FIN3244 EXAM 2

Financial innovation in mortgage markets

- financial engineers created financial products that allowed for "subprime mortgages" to become more available -they would "bundle" these mortgages into a single security (MBS) or mortgage backed securties -this allowed these portages to be traded like stocks by investors

federal reserve system

-board of governors -federal open market committee -chairman -3000 member banks

Asymmetric information in the credit ratings

-they get paid by creating ratings for securities and also helped create the MBS in the first place through advising -If they did not give these junk bonds MBS good ratings, the people making the MBS will just go to another credit rating agency

recent example of financial crisis

2007-2008 finial crisis is the largest financial crisis in recent history

Americans' fear of centralized power and their distrust of moneyed interests explain why the U.S. did not have a central bank until the 19th century. 18th century. 20th century. 17th century.

20th century.

how much did house prices fall by from 2007-2009

30%

board of governers

7 members main governing body in the fed

financial innovation

CDO's are an example from 2008 -a new product was introduced on financial markets and then was abused, causing a bible in asset prices that later popped

CDO

Collateralized Debt obligations

what country is insider trading legal(F)

Germany

who is the current chairman

Jerome Powell as of 2018

Factors that can lead to worsening conditions in financial markets include increasing interest rates and asset price booms.

True

Agency problems in mortgage markets

- mortgage brokers did not care if people could repay their mortgages because they would not be stuck with the loan because they would sell it as a securities to investors -these mortgage brothers get their fee for creating the mortgages and then not have to worry about the mortgages being paid back

Factors that provide the Federal Reserve with a high degree of independence include -14-year terms for members of the Board of Governors. -a four-year term for the chairman of the Board of Governors that is not coincident with the president's term of office. -constitutional independence from Congress and the president. -all of the above.

-14-year terms for members of the Board of Governors. -a four-year term for the chairman of the Board of Governors that is not coincident with the president's term of office.

what areas suffered the most from this crisis

-US residential market -financial institutions -the "shadow" banking system -global financial markets -major financial firms

Most financial crises in the United States have begun with -an increase in uncertainty resulting from the failure of a major firm. -a steep stock market decline. -a steep decline in interest rates.

-an increase in uncertainty resulting from the failure of a major firm. -a steep stock market decline.

what happens when investors rush to buy securities when low

-buy until the price rises to the point that returns are normal is an unexploited profit opportunity -Think demand goes up if something is underpriced until the price rises and reaches an equilibrium point, where it is appropriately price.

Federal reserve

-central bank of the US -responsible for managing monetary policy

what happened in the residential housing market during the crisis

-housing prices went way up as the subprime mortgage grew -when the bubble burst, housing prices fell sharply

Debt deflation

-if the economy does poorly enough, prices will go down -companies will not be able to make as much doing the same thing they were doing before, however they will still owe the same amount of money in debt -therefore, the real value of their debt goes up

According to the efficient market hypothesis -information in newspapers and in the published reports of financial analysts is already reflected in market prices. -one cannot expect to earn an abnormally high return by purchasing a security. -unexploited profit opportunities abound, thereby explaining why so many people get rich by trading securities. -all of the above are true. -only A and B of the above are true.

-information in newspapers and in the published reports of financial analysts is already reflected in market prices. -one cannot expect to earn an abnormally high return by purchasing a security.

who is to blame for the crisis

-low interest rates on housing cause bubble -relaxed lending standards and subprime mortgages -creation of MBS and CDO -money coming from other countries to invest caused a large money supply in the housing market -prob combination of lots of things

An increase in uncertainty

-when major shock occurs in financial markets, it causes uncertainty among investors (ex: bank failure) -this can create moral hazards and adverse selection, causing economic activity to decline

what are the three stages of a financial crisis

1-initial phase 2-banking crisis 3-debt deflation

three major factors in the financial crisis

1. financial innovation in mortgage markets 2. agency problems in mortgage markets, and asymmetric information in credit ratings

when does a credit boom or bust happen

1. financial innovation is mismanaged 2. financial liberalization is mismanaged

how many federal reserve banks

12

when was the first US bank terminated and why

1811 due to mistrust of centralized authority and moneyed interests

when was the second US bank terminated

1836 because there was no lender for distressed banks

what was the credit spread of banks after the great depression

2% to 8%

Currently about 38% of the commercial banks in the United States are members of the Federal Reserve System, having declined from a peak figure of ________ in 1947. 49% 63% 42% 55%

