Financial Markets and Institutions Final
Why do currency crises make financial crises in emerging market economies even ore severe?
Banks are partly funded by foreign debt and a currency crises (sharp drop in the value of the currency) makes their problems worse.
Why is a flattened yield curve a problem for the profitability of banks?
Banks profit from a steep yield curve (borrow short, lend long) and suffer if it becomes flatter
Why do equity holders care more about ROE than about ROA?
Because ROE, the return on equity, tells stock holders how much they are earning on their equity investment, while ROA, the return on assets, only provides an indication how well the bank's assets are being managed.
Would you recommend the adoption of a system of deposit insurance, like the FDIC in the United States, in a country with weak institutions, prevalent corruption, and ineffective regulation of the financial sector?
You probably would not recommend the adoption of a system of deposit insurance in a country with weak institutions, prevalent corruption and ineffective regulation of the financial sector. The main reason not to implement such a system is that its adoption solves the bank runs problem, but it creates moral hazard incentives for banks to engage in risky lending. Decreasing the moral hazard incentives for risky lending requires stringent financial regulation and supervision, which requires strong (and honest) institutions.
If you are a banker and expect interest rates to rise in the future, would you prefer to make short-term loans or long-term loans?
You should want to make short-term loans. Then, when these loans mature, you will be able to make new loans at higher interest rates, which will generate more income for the bank.
If interest rates decline, which would you rather be holding, long-term bonds or short-term bonds? Why? Which type of bond has the greater interest-rate risk?
You would rather be holding long-term bonds because their price would increase more than the price of the short-term bonds, giving them a higher return. Longer-term bonds are more susceptible to higher price fluctuations than shorter-term bonds, and hence have greater interest-rate risk.
Identify three factors that can shift the aggregate demand curve to the right and three different factors that can shift the aggregate demand curve to the left.
right: monetary policy easing, increase in government spending, decrease in taxes, autonomous increase in consumption, autonomous increase in investment, an increase in net exports, and a decrease in financial frictions left: ^opposite
haircuts
the difference between current market value of an asset and the value ascribed to the asset falling in value in an immediate cash sale or liquidation
Compute the price of a share of stock that pays a $1 per year dividend and that you expect to be able to sell in one year for $20, assuming you require a 15% return.
$1/(1.15)+$20/(1.15)=$18.26
Consider a coupon bond that has a $900 par value and a coupon rate of 6%. The bond is currently selling for $860.15and has two years to maturity. What is the bond's yield to maturity?
$860,15 = (54/1+i) + (54/(1+i)^2) + (900/(1+i)^2)-> i = 1,085 -> Yield to maturity = 8,5%
What are the two problems that pension funds have with low interest rates?
1. The value of their liabilities is high. 2. The expected returns on assets, e.g., bonds, are low.
What events can ignite a currency crisis?
1. deterioration of banks balance sheets 2. severe fiscal imbalances
What can emerging market countries do to strengthen prudential regulation and supervision of their bank systems? How might these steps help avoid future financial crises?
1. ensure banks hold enough capital 2. good risk management and monitoring 3. prevent commercial businesses from owning banking institutions 4. ensure the independence of supervisors, it helps avoid future crisis because banks will be less likely to get into financial problems
What are the two basic causes of financial crisis' in emerging economies?
1. mismanagement of financial liberalization and globalization 2. sever fiscal imbalances
Which should have the higher risk premium on its interest rates, a corporate bond with a Moody's Baa rating or a corporate bond with a C rating? Why?
A bond with a C rating, because the chance of default of the bond with a C rating is higher. This means that people would want to receive a higher risk premium.
What happens to inflation and output in the short run and the long run when taxes decrease?
A decrease in taxes will lead to a rightward shift of the aggregate demand curve. In the short run, inflation and output will both rise. This leads to tightness in the labor market, which raises inflation expectations and shifts the short-run aggregate supply curve up; as this occurs, the economy moves to a new long-run equilibrium, output falls back to potential, and inflation increases.
Why are deposit insurance and other types of government safety nets important to the health of the economy?
