Question

1. What is the cost of money, and how is it determined? What factors affect the cost of money? 2. What is a yield curve? Why do yield curves differ? 3. Discuss the explanations for various shapes of yield curves. How can yield curves by used to forecast future interest rates? How does the Federal Reserve change the money supply in the United States? What actions would the Fed take to increase interest (decrease) rates? 5. How does general business activity affect interest rates? 6. How are the values of financial assets affected by changes in interest rates? FINANCE

Answer 1

Cost of money refers to the interest that could be earned if the amount invested in a business or security was invested in a government bond or time deposit. In other words the amount of interest that would be earned if the dollar value of inventory were invested at the State's current investments earning rate. Step 1 - Identify all of the sources of money for your business and list them in order. Step 2 - Next to each source, write down the interest rate you are paying. Step 3 - Add or less each source. For Interest : Borrowing -add Deposit - less Step 4 - Finding weighted average rate. Based onabove data Cost of Money = (Total Interest/Total Amount) *100 b. Ans 1. The cost of money is the weighted average interest rate for the money supply into your business. Factors affecting the cost of money: Central Bank Rate Money Supply in the economy Credit worthiness of borrower Type of security mortgage Time of repayment State of economy C.

5.2 A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The Definition slope of the yield curve gives an idea of future interest rate changes and economic activity. There are three main types of yield curve shapes 1. normal (upward sloping curve) 2. inverted (downward sloping curve) Types 3.flat. Example Normal curve : The market expects the economy to function at normal rate of growth: Dec 1984 – middle of No significant changes in inflation or available longest postwar capital. So, investors who risk their money for expansion longer periods expect higher yields. in the US Inverted Yield Curve :The market expects the economy to slow down Recession in the early Why do and interest rates to drop in the future. 1980's yield curve Long term investors want to take the opportunity in UK due to excess differs to lock in interest rates before they fall even further. demand from pension funds. Nov 1989 - the curve flattened. The economy Flat curve : The market is at the point of inflection, preceding was either a recession or an economic pick-up. in recession by 1991. Normal yield curve Inverted yield curve Flat yield curve Yield (%) Yield (%) Yield (%) Maturity (yrs) Maturity (yrs) Maturity (yrs)

Types Example There are three main types of yield curve shapes 1. normal (upward sloping curve) 2. inverted (downward sloping curve) 3.flat. Normal curve : The market expects the economy to function at normal rate of growth: No significant changes in inflation or available capital. So, investors who risk their money for longer periods expect higher yields. Inverted Yield Curve :The market expects the economy to slow down and interest rates to drop in the future. Long term investors want to take the opportunity to lock in interest rates before they fall even further. Ans.3 Forecasting future based on past trends Dec 1984 – middle of longest postwar expansion in the US Recession in the early 1980's in UK due to excess demand from pension funds. Nov 1989-the curve flattened. The economy was in recession by 1991. Flat curve : The market is at the point of inflection, preceding either a recession or an economic pick-up.

Interest rate adjustments directly affect the availability of money supply. The short term interest rates are set higher, this tightens (reduces the demand for money) and lowering the short tern interest rates frees up (makes more money available). Ans.4 Banks are required to carry a percentage of reserve funds against deposits and this amount required can also be adjusted up or down. In addition the Feds can buy treasuries and provide the member banks with more cash or liquidity (increases the money supply).