49%

how much did the stock market fall by from 2007 to 2009

50%

how many meetings a year does the fed have

8 a year normally in secret and can be held more often

From its peak in 1929 to the trough in December 1932, the Dow Jones Industrial Average fell how much? 90% 80% 70% 60%

90%

January effect(UF)

=high returns in january investors could be trying to lower tax liability by selling off capital losses in December

The ________ of the Board of Governors is the spokesperson for the Fed. president chairman either of the above can be the spokesperson neither of the above

chairman

what happens when banks start deleveraging

depositors see the risk and pul funds from banks

what did such a high credit spread lead to

lead to debt deflation as price levels fell by 25% and company value began to fall

what do the 3000 member banks do

maintain the reserve deposits in the FED bank within their respective districts

what was the affect of the FED increasing interest rates to decrease the bubble

the stock market crashes by 40% from October through December of 1929

fundamental value

the value that an asset should have

Stock prices publicly reflect available info (F)

true

economic contraction was severe

true

what was the stock market worth in 1932

worth 10% of what it had been worth at the peak in 1929

Which of the following is NOT considered one of the four groups in the Federal Reserve System? Federal Reserve banks Federal Deposit Insurance Corporation Board of Governors Federal Open Market Committee

Federal Deposit Insurance Corporation

where else were there debt crisis besides the US in 2008

Greece, Ireland, Portugal and Spain hit hard

The national economic forecast for the next two years prepared by the staff of the Board of Governors is published in the Green Book Beige Book Blue Book Fed Book

Green Book

Which of the following does not weaken the efficient markets hypothesis? Success of buy-and-hold strategy Mean reversion January effect Excessive volatility

Success of buy-and-hold strategy

When was the worst and longest economic recession in modern history

THE GREAT DEPRESSION began in 1929 with stock crash ended in 1946 at the end of WW2

Housing prices boomed from 2002 to 2006, fueling the market for subprime mortgages and forming an asset-price bubble. Housing prices began declining in 2006, falling by more than 30%, which led to defaults by subprime mortgage holders.

True

Technical analysis is a popular technique used to predict stock prices by studying past stock price data and searching for patterns such as trends and regular cycles.

True

This worldwide depression led to the rise of fascism in Europe and some would argue WW2

True

Should you be skeptical of hot tips?

YES! EMH indicates fi the market is efficient it is already prices in the stock and as soon as information is available to everyone, someone will have already exploited the profit opportunity (could also be insider trading)

did the bank panics in the US affect other countries

YES- the worldwide depression led to the rise of fascisim in Europe and some argue started WW2

was a bailout package created for 2008 crisis?

Yes- created to purchase this worthless assets from banks to keep them from failing

what is the small-firm effect for EMH(UF)

abnormally high returns

example of a government safety net company

FDIC bank insurance -banks know they are protected form losses and take on more risk

Federal Open Market Committee

FOMC -makes monetary policy decisions -consists of 7 BOG members and 5 federal reserve bank presidents

An unusual feature of the "Great Recession" in the U.S. from 2007-2009 was that the crisis did not spread to European nations.

False

Evidence that a mutual fund has performed extraordinarily well in the past contradicts the efficient market hypothesis.

False

Evidence that stock prices sometimes fall when a firm announces good news contradicts the efficient market hypothesis.

False

Initial phase

can be caused by a credit boom or bust, asset price boom or bust or an increase in uncertainty

chairman

chairs of BOG and FOMC

Sometimes one observes that the price of a company's stock falls after the announcement of favorable earnings. This phenomenon is -consistent with the efficient market hypothesis if the earnings were not as low as anticipated. -clearly inconsistent with the efficient market hypothesis. -consistent with the efficient market hypothesis if the earnings were not as high as anticipated. -the result of none of the above.

consistent with the efficient market hypothesis if the earnings were not as high as anticipated.