A government safety net can short-circuit runs on banks and bank panics, and overcome reluctance by depositors to put funds in the banking system. This helps to eliminate a contagion effect, in which both good and bad banks could become insolvent in the event of a bank panic. Without confidence in the banking system, such panics could result in a collapse of the financial system and severely inhibit investment and economic growth.
What will happen in the bond market if the government imposes a limit on the amount of daily transactions? Which characteristic of an asset would be affected?
A limit (or fee) on transactions makes it more expensive to buy or sell a bond. Or it increases the time it takes to transact. This makes bonds less attractive. This characteristic of an asset is 'liquidity'.
Suppose you are in charge of the financial department of your company and you have to decide whether to borrow short or long term. Checking the news, you realize that the government is about to engage in a major infrastructure plan in the near future. Predict what will happen to interest rates. Will you advise borrowing short or long term?
An increase in lending by the government crowds out other bonds. Assuming demand for bonds stays the same, an increase in supply leads to lower prices and higher interest rates. Infrastructure is a long-term investment, so this effect will be seen in long-term bonds. The advice would be to borrow long-term, as future rates will be higher.
How does the concept of asymmetric information help to define a financial crisis?
Asymmetric information problems (adverse selection and moral hazard) are always present in financial transactions but normally do not prevent the financial system from efficiently channeling funds from lender-savers to borrowers. During a financial crisis, however, asymmetric information problems intensify to such a degree that the resulting financial frictions lead to flows of funds being halted or severely disrupted, with harmful consequences for economic activity.
Just before the collapse of the subprime mortgage market in 2007, the most important credit-rating agencies rated mortgage-backed securities with Aaa and AAA ratings. Explain how it was possible that a few months into 2008, the same securities had the lowest possible ratings. Should we always trust credit-rating agencies?
Because the customers didn't trust the ratings anymore and started to invest in treasury bills.Rating agencies made mistakes.Slightly longer answer: the rating agencies (S&P, Moody's) used models to rate bonds that were not suitable for CDO's. These new financial instruments exploited the shortcomings of the rating models, so they looked very safe (AAA), while they were not.
How could you see that the decline in interest rates in the UK was unanticipated?
By the similar decline in the 20-minus-10 year rates over time.
Why is there usually a liquidity premium in the term structure of interest rates?
Credit risk, inflation risk, liquidity risk
What is a credit spread? Why do credit spreads rise significantly during a financial crisis?
Credit spreads measure the difference between interest rates on corporate bonds and Treasury bonds of similar maturity that have no default risk. The rise of credit spreads during a financial crisis (as occur red during the Great Depression and again during 2007-2009) reflects the escalation of asymmetric information problems that make it harder to judge the riskiness of corporate borrowers and weaken the ability of financial markets to channel funds to borrowers with productive investment opportunities.
Why would haircuts on collateral increase sharply during a financial crisis? How would this lead to fire sales on assets?
During a financial crisis, asset prices fall, oftentimes very rapidly and unexpectedly. This leads to the expectation that asset prices may fall further in the future and increases the uncertainty over the value of assets put up as collateral. As a result, firms accepting collateral assets require larger and larger haircuts, or discounts on the value of collateral in expectation of future lower values. This requires firms to put up increasingly more collateral for the same loans over time. Due to the falling asset prices and rising haircuts, it becomes a "buyers market"for these rapidly falling assets; any firms needing to raise funds quickly would then be forced to sell assets at a fraction of their original worth.
If you read in the Wall Street Journal that the "smart money"on Wall Street expects stock prices to fall, should you follow that lead and sell all your stocks?
No, because this is publicly available information and is already reflected in stock prices. The optimal forecast of stock returns will equal the equilibrium return, so there is no benefit from selling your stocks.
Why might financial liberalization and globalization lead to a financial crisis in emerging market economies?
Emerging economies are more dependent on external capital flows. A credit boom can end abruptly by external shocks being propagated due to financial globalization.
Why might severe fiscal imbalances lead to financial crisis in emerging market economies?
