanable funds decreases, or the demand
Economic Conditions. When the domestic economy is experiencing a period of growth, market participants are
willing to borrow more heavily. Accordingly, at every interest rate the demand of loanable funds increases, or the
demand curve shifts up and to the right. As competitive forces adjust, and holding all other factors constant, the
7. Explanations for the yield curve’s shape fall predominantly into three categories: the unbiased expectations
theory, the liquidity premium theory, and the market segmentation theory.
According to the unbiased expectations theory of the term structure of interest rates, at any given point in time, the
yield curve reflects the market's current expectations of future short-term rates. The second popular
explanation―the liquidity premium theory of the term structure of interest rates—builds on the unbiased
9. The liquidity premium theory is an extension of the unbiased expectations theory. It based on the idea that
investors will hold long-term maturities only if they are offered at a premium to compensate for future uncertainty in
a security’s value, which increases with an asset’s maturity. Specifically, in a world of uncertainty, investors prefer to
10. A forward rate is an expected or implied rate on a short-term security that will originate at some point in the
future.
11. The present value of an investment decreases as interest rates increase. Also as interest rates increase, present
Problems:
1. The fair interest rate on a financial security is calculated as
8. 1R1 = 6%
10. 1 + 1R2 = {(1 + 1R1)(1 + E(2r1))}1/2
11. 1.12 = {(1 + 1R1)(1 + E(2r1))(1 + E(3r1))}1/3
1.12 = {(1 + 1R1)(1.08)(1.10)}1/3
12. 1 + 1R5 = {(1 + 1R4)4(1 + E(5r1))}1/5
1.0615 = {(1.056)4(1 + E(5r1))}1/5
13. 1 + 1R4 = {(1 + 1R3)3(1 + E(4r1))}1/4
1.026 = {(1.0225)3(1 + E(4r1))}1/4
14. 1R1 = 5.65%
15. (1 + 1R2) = {(1 + 1R1)(1 + E(2r1) + L2)}1/2
1.14 = {1.10 x (1 + 0.10 + L2)}1/2
16. 1 + 1R4 = {(1 + 1R3)(1 + E(4r1) + L4)}1/4
1.0550 = {(1.0525)3(1 + 0.0610 + L4)}1/4
19. 2f1 = [(1 + 1R2)2/(1 + 1R1)] - 1 = [(1 + 0.0495)2/(1 + 0.0475)] - 1 = 5.15%
20. 4f1 = [(1 + 1R4)4/(1 + 1R3)3] - 1 = [(1 + 0.0635)4/(1 + 0.06)3] - 1 = 7.41%
21. 1R1 = 4.5%
22. a. PV = $5,000/(1+.06)5 = $5,000 (0.747258) = $3,736.29
b. PV = $5,000/(1+.08)5 = $5,000 (0.680583) = $3,402.92
From these answers we see that the present values of a security investment decrease as interest rates increase. As
rates rose from 6 percent to 8 percent, the (present) value of the security investment fell $333.37 (from $3,736.29 to
From the above answers, we also see that the greater the number of compounding periods per year, the smaller the
23. a. FV = $5,000 (1+0.06)5 = $5,000 (1.338226) = $6,691.13
From these answers we see that the future values of a security investment increase as interest rates increase. As rates
rose from 6 percent to 8 percent, the (future) value of the security investment rose to $655.51 (from $6,691.13 to
24. a. PV = $5,000{[1 - (1/(1 + 0.06)5)]/0.06} = $5,000 (4.212364) = $21,061.82
25. a. FV = $5,000{[(1 + 0.06)5 -1]/0.06} = $5,000 (5.637092) = $28,185.46
26. FV = $123{[(1 + 0.13)13 -1]/0.13} = $3,688.12
FV = $123{[(1 + 0.13)13 -1]/0.13} (1 + 0.13/1) = $4,167.57
27. PV = $678.09{[1 - (1/(1 + 0.13)7)]/0.13} = $2,998.93
PV = $678.09{[1 - (1/(1 + 0.13)7)]/0.13}(1 + 0.13/1) = $3,388.79