CDO def

created to further break up MBS. it created default priorities for the owners of MBS- in other words, the highest CDO would be paid first

What happens when some banks become insolvent?

depositors run to their banks that may or may not be in financial trouble and pull their deposits out to be safe, this causes more banks to be insolvents and worsen the issue

higher tranches of CDO vs lower tranches

higher tranches get a lower interest rate so their investment is safer lower tranches get higher interest rates but bear more risk of default

What is the only way to beat the market?(F)

insider information which is illegal in the U.S.

The efficient market hypothesis suggests that allocating your funds in the financial markets on the advice of a financial analyst -will always mean lower returns than if you had made selections by throwing darts at the financial page. -will certainly mean higher returns than if you had made selections -by throwing darts at the financial page. -is not likely to prove superior to a strategy of making selections by throwing darts at the financial page. -is good for the economy.

is not likely to prove superior to a strategy of making selections by throwing darts at the financial page.

financial crisis

is when a disruption occurs in the flow of information in financial markets causing to slow or even stop -this causes market inefficiencies-money goes to the wrong use or does not flow at all

what is the important of October 24th, 1929

known as Black Thursday because it was a huge single day los in stock value

technical analysis(F)

looks at past trees and irregular cycles to predict stock prices which it can not accurately do because stock prices are unpredictable

how to fix banks insolvency

must sell assets quickly to further deteriorating their balance sheets

The advantage of a "buy and hold strategy" is that -net profits will tend to be higher because there will be fewer brokerage commissions. -losses will eventually be eliminated. -the longer a stock is held, the higher its price will be. -only B and C of the above are true.

net profits will tend to be higher because there will be fewer brokerage commissions.

do anticipated announcements reflect stocks?(F)

no, on average earnings announcements do not raise the stock prices

new information in EMH (UF)

not always immediately incorporated into stock prices

Bubble

occurs when the price of an asset gratuity exceeds the fundamental value of that asset

how often did bank insolvency happen

semi regular occurrence before WW2 and occurred about every 20 years and takes years to recover as an economy

Purpose of EMH

should eliminate all unexploited profit opportunities because some investors will find them and exploit these opportunities

Random walk behavior(F)

stock prices are not predictable because if they are predicated to fall/rise, investors would sell/buy to equilibrium

Market Overreaction(UF)

stock prices overreact to news announcements -Investors may purchase a stock after bad earnings report then sell it a couple of weeks later after it gone back to normal level

mean reversion(UF)

stocks with low return tend to have high returns in the future

what was the view on stocks before the great depression

the American public began investing in stocks carelessly and raising the price of stocks -also borrowed money on "margin" to invest in other people money as well and created a bubble

Evidence in favor of market efficiency does not include -technical analysis. -walk behavior. -performance of investment analysts and mutual funds. -the January effect.

the January effect

Bank panic

the banks balance sheets value go low enough

when did the stock market recover half of its value

the middle of 1930

how is the 2008 crisis similar to the great depression

the raised credit spreads and made loans harder to come by, in turn causing the economy to contract

The Federal Open Market Committee consists of the seven members of the Board of Governors and seven presidents of the regional Fed banks. the seven members of the Board of Governors and five presidents of the regional Fed banks. the twelve regional Fed bank presidents and the chairman of the Board of Governors. the five senior members of the seven-member Board of Governors.

the seven members of the Board of Governors and five presidents of the regional Fed banks.

what happened in 1920-1921

there was a short depression in which the stock market fell by 50% and corporate profits fell by 90%

Frannie mae and Freddie mac

they were protected by the government from failing but would have failed in much of the same way if they had not been bailed out

"Investment dartboard" often beats investment managers

true

1/3 of American banks had failed by the end of it all

true

Any time you find a pattern, its against EMH since EMH says you can't predict stock prices (UF)

true

In an efficient profit market, all the unexploited profit opportunities will be eliminated

true

adverse selection and moral hazard were created as loans were hard to come by

true

droughts entered the midwest, causing farmers to default on loans, and causing bank panics as banks went out of business

true

investment markets and mutual funds dont beat the market(F)

true

the unemployment rate rose to 25% during the great depression

true

banks charged higher interest rates due to uncertainty creating high credit spread

true -the difference between the rates on loans and the rates on US treasury securities = credit spread