Emerging economies force banks to take on domestic (government) debt.This creates a vicious cycle when the government runs in to problems financing an excessive debt: a bad state of the banking systems leads to bank runs and the need for more government assistance.
According to the expectations theory of the term structure, it is better to invest in one-year bonds, reinvested over two years, than to invest in a two-year bond if interest rates on one-year bonds are expected to be the same in both years." Is this statement true, false, or uncertain?
False, because the interest rates will be the same, as well as the return.Expectations theory says that the two-year return should be the same as the one year + second year return
True, false, or uncertain: Deposit insurance always and everywhere prevents financial crises.
False. Deposit insurance is a very good system to prevent bank panics, but these events are just one potential element in a financial crisis. As the events that unfolded during the Great Recession illustrate, financial crisis have many aspects evolving at the same time. A system of deposit insurance might help to prevent bank panics, but it is unable to prevent the effects of the asset price decline in the housing market or the spreading of the crisis to international financial markets. Also, deposit insurance creates moral hazard incentives encouraging risk-taking on the part of banks that might make a financial crisis more likely.
"Bank managers should always seek the highest return possible on their assets."Is this statement true, false, or uncertain? Explain your answer.
False. If an asset has a lot of risk, a bank manager might not want to hold it even if it has a higher return than other assets. Thus, a bank manager has to consider risk as well as the expected return when deciding to hold an asset.
"An efficient market is one in which no one ever profits from having better information than the rest of the market participants."Is this statement true, false, or uncertain? Explain your answer.
False. The people with better information are exactly those who make the market more efficient by eliminating unexploited profit opportunities. These people can profit from their better information.
Define "financial frictions"in your own terms and explain why an increase in financial frictions is a key element in financial crises.
Financial frictions are a set of conditions that prevent financial markets to effectively assign funds to the best investment opportunities. In general, they increase when information asymmetries worsen, preventing lenders from ascertaining the best potential borrowers. Financial frictions are a key element in financial crises because as the channeling of funds through the financial market is interrupted or limited, the economy slows down. This could trigger an asset price decline, increase in uncertainty, and the deterioration in financial institutions' balance sheets.
How can economies of scale help explain the existence of financial intermediaries?
Financial intermediaries can take advantage of economies of scale and thus lower transactions costs. For example, mutual funds take advantage of lower commissions because the scale of their purchases is higher than for an individual, while banks'large scale allows them to keep legal and computing costs per transaction low. Economies of scale, which help financial intermediaries lower transactions costs, explain why financial intermediaries exist and are so important to the economy.
For each of the following countries, identify the single most important (largest) and least important (smallest) source of external funding: United States; Germany; Japan; Canada. Comment on the similarities and differences among the countries' funding sources.
For each country, the largest (most important) is listed first, and smallest (least important) is listed second, as reported in Figure 1 in the text. United States: Nonbank loans; Stocks. Germany: Bank loans; Bonds. Japan: Bank loans; Stocks. Canada: Bank loans; Stocks. For the United States, bank loans are relatively unimportant, but for the other countries, this makes up a very large part of overall external financing. For these countries (with the exception of the United States), stock and bond financing are relatively unimportant.
Suppose that you decide to play a game. You buy stock by throwing a dice a few times, using that method to select which stock to buy. After ten months you calculate the return on your investment and the return earned by someone who followed "expert"advice during the same period. If both returns are similar, would this constitute evidence in favor of or against the efficient market hypothesis?
If both returns are similar, this would constitute evidence in favor of the efficient market hypothesis, that states that so called "expert"advice is not a better predictor of movements in stock prices than a random method. No one can predict a stock price movement if the market is efficient. The only thing that can create a price movement is new information, that by definition no one has.
Following a policy meeting on March 19, 2009, the Federal Reserve made an announcement that it would purchase up to $300 billion of longer-term Treasury securities over the following six months. What effect might this policy have on the yield curve?
If the Federal Reserve purchases a significant amount of longer-term treasury debt, this will reduce the effective supply of treasuries of those particular maturities, resulting in a higher price and lower yield. This should have the effect of lowering the "long end" of the curve, decreasing medium and longer-term yields. In other words, the yield curve will shift down, but mostly on medium-and long-term maturities.
