Money and Banking

Question 1

Glass co. has a credit rating of AAA which implies that it is rated highly credit wise and has a low chance of defaulting its credit obligations. Aluminum Co. has a credit rating of BB- which is quite low and indicates a higher chance of defaulting on its financial obligations. This in itself should worry an investor because there is no guarantee of dividend being paid. The share price of Glass Co. is twice as high as that of Aluminum Co. but it yields dividend twice those of Glass Co. this implies that even though an investor may be able to buy more shares of Glass Co. than of Aluminum Co., the returns will be the same. There is a higher risk in investing in Glass Co. than Aluminum Co and so I would advise Sam to invest in Aluminum Co.

Credit ratings

Color code	Number	Definition	Moodys	S & P	Fitch
		Investment Grade
	10	Prime, maximum safety	Aaa	AAA	AAA
	9.5	Very high grade/quality	Aa1	AA+	AA+
	9	“	Aa2	AA	AA
	8.5	“	Aa1	AA-	AA-
	8	Upper medium quality	A1	A+	A+
	7.5	“	A2	A	A
	7	“	A3	A-	A-
	6.5	Lower medium grade	Baa1	BBB+	BBB+
	6	“	Baa2	BBB	BBB
	5.5	“	Baa3	BBB-	BBB-
Color code	Number	Definition	Moodys	S & P	Fitch
		Speculative grade
	5	Speculative	Ba1	BB+	BB+
	4.5	“	Ba2	BB	BB
	4	“	Ba3	BB-	BB-
	3.5	Highly speculative	B1	B+	B+
	3	“	B2	B	B
	2.5	“	B3	B-	B-
	2	Substantial risk	Caa1	CCC+	CCC+
	1.5	In poor standing	Caa2	CCC	CCC
	1	“	Caa3	CCC-	CCC-
	0.5	Extremely speculative	Ca	CC	CC
	0	Maybe in or extremely close to default	C	C+,C,C-	C+,C,C-
	0	Default		D	D

money and banking- Credit ratings

Question 2

Financial investments require brokers to complete the transaction. Brokers are licensed to do this job and acquire their profits from brokerage fee that they charge (Sanderson 1992). This is the first cost that any financial investment incurs. There is the spread cost which is the difference between the price the dealer paid for the stock and the price the buyer pays. Brokerage fees and spread cost can be reduced by making the purchase of securities once. This will minimize the amount of money that may be lost through spread cost. Quoting the lowest price possible for the security being bought will also reduce the amount of spread costs.

Question 3

Real interest rate is nominal interest rate- inflation rate

Inflation rate 1%

Government bond= 3%-1%=2%

Commercial bonds = 7% – 1% =6%

CBAF Fin. Inv. Inc. = 10% – 1% = 9%

Based on the current inflation rate of 1% none of the investments can be termed as loss. All of them are going to yield a positive increment to the investors’ purchasing power after the changes in prices are accounted for (Neely and Rapach 2008).

Graph showing the relationship between real and nominal rates

Graph showing the relationship between real and nominal rates

Question 4

Risk premium is the amount of money paid in excess of the risk free return that an investment is expected to yield. It acts as form of compensation to investors to tolerate the risks of their investment. An investment with a very low risk has a low risk premium (Lally 2010). This is because the investor has a little chance of losing the investment made. Investments carrying huge risks such on commercial bonds from small companies have a high risk premium because the investments are highly risky. Sam should consider risk premium when investing in commercial bond floated by Giants Corp. this is because the credit rating of the company is very low which makes the investment a high risk one. This is highly risky although it has a relatively high return rate Sam should consider the risk premium if he decides to invest in it.

Question 5

There are risks that are likely to come along with the investments. But Sam does not really need to inform the bank about his investment because when he borrowed the money the repayment was not pegged on his inheritance. This implies that he was supposed to pay the loan using income from his job. He does not plan to quit his job which implies that even if his investment makes losses he will still have income to service the loan. As long as he is paying his monthly instalments as agreed the bank has no need of information pertaining to his inheritance not unless he intends to change his payment schedule.

Question 6

Sam has enough money to clear his loan and still invest. But he has the option of maintaining the instalments and paying the loan in the remaining 20 years. This would be the best option if he decides to make an investment with a higher return than the interest rate of the loan. If he invests in CBAF Fin. Inv. Inc. he will be receive an interest of 10% per annum. This will be double the amount of interest he is paying on his loan. He can therefore pay the loan using the interest from the investment. This implies that the money he needs to clear the loan will yield much more if he invests it. It will have given him an equivalent or quarter of the money he owes the bank. He will earn 10% from the investment and pay an interest rate of 5%. This implies that if we factor in the inflation rate of the 20 years duration he will generate at least 3% interest from the money he could have used to clear the loan in lump sum (Fairfield 1994). Therefore it makes more financial sense to invest the money rather than clear the loan due to the benefits arising from the interest the investment will bring.

Question 7

100, 000 dollars per year for 3 years = 300, 000.

Pv= future cash flow/ (1+ interest rate) number of years

300,000/ (1+7%) 3=244,889.36

The value obtained indicates that the actual value of the money genarted by the investment will be less than the value obtained. This is because cost of living will be higher making the worth of dollar today higher than in three years time.

Question 8

Monetary policy is the process that the monetary authority of a country uses to control the supply of money. This is done by manipulating the interest rates charged by commercial banks on loan (Zoli 2006). This is done to control aspects of economy such as prices and unemployment. This is meant to control, the amount of money in circulation. When the banks change low interest rate many people are able to borrow which increases the amount of money in circulation. When the government wants to reduce the amount of money in circulation it increase the interest rates which reduces the amount of loans people are taking effectively reducing the amount of money in circulation.  Fiscal policies are the control of the economy by the government through revenue collection and expenditure. This is done to control the economy by determining how the government spends in different sectors. The amount of revenue the government collected determines how it is able to deal with its financial obligations. When  the government has huge debts it increase its revenue collection to foot its bills and clear its debts and when it has more income than its debts and expenditure it reduces the amount of tax it collects. This is all that fiscal policy is meant to do, control the amount of money government has by regulating the amount of taxes it collects based on its expenditure (Bunea-Bontas and Petre 2010).

References

Bunea-Bontas, C. & Petre, M.C. 2010, “FISCAL POLICY DURING THE CURRENT CRISIS”, Romanian Economic and Business Review, vol. 5, no. 4, pp. 48-67.

Fairfield, P.M. 1994, “P/E, P/B and the present value of future dividends”, Financial Analysts Journal, vol. 50, no. 4, pp. 23.

Lally, M. 2010, Estimating the Market Risk Premium Using Historical Data from Multiple Markets, Rochester.

Neely, C.J. & Rapach, D.E. 2008, “Real Interest Rate Persistence: Evidence and Implications”, Review – Federal Reserve Bank of St.Louis, vol. 90, no. 6, pp. 609-641.

Sanderson, S. 1992, “The Financial Impact of Risk Costs”, Risk Management, vol. 39, no. 8, pp. 46.

Zoli, E. 2006, How does Fiscal Policy Affect Monetary Policy in Emerging Market Countries?, Rochester.

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