Chapter 6 Review Session

Chapter 6 Review Session - Chapter 6 Review Session 2007...

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© 2007 Robert H. Smith School of Business University of Maryland “Chapter 6 Review Session”
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© 2007 Robert H. Smith School of Business University of Maryland Chapter 6 Review Session 1. Which of the following is true? a. Suppose financial institutions, such as savings and loans, were required by law to make long term, fixed interest rate mortgages, but at the same time, they were largely restricted, in terms of their capital sources, to taking deposits that could be withdrawn on demand. Under these conditions, these financial institutions should prefer a “normal” yield curve to an inverted curve. b. You are considering establishing a new firm, the University Assistance Company. The UAC would obtain funds in the short term money market and write long term mortgage loans to students so that they might buy condominiums rather than rent. A downward sloping yield curve, if it persisted over time, would be best for UAC. c. The yield curve is upward sloping, or normal, if short term rates are higher than long term rates.
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© 2007 Robert H. Smith School of Business University of Maryland Chapter 6 Review Session 1. A is correct. Statement b is incorrect. If a downward sloping yield curve existed, long term interest rates would be lower than short term rates. This would be very serious for UAC. UAC receives as income the interest it charges on its long term mortgage loans, but it has to pay out interest for obtaining funds in the short term money market. Therefore, UAC would be receiving low interest income, but it would be paying out even higher interest. Statement c is incorrect. An upward sloping yield curve would indicate higher interest rates for long term securities than for short term securities.
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© 2007 Robert H. Smith School of Business University of Maryland Chapter 6 Review Session 1. Assume interest rates on 30 year government and corporate bonds were as follows: T-bond = 7.72%, AAA = 8.72%, A = 9.64%, BBB = 10.18%.
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