In December 2001, Argentina announced it would not honor its sovereign (government-issued) debt. Many investors were left holding Argentinean bonds priced at a fraction of their previous value. A few years later, Argentina announced it would pay back 25% of the face value of its debt. Comment on the effects of information asymmetries on government bond markets. Do you think investors are currently willing to buy bonds issued by the government of Argentina?
Information asymmetries are also present in government bond markets. Usually investors resort to many information sources about the characteristics of particular governments to assess their ability or willingness to honor their debt. As the Argentinean case illustrates, sometimes this lack ofinformationresults in huge losses for bondholders. In this respect, the problem is not significantly different from an investor who decides which corporate bond to buy, although it may be fair to say that information about corporate bonds is more standardized (making it easier to compare firms). After the Argentineandefault, investors were willing to buy bonds issued by its government only at a significant risk premium,making it very costly for Argentina to raise funds in bond markets.
If junk bonds are "junk," then why do investors buy them?
Investors buy ''junk bonds'' to spread the risk and diversify their portfolio.
If a bank is falling short of meeting its capital requirements by $1 million, what three things can it do to rectify the situation?
It can raise $1 million of capital by issuing new stock. It can cut its dividend payments by $1 million, thereby increasing its retained earnings by $1 million. It can decrease the amount of its assets so that the amount of its capital relative to its assets increases, thereby meeting the capital requirements.
Why do some central banks charge negative deposit rates to banks? And what happens when no good investment opportunities arise?
It encourages banks to lend out the deposits that they were holding at the central bank. If there are no good investment opportunities, banks instead might move the deposits into (physical) cash.
What is meant by maturity transformation of a bank?
It is a specific form of asset transformation: a bank borrows short-term (deposits) and lends long-term (for example, a mortgage). Hence, it transforms the maturity of one form of claim (a deposit) to another (a long-term loan).
In the late 1990s, as information technology advanced rapidly and the Internet was widely developed, U.S. stock markets soared, peaking in early 2001. Later that year, these markets began to unwind and then crashed, with many commentators identifying the previous few years as a "stock market bubble."How might it be possible for this episode to be a bubble but still adhere to the efficient market hypothesis?
It may be considered a bubble in that stock market prices rose well above true fundamental values. However, given the relatively new and rapid technology advances during the time, there was a great deal of uncertainty over what the true fundamental values of many technology-related companies were. Thus, even though it might be easy to identify the bubble after the fact, the efficient market hypothesis could still hold in that market participants were at the time acting on the best information available in valuing the stocks, considering much of the technology was new and had seemingly unlimited growth potential.
Auto loan rates declined from 2008 to 2017 and sales increased. How does this relate to monetary transmission?
It relates to the traditional interest rate channel (spending on durable goods by consumers is affected by the interest rate)
Would $200, to be received in one year, be worth more to you today when the interest rate is 12% or when it is 17%?
It would be worth 1/(1 + 0.20) = $0.83 when the interest rate is 20%, rather than 1/(1 + 0.10) = $0.91 when the interest rate is 10%. Thus, a dollar tomorrow is worth less with a higher interest rate today.
Explain why you would be more or less willing to buy long-term Delta Airlinesbonds under the following circumstances: a.Company has just released its financial statements, indicating that income decreased and liabilities increased
Less, because they have less revenue and more debts to pay, so probably my bonds will become worth less.
Why is it a good idea for macroprudential policies to require countercyclical capital requirements?
Leverage cycles indicate that over business cycles, lending increases substantially in booms and decreases substantially in downturns. If countercyclical capital requirements were initiated, this would require more capital held at institutions during booms, which would reduce lending and help to mitigate credit bubbles that can be damaging later on. Likewise, when the economy goes into a downturn, capital requirements could be lowered, which would encourage more lending and facilitate faster economic growth.
e.Your income and wealth increased over the last two years
More, because I will have more money to invest in bonds.
b. You expect a bull market instocks (expected increase)
More, because my bonds are expected to be worth more when there will be an increase in stock prices.
d.Brokerage commissions on bonds fall.
