- 1. An efficient market refers to the money market whereby the market price represents an impartial approximation of the true value of a given investment. The markets are expected to be efficient most of the time because the errors recurring in the market price are always impartial and arbitrary in nature. Although the norm for security purchasers has been the use of inside information to achieve abnormal returns even in risks, the security markets remain efficient. This is because market price variations serve as indicators that the stock’s value may be inflated or deflated.
- 2. Securities are more marketable than loans in the secondary market because they have lower amount of risks attached to them.
- 3. The function of a mutual fund is to act on behalf of inactive investors in buying and selling of equity. Their popularity rests on the fact that the fund employs the services of professional finance managers to manage the investment funds in a manner that accrues returns and the charges levied for these services are low. Money market mutual funds are those that trade in short term securities while the stock and bond mutual funds trade in stocks and bonds respectively. The money market mutual fund is therefore more liquid than the other two.
Q. 4. Low interest rates during recession encourage consumer-spending translating to investments. In the 1981-1982 recession, the federal funds rate rose by 9% pushing the prime interest rate upwards to 21.5%. In the period between 1999-2001 during the dot-com fall and the September 11 attacks, the federal government had to increase the interest rates six times to fir with the economic state. These moves were criticized by economists especially Keynesian enthusiasts due to slowing down economic growth because of few investments. During the 2008-09 recession periods, the rates were reduced from 3.5% to 3%. The increased money in investments was then used to revive the economy.
- 5. Expansionary monetary policies increase the money supply in the economy, which increases the interest rates. This is an upward pressure.
- 6. Where r = real interest rate, i = inflation rate, R = nominal interest rate. If r = 6% and i=2% then (1+0.06) (1+0.02) = (1+R)
(1.06) (1.02) = (1+R)
1.0812 = 1+R hence R= 0.0812 or 8.12%
- 7. (1+r) (1+i) = (1+R) If R = 9% and i = 3% then (1+r) (1+0.03) = (1+0.09)
(1+r) (1.03) = 1.09
1.03 + 1.03r = 1.09
1.03r = 1.09- 1.03
1.03r/1.03= 0.06/1.03 equal to 0.05825243 = 0.0583 (4 d.p.) hence r = 0.0583 or 5.83%
- 8(a) One year forward rate estimate = (1+ i2)2 / (1+i1)) – 1 where i2 = annualized two year interest rate and i1 = one year interest rate. If i2 = 13% and i1 = 12% then
((1+ 0.13) 2 / (1+ 0.12)) – 1
((1.13) 2 / (1.12)) -1 equals to (1.2769/ 1.12) – 1 = 0.1401 or 14.01%
- 8(b) (1+ i2)2 = (1+i1) (1+ x) + LP2 where LP2 = liquidity premium on a two year security and x = one year forward rate estimate. If i2 = 13%, i1 = 12%, LP2 = 0.3%
1.2769= (1.12) (1+ x) + 0.0003
1.2769= 1.12 + 1.12x + 0.0003
1.2769- 1.12 – 0.0003 =1.12x
0.1566/1.12 = 1.12x / 1.12 equals to x = 0.1398 or 13.98%
- 9(a) Y = R + DP + LP + TA where Y= appropriate yield, R= annualized rate, DP= default risk premium, LP= liquidity premium and TA= tax adjustment. If Y= 8.4%, R=7%, DP= 0.6%, and TA= 0.4% then 8.4%= 7% + 0.6% + 0.4% + LP
LP= 8.4%-8.0% hence LP= 0.4%
- 9(b) If DP= 0.8% ceteris paribus Y= 7% + 0.8% + 0.4% + 0.4% then Y= 8.6%.
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