Deleverage

when baks have stocks in the overpriced assets, they will see the value of their assets fall causing credit to be less available and adverse selection

what leads to a credit bust

when banks start deleveraging and depositors pull their funds from the bank

economic contraction

when firms that should be getting loans are not because the banks have less money to loan and are loaning less in general. this lack of available funds for firms cause them to not be able to invest in new projects which creates the economic contraction

when will the bubble burst

when investors being to sell off these overprices assets

what creates moral hazard problem

when investors sell these overprices assets, companies make more risky investment to try and save their companies

financial liberalization

when laws are lifted and the market is allowed to operate more freely- this can cause rapid growth that later pops when the price becomes too inflated

deleveraging

when risky loans they give out start defaulting, they loan out less

Government safety nets

when the govenment introduces laws that protect companies, those companies feel that they can take more risks and this weakens incentives for risk management

Buy-and-hold strategy

where they buy stocks, construct a portfolio and hold them for a long time (should be embraces by investors)

panic of 1907

widespread bank failures resulted in substantial losses

can EMH be used to predict foreign exchange rates/currency(F)

yes, evidence shows these are unpredictable

Which of the following statements regarding member banks is TRUE? -A majority of banks are part of the Federal Reserve System, and they hold a majority of all bank deposits. -A minority of banks are part of the Federal Reserve System, but they hold a majority of all bank deposits. -A majority of banks are part of the Federal Reserve System, but they hold a minority of all bank deposits. -A minority of banks are part of the Federal Reserve System, and they hold a minority of all bank deposits.

A minority of banks are part of the Federal Reserve System, but they hold a majority of all bank deposits.

Efficient Market Hypothesis (EMH) def

A security's price fully reflects all available information in an efficient market

examples of bank failures

Bear Stern and Lehman brothers in 2008 crisis

what was the first bank to fail

Bear and Stearns and sold to JP Morgan for 5% of their value -american banks with the high levels of investment in MBS failed

How valuable are published reports by investment advisors?

EMH says it can't help you to beat the market. empirical evidence backs this up

do stock prices always rise when there is good news?

NO, it depends not the news. if expected the price shouldn't change, but if unexpected there will be a response

Do stock prices always rise when there is good news?

NO- in the EMH, they will only rise when the information being announced is new or unexpected

Does every investor need to be aware of every security?

NO- only a few do, they will eliminate the profit opportunities that appear because in so doing, they make a profit

Do mutual funds consistently outperform the market?

NO- they can't constantly outperform the market, therefore investors shouldn't buy into ones that have high fees or sales commissions to brokers but buying mutual funds are a sensible strategy for small investors

does the EMH support technical analysis

NO- they think it is a waste of time because it does not successfully predict forecast of stock because stock prices are unpredictable

Which of the following banks are required to be members of the Federal Reserve System? State-chartered banks Banks having over $500 million in assets Insured banks None of the above

None of the above

Which of the following types of information will most likely enable the exploitation of a profit opportunity? Financial analysts' published recommendations Hot tips from a stockbroker Technical analysis None of the above

None of the above

Investors should try to outguess the market with constant buying and selling of securities, which only puts money in the brokers pockets

false

federal reserve act of 1913

fed established to facilitate economic stability

what happened to Lehman brothers

filed for bankruptcy and Meriil Lynch sold to Bank of America in "fire" sale

How much did real GDP and unemployment increase in 2009

over 10%

Instrument independence means the central bank is free from -political pressure regarding how it uses the tools of monetary policy. -political pressure regarding the goals it pursues. -both A and B of the above. -neither A nor B of the above.

political pressure regarding how it uses the tools of monetary policy.

what did the FED do in attempt to decrease the bubble before the great depression

raised interest rates, therefore people saw the higher interest rates and began investing in bonds by pulling their money out of the stock market to lend at higher interest rates