More, because they have become more liquid
c. You expect interest rates to decrease
More, because when interest rates tend to decrease, bond/stock prices tend to rise.
If the income tax exemption on municipal bonds were abolished, what would happen to the interest rates on these bonds? What effect would the change have on interest rates on U.S. Treasury securities?
Municipal bonds become less attractive vis-a-vis Treasury bonds. So, rates would go up for municipal bonds and *down* for Treasury bonds. (more attractive => higher price => lower yield to maturity)
In Japan, negative rates led to an increase in home sales. Why might this be, and what is the consequence for the effectiveness of negative interest rate policy?
Negative rates means that mortgages rates will be low as well. This explain the increase in home sales in Japan. It leads to inflation in asset prices, to potential bubbles, which is not good for the stability of the economy. This limits the effectiveness of negative interest rates.
Can a person with rational expectations expect the price of a share of Google to rise by 10% in the next month?
No, if the person has no better information than the rest of the market. An expected price rise of 10% over the next month implies over a 100% annual return on Google stock, which certainly exceeds its equilibrium return. This would mean that there is an unexploited profit opportunity in the market, which would have been eliminated in an efficient market. The only time that the person's expectations could be rational is if the person had information unavailable to the market that allowed him or her to beat the market.
Are interest rates low everywhere in the world?
No, only in developed/rich countries.
If the bank you own has no excess reserves and a sound customer comes in asking for a loan, should you automatically turn the customer down, explaining that you don't have any excess reserves to lend out? Why or why not? What options are available that will enable you to provide the funds your customer needs?
No. When you turn a customer down, you may lose that customer's business forever, which is extremely costly. Instead, you might go out and borrow from other banks, corporations, or the Fed to obtain funds so that you can make loans to the customer. Alternatively, you might sell negotiable CDs or some of your securities to acquire the necessary funds.
Which relationship would you expect to exist between measures of corruption and living standards at the country level? Explain by which channel corruption might affect living standards.
One would expect corruption measures to be negatively correlated with living standards. Corruption usually deters investment, since it undermines the legal system. Countries in which corruption is prevalent have trouble encouraging individuals or companies to invest in them. Corruption affects living standards by undermining the efficiency of the legal system, thereby lowering investment, one fundamental ingredient to economic growth, the basis of higher living standards.
Suppose you have data about two groups of countries, one with efficient legal systems and the other with slow, costly, and inefficient legal systems. Which group of countries would you expect to exhibit higher living standards?
One would expect the group of countries with more efficient legal systems to exhibit higher living standards. Legal systems are an important part in the lending process, precisely because they are part of the mechanisms of enforcement of contracts that deal with the moral hazard problem. Costly, slow, and inefficient legal systems do not promote lending and thereby funding of investment opportunities.
If the yield curve suddenly became steeper, how would you revise your predictions of interest rates in the future?
Prediction of future interest rates would go up. (more steeper yield curve == higher rates in the future)
What is the price of a perpetuity that has a coupon of $70 per year and a yield to maturity of 1.5%? If the yield to maturity doubles, what will happen to the perpetuity's price?
Price = 70/0.015 = $4666, 67
If a bank doubles the amount of its capital and ROA stays constant, what will happen to ROE?
ROE will fall in half.
What factors shift the short-run aggregate supply curve? Do any of these factors shift the long-run aggregate supply curve? Why?
Shifts in the short-run aggregate supply curve result from changes in expected inflation, price shocks, and persistent output gaps. None of these factors shift the long-run aggregate supply curve because price and wage flexibility ensures that in the long run the economy produces at its potential output level. Potential output depends not on actual or expected inflation but rather on the capital, labor, and technology available for producing goods and services. However, a change in potential output shifts the long-run aggregate supply curve and also the short-run aggregate supply curve because it changes the output gap at any given level of actual output.
What are reasons for deposits drains?
Solvency concerns, failure or related institutions (contagion), changes in investor preferences
How do standardized accounting principles help financial markets work more efficiently?
