Understanding Certificates of Deposit and Fed Rates

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Questions and Answers

What is typically associated with a higher interest rate on Certificates of Deposit (CDs)?

Lower risk investments

Monthly compounding

Larger amounts of saving (correct)

Shorter maturity periods

What is indicated by a higher 3-month interest rate compared to a 9-month interest rate?

Inverted yield curve (correct)

Stable economic conditions

Increased inflation rates

Normal yield curve

What fundamental interest rate significantly impacts almost all market interest rates?

Discount rate

Libor rate

Prime rate

Federal funds rate (correct)

Why might the Federal Reserve decide to cut its Federal Funds Rate?

Due to expected changes in economic conditions Signup and view all the answers

What do banks need to maintain with the Federal Reserve?

Cash reserves Signup and view all the answers

What is the main reason for borrowing and lending transactions overnight among banks?

To meet reserve requirements Signup and view all the answers

What is a common outcome when short-term interest rates exceed long-term rates?

Heightened economic uncertainty Signup and view all the answers

What can a large-value CD allow an investor to do?

Negotiate a more favorable interest rate Signup and view all the answers

What is the primary reason the Fed raises the federal funds rate?

To cool down an overheating economy Signup and view all the answers

What effect does lowering the federal funds rate typically have on consumer behavior?

Encourages greater consumer confidence and spending Signup and view all the answers

What happens to the yield on T-bills during a financial crisis?

It decreases as investors seek safer assets Signup and view all the answers

Which of the following is NOT one of the Fed's dual goals?

Controlling government spending Signup and view all the answers

What is the typical maturity range for commercial paper?

1-2 months Signup and view all the answers

Why is the yield spread typically larger during economic recessions?

The risk associated with CDs increases Signup and view all the answers

What is generally true about the relationship between risk and required rate of return?

Higher risk is associated with a higher required rate of return Signup and view all the answers

What is the minimum denomination for issuing commercial paper?

$100,000 Signup and view all the answers

When the Fed lowers the federal funds rate, which of the following is a likely outcome?

Boost in investments and job creation Signup and view all the answers

How are Treasury bonds and notes typically sold in terms of their repayment?

They pay semi-annually. Signup and view all the answers

What is the main difference between Treasury notes and Treasury bonds?

They have different maturities. Signup and view all the answers

What is a characteristic difference between CDs and T-bills?

CDs are typically less liquid than T-bills Signup and view all the answers

What occurs when commercial paper is issued?

It matures at its face value. Signup and view all the answers

What is the typical par value for Treasury notes and bonds?

$1,000 Signup and view all the answers

What does a bond's bid price represent?

The price at which a dealer buys from an investor. Signup and view all the answers

How is the bid price of 100.3047 expressed in dollar terms for a $1,000 par value bond?

$1,003.047 Signup and view all the answers

What is the equivalent taxable yield of a 4% tax-free municipal bond for an investor in a 28% tax bracket?

5.55% Signup and view all the answers

If an investor has a tax bracket of 28%, which investment option yields a higher after-tax return?

6% taxable corporate bond Signup and view all the answers

Which formula represents the relationship between the yield of taxable bonds and the yield of municipal bonds?

$r_{muni} = r_{taxable} / (1 - t)$ Signup and view all the answers

What is the cutoff tax bracket where the after-tax yield of a taxable bond equals the yield on a muni bond?

$t_{cutoff} = 1 - r_{muni}/r_{taxable}$ Signup and view all the answers

What could cause yields on municipal bonds to be lower than those on taxable bonds with similar risk?

Municipal bonds have tax advantages Signup and view all the answers

If the interest rate on a taxable bond is 6%, what is the expected taxable yield for an investor in a 28% tax bracket?

4.32% Signup and view all the answers

A tax-free municipal bond has a yield of 4%. What is the result if an investor in a 38% tax bracket is comparing it to a taxable bond?

The muni yields lower after-tax Signup and view all the answers

Which of the following statements is true regarding capital gains on municipal bonds?

They are taxable if sold for more than the purchase price Signup and view all the answers

What is the after-tax return for a 6% taxable investment if the tax rate is 38%?

3.72% Signup and view all the answers

Which investment strategy is preferred if the goal is to achieve a higher yield after tax?

Investing in a 4% tax-free return Signup and view all the answers

What is the nominal coupon payment for a bond with a 6.5% coupon rate and a $1,000 par value?

$65 Signup and view all the answers

Who is more likely to invest in municipal bonds (munis)?

High tax-bracket investors Signup and view all the answers

What does the yield to maturity (YTM) represent for a bond?

The rate of return expected if the bond is held to maturity Signup and view all the answers

What factor influences a bond's rating?

Credit quality of the issuer Signup and view all the answers

If a bond is selling for 109.13% of its par value, what is its purchase price if the par value is $1,000?

$1,091.30 Signup and view all the answers

Which statement is true about corporate bonds?

They represent loans made by investors to companies. Signup and view all the answers

Study Notes

Certificates of Deposit (CDs)

CDs are a type of investment where you deposit a fixed amount of money for a fixed period of time.
Higher interest rates are associated with CDs that have a longer maturity and larger deposits.
An inverted yield curve occurs when short-term interest rates are higher than long-term rates.
This happens when the market anticipates the Federal Reserve (the Fed) to reduce the Federal Funds Rate soon due to economic changes.

Federal Funds Rate

The Fed controls the federal funds rate which affects other interest rates in the market.
Banks are required to maintain a certain amount of cash reserves with the central bank.
The federal funds rate is the overnight interest rate at which banks borrow and lend reserves from each other to meet their reserve requirements.
The Fed changes the federal funds rate to either promote economic growth or control inflation.
The Fed raises the federal funds rate to cool down an overheating economy and control inflation.
This increases borrowing costs, discourages borrowing and spending, while encouraging saving.
The Fed lowers the federal funds rate to stimulate economic activity during periods of weakness.
Lower interest rates make it cheaper to borrow, boosting investments, consumer spending and job creation.

Yields of T-bill and CD

T-bills have a lower risk and a lower yield compared to CDs.
During financial crises, investors lose confidence in banks, making CDs riskier and increasing the yield spread between T-bills and CDs.

Commercial Paper (CP)

CP is a short-term debt issued by corporations.
They typically mature in 1-2 months.
CP has a minimum denomination of $100,000 and is held by money market mutual funds.

Treasury Notes and Bonds (T-notes and T-bonds)

The U.S. Department of Treasury sells T-notes and T-bonds to borrow money.
T-notes have maturities from 1 to 10 years, while T-bonds have maturities from 10 to 30 years.
T-notes and T-bonds pay semi-annual coupons and their face value at maturity.

Municipal Bonds (Munis)

Municipal bonds are tax-free bonds and are issued by state and local governments.
Returns on munis are lower than taxable bonds with similar risk due to the tax-free feature.
High tax-bracket investors are more likely to favor munis because they benefit from the tax-free interest payments.

Corporate bonds

Corporate bonds are mid-term and long-term debt securities issued by companies.
They represent fixed payments from a corporation to the bondholder.
Bonds are quoted as a percentage of par value.
Yield to maturity (YTM) summarizes a bond’s overall investment value and is the bond’s annual discount rate.
A higher bond rating indicates higher credit quality and lower default risk.

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Description

This quiz explores the concepts of Certificates of Deposit (CDs) and the Federal Funds Rate, focusing on their implications for investment and economic conditions. Test your knowledge on the relationship between interest rates, maturity durations, and the Federal Reserve's role in the economy.