Standardized accounting principles make profit verification easier, thereby reducing adverse selection and moral hazard problems in financial markets, hence making them operate better. Standardized accounting principles make it easier for investors to screen out good firms from bad firms, thereby reducing the adverse selection problem in financial markets. In addition, they make it harder for managers to over-or understateprofits, thereby reducing the principal-agent (moral hazard) problem.
Suppose you are applying for a mortgage loan. The loan officer tells you that if you get the loan, the bank will keep the house title until you pay back the loan. Which problem of asymmetric information is the bank trying to solve?
The bank is trying to solve the moral hazard problem by placing a lien on the house title. In general, the bank does not "keep the house title", but it places a lien on it instead to prevent the house owner from selling the house without its supervision. In this case, the bank wants to make sure that you do not sell the house, get the money and never pay back the loan.
What are the benefits and costs for a bank when it decides to increase the amount of its bank capital?
The benefit is that the bank now has a larger cushion of bank capital and so is less likely to go broke if there are losses on its loans or other assets. The cost is that for the same ROA, it will have a lower ROE, return on equity.
How did the global financial crisis promote a sovereign debt crisis in Europe?
The contraction in economic activity reduced tax revenues at the same time that government bailouts of failed financial institutions required an increase in government outlays. The result was a surge in budget deficits that lead to fears that the governments of hard-hit countries would default on their debt. The result was a huge sell off in the sovereign bonds of these countries that led to a surge in interest rates on these bonds.
When is the current yield a good approximation of the yield to maturity?
The current yield will be a good approximation to the yield to maturity whenever the bond price is very close to par or when the maturity of the bond is over about ten years. This is because cash flows farther in the future have such small present discounted values that the value of a long-term coupon bond is close to a perpetuity with the same coupon rate.
Suppose that many big corporations decide not to issue bonds, since it is now too costly to comply with new financial market regulations. Can you describe the expected effect on interest rates?
The effect on interest rates depends on what effect dominates. If demand remains the same, prices will go up and interest rates will go down(!). If, however, demand changes, because other bonds are not perfect substitutes for those of big corporations, the effect might be different: higher or no change in interest rates. (This question is a bit too subtle for an exam question, but useful for your thought process)
How does the free-rider problem aggravate adverse selection and moral hazard problems in financial markets?
The free-rider problem means that private producers of information will not obtain the full benefit of their information-producing activities, and so less information will be produced. This means that there will be less information collected to screen out good from bad risks, making adverse selection problems worse, and that there will be less monitoring of borrowers, increasing the moral hazard problem.
Do you think that a U.S. Treasury bill will have a risk premium that is higher than, lower than, or the same as that of a similar security (in terms of maturity and liquidity) issued by the government of Colombia?
The government of Colombia(the country in South America) will have a much higher chance of default, so it will have a higher risk premium.
Suppose the public believes that a newly announced anti-inflation program will work and so lowers its expectations of future inflation.What will happen to aggregate output and the inflation rate in the short run?
The inflation rate will be lower than it otherwise would be and aggregate output will be higher. The lower expected inflation will cause the short-run aggregate supply curve to shift down, so that the intersection of the short-run aggregate supply curve with the aggregate demand curve will be at a higher level of output and a lower inflation rate.
he president of the United States announces in a press conference that he will fight the higher inflation rate with a new anti-inflation program. Predict what will happen to interest rates if the public believes him.
The interest rates will be lower, because people will accept less compensation for the inflation, when they believe that the new anti-inflation program will be effective.
What are some of the limitations to the Basel and Basel 2 Accords? How does the Basel 3 Accord attempt to address these limitations?
The original Basel Accord takes into account the riskiness of capital, but in practice, the risk weights can differ substantially from the actual risk the bank faces. The Basel 2 Accords were created to address this limitation; however, addressing these shortfalls greatly increased the complexity of the accord, andmthere was substantial delay with countries adopting and implementing the regulations. More specifically, Basel 2 did not require banks to hold adequate capital to survive financial crises. Moreover, risk weights were dependent on credit ratings, which can be unreliable, particularly in financial crises. In addition, Basel 2 implies procyclical capital requirements, whereas countercyclical capital requirements would be more prudent. Also, there is not a sufficient focus on the need for liquidity, which is necessary particularly during financial crises. Basel 3 attempts to address these shortfalls by increasing the quality and quantity of capital requirements, making capital requirements less procyclical, establishing rules on the use of credit ratings, and requiring firms to have access to more stable funding to increase liquidity.
If the interest rate is 15%, what is the present value of a security that pays you $1,100 next year, $1,250 the year after, and $1,347the year after that?
The present value = (1100/1.15) + (1250/1.15^2) + (1347/1.15^3) = $2787,37.
What will happen to the demand for Rembrandt paintings if the stock market undergoes a boom? Why?
The price of Rembrandt paintings will rise, because people have more money than before when the stock market undergoes a boom. This means that people are willing to spend more money on the paintings, which means that the prices will rise.
What is default risk?
The risk that a borrower is unable (or unwilling) to fulfill the terms promised under the loan contract.
Explain how the separation of ownership and control in American corporations might lead to poor management.
The separation of ownership and control creates a principal-agent problem. The managers (the agents)do not have as strong an incentive to maximize profits as the owners (the principals). Thus, the managers might not work hard, might engage in wasteful spending on personal perks, or might pursue business strategies that enhance their personal power but do not increase profits.
If large budget deficits cause the public to think there will be higher inflation in the future, what is likely to happen to the short-run aggregate supply curve when budget deficits rise?
The short-run aggregate supply curve will shift upward because wages and production costs rise, since workers and firms expect prices to be higher.
If expectations of future short-term interest rates suddenly fell, what would happen to the slope of the yield curve?
The slope of the yield curve would fall because the drop in expected future short rates means that the average of expected future short rates falls so that the long rate falls.
What basic principle of finance can be applied to the valuation of any investment asset?
The value of any investment is found by computing the value today of all cash flows the investment will generate over its life.
What are the two main sources of cash flows for a stockholder? How reliably can these cash flows be estimated? Compare the problem of estimating stock cash flows to the problem of estimating bond cash flows. Which security would you predict to be more volatile?
There are two cash flows from stock: periodic dividends and a future sales price. Dividends are frequently changed when a firm's earnings either rise or fall, which can make them difficult to estimate. The future sales price is also difficult to estimate, because it depends on the dividends that will be paid at some date even further in the future. Bond cash flows also consist of two parts, periodic interest payments and a final maturity payment. These payments are established in writing at the time the bonds are issued and cannot be changed without the firm defaulting and being subject to bankruptcy. Stock prices tend to be more volatile, because their cash flows are more subject to change.
If casualty insurance companies provided fire insurance without any restrictions, what kind of adverse selection and moral hazard problems might result?
There would be adverse selection, because people who might want to burn their property for some personal gain would actively try to obtain substantial fire insurance policies. Moral hazard could also be a problem, because a person with a fire insurance policy has less incentive to take measures to prevent fire.
Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?
This is the case, because when there is a business cycle expansion the changes of default decrease. However, during a recession the changes of default increase, so people want a higher risk premium when the changes of default increase.
If a bank finds that its ROE is too low because it has too much bank capital, what can it do to raise its ROE?
To lower capital and raise ROE, holding its assets constant, it can pay out more dividends or buy back some of its shares. Alternatively, it can keep its capital constant, but increase the amount of its assets by acquiring new funds and then seeking out new loan business or purchasing more securities with these new funds.
"If stock prices did not follow a random walk, there would be unexploited profit opportunities in the market."Is this statement true, false, or uncertain? Explain your answer.
True, as an approximation. If large changes in a stock price could be predicted, then the optimal forecast of the stock return would not equal the equilibrium return for that stock. In this case, there would be unexploited profit opportunities in the market and expectations would not be rational. Very small changes in stock prices could be predictable; however, and the optimal forecast of returns would equal the equilibrium return. In this case, an unexploited profit opportunity would not exist.
"The more collateral there is backing a loan, the less the lender has to worry about adverse selection."Is this statement true, false, or uncertain? Explain your answer.
True. If the borrower turns out to be a bad credit risk and goes broke, the lender loses less, because the collateral can be sold to make up any losses on the loan. Thus, adverse selection is not as severe a problem.
True or False: With a discount bond, the return on the bond is equal to the rate of capital gain.
True. The return on a bond is the current yield iCplus the rate of capital gain, g. A discount bond, by definition, has no coupon payments, thus the current yield is always zero (the coupon payment of zero divided by current price) for a discount bond.
What role does weak financial regulation and supervision play in causing financial crises?
Weak regulation and supervision mean that financial institutions will take on excessive risk, especially if market discipline is weakened by the existence of a government safety net. When the risky loans eventually go sour, this causes a deterioration in financial institution balance sheets, which then means that these institutions cut back lending and economic activity declines.
How can the bursting of an asset-price bubble in the stock market help trigger a financial crisis?
When an asset-price bubble bursts and asset prices realign with fundamental economic values, the resulting decline in net worth means that businesses have less skin in the game and so have incentives to take on more risk at the lender's expense, increasing the moral hazard problem. In addition, lower net worth means there is less collateral and so adverse selection increases. The bursting of an asset-pricebubble therefore makes borrowers less credit-worthy and causes a contraction in lending and spending. The asset price bust can also lead to a deterioration in financial institutions' balance sheets, which causes them to deleverage, further contributing to the decline in lending and economic activity.
If yield curves, on average, were flat, what would this say about the liquidity (term) premiums in the term structure? Would you be more or less willing to accept the expectations theory?
When it is flat, it suggests that future interest rates, in expectation, will be the same as now. That would fit with the expectations theory.
If monetary policy becomes more transparent about the future course of interest rates, how will stock prices be affected, if at all?
With more certainty over the course future interest rates will follow, uncertainty and risk would likely be reduced, which will lower the required return on investment ke and lead to a higher stock price. In addition, with a reduction in the uncertainty of future short-term interest rates, this would likely lower longer-term interest rates, increasing capital investment. This would likely raise long-run economic growth and dividend growth, also pushing stock prices higher.
Do bondholders fare better when the yield to maturity increases or when it decreases? Why?
When the yield to maturity increases, this represents a decrease in the price of the bond. If the bondholder were to sell the bond ata lower price, the capital gains would be smaller (capital losses larger) and therefore the bondholder would be worse off.
Are there any "good" supply shocks? Explain
Yes. There are negative and positive supply shocks. An example of a positive supply shock is the 1995-1999 period in the US, with falling medical care costs and productivity increases due to the computer revolution.
deposit insurance
a measure implemented in many countries to protect back depositors, in full or in part, from losses caused by a bank's inability to pay its debts when due
What do we mean by maturity transformation of banks?
borrowing short-term and lending long-term
Rank the following bank assets from most to least liquid: a.Commercial loan sb.Securities c.Reserves d.Physical capital
reserves, securities, commercial loans, and physical capital
Reasons that make banks different from other companies
•Capital structure: they are highly leveraged and have demand deposits as liabilities •Public confidence matters •They have diffuse debtholders •They are large creditors •Bank assets are opaque; Bank risk taking can be unnoticeable &fast-changing •They are systemically important & benefit from the safety net (i.e., deposit insurance, LoLR, TBTF)
The challenges for European banks
•High impairments (mostly southern countries) •Legacy issues (data management) •Low interest rates (impact on Net Interest Income)•High competition (from non-banks and Fintechs) •Environmental concerns (transition and physical risk) •Regulatory pressure
Shortcomings of the 1988 Basel I Accord
•The risk classes are crude, inviting for exploitation (e.g. mortgages require half of the capital of business loans) •Risk classes do not properly reflect actual credit risk exposure •Does not reward diversification within portfolio; so No recognition of the covariance of returns that affect diversification and portfolio risk •It assumes that banking risk is the same across countries and time •Capital ratios are expressed in book-value and they fail to adjust for changes in market values
