FIN3244 Test 2
How are banks able to attract small savers if small savers can usually receive a higher interest rate from money market mutual funds than from bank savings accounts?
Deposits in bank savings accounts are covered by federal deposit insurance whereas money market mutual fund shares are not. Also, money market mutual funds restrict savers to writing checks only above a specified amount, such as $500 (Money market savings aren't as liquid as bank deposits.)
1. Chris estimates that if he does 5 hours of research using data that costs him $75, there's a good chance that he can improve his expected return on a $10,000, 1-year investment from 8% to 10%. Chris feels that he must earn at least $20 per hour on the time he devotes to his research a. Find the cost of Chris' research b. By how much (in dollars) will Chris' return increase as a result of the research? On a strictly economic basis, should Chris perform the proposed research?
(a) Cost of research: Five hours at $20 per hour $100 Research data 75 Total $175 (b) Increase in expected return: New return of 10% - Current return of 8% = 2% increase $10,000 investment x .02 increase = $200 (c) Yes; the expected increase in return is greater than the cost of doing the research.
Why have runs on commercial banks become rare while multiple shadow banking firms experienced runs during the financial crisis?
A run on a financial firm is the attempt by investors to get their money out before the firm fails. Commercial banks do not typically have bank runs because their deposits are insured by the Federal Deposit Insurance Corporation (FDIC) which reduces the risk to depositors. The shadow banking industry, however, is not covered by the FDIC because their short-term borrowing is not in the form of deposits.
In what ways are contractual savings institutions similar to commercial banks? In what ways are they different?
Contractual savings institutions are similar to commercial banks because like all financial intermediaries, they raise funds and invest them in loans and securities. Unlike commercial banks, however, contractual savings institutions do not raise funds through deposits but rather, receive payments from individuals as a result of a contract. They also have access to a wider range of assets than commercial banks.
In 2005, prior to the financial crisis, Timothy Geithner, then president of the Federal Reserve Bank of New York, thought that hedge fund leverage was rising, "probably because of heightened competitive pressure." Why might competitive pressure lead a hedge fund manager to take on more leverage? Would the same reasoning apply to managers of an investment bank? Briefly explain.
Hedge funds compete for investor funding by offering higher rates of return than alternative investments. If a hedge fund manager sees that other hedge funds are earning higher rates of return because of the leverage they employ, the manager may feel the need to increase the leverage at his or her fund to compete. The same reasoning applies to investment banks and their proprietary trading.
What incentives would the partners in an investment bank have to turn it into a public corporation? If becoming a public corporation increases the risk in investment banking, how do publicly traded investment banks succeed in selling stock to investors?
If an investment bank went public, it would have more access to capital because it could sell stock to the public and not have to rely entirely on the funds contributed by the firm's partners. Going public also reduces the risk involved to the top executives, as it is not solely their money that is being invested. Although investment banks may take on more risk than commercial banks or most other financial firms, they also may deliver higher returns. Investors who find this trade-off between risk and return to be attractive will buy the investment banks' stock.
In what ways are insurance companies financial intermediaries?
Insurance companies are financial intermediaries in that they obtain funds by charging premiums to policyholders and then use these funds to make investments.
What are the key differences between investment banks and commercial banks?
Investment banking involves, among other activities, underwriting new security issues and providing advice on mergers and acquisitions, whereas commercial banking primarily involves taking deposits and making loans.
An article in the Economist magazine says about investment banks: "By unlocking the capital markets and helping firms to manage risks, investment banks are important conduits of credit." How do investment banks 'unlock capital markets'? How do investment banks help firms to manage risk? How do these activities make investment conduits of credit?
Investment banks 'unlock capital markets' by knowing the ins and outs of financial markets and knowing the current willingness of investors to buy different types of securities as well as the price investors are likely to require. Investment banks use this knowledge to help firms raise funds through stock and bond issues. Investment banks help firms use derivative contracts and design new securities to help corporations manage risk. Investment banks are conduits of credit for all of the above mentioned reasons. In this role, they help match savers and borrowers and decrease the risk of borrowing and lending.
In what ways are investment institutions similar to commercial banks? In what ways are they different?
Investment institutions are similar to commercial banks because they are financial intermediaries that raise funds and invest them in loans and securities. Unlike commercial banks, investment institutions do not raise funds through deposits and they have access to a wider variety of investment assets than commercial banks.
During the 2000s, why did investment banks become more reliant on repo financing and also, more highly leveraged? In your answer, be sure to define repo financing and leverage.
Repo financing is a way of borrowing funds through the use of repurchase agreements. A repurchase agreement is the selling of securities under the condition that the seller is to buy back the securities at a slightly higher price within a short period of time (typically, the next day or within a few days.) Repos are short-term loans with the securities serving as collateral. Leverage is the financing of investments by borrowing rather than using capital. Investment banks became more reliant on repo financing and more highly leveraged because by the 1990s most of these banks had converted from partnerships to publicly traded companies. As proprietary trading became a more important source of profits, investment banks increasingly borrowed to finance investments in securities and direct loans to firms.
Describe the basic philosophy and use of stock market averages and indexes. Explain how the behavior of an average or index can be used to classify general market conditions as bull or bear.
Stock market averages and indexes are used to measure the general behavior of the security markets they are representative of. They are a convenient way to capture the general mood of the market. When they reflect a sustained upward trend in prices over time, a bull market is said to exist. Likewise, when these measures exhibit a sustained downward trend over time, a bear market exists.
Explain the basic differences between the DJIA, the S&P500 and the Nasdaq Composite indexes.
The DJIA (commonly referred to as 'the Dow' is the oldest, likely best known, measure of U.S. stock market performance. It consists of 30 large, high quality stocks selected from various sectors of the economy. The Dow considers only the prices of the firms that comprise the average. The S&P500 is a broader index than the Dow since it consists of 500 firms. As a value-weighted index, it considers both the price and the '# of shares outstanding' for each firm it holds. It's generally considered a more accurate reflection of the U.S. economy than the DJIA. Although it holds only U.S. corporations, approximately 50% of the earnings made by the firms in the S&P500 come from overseas. The NASDAQ Composite Index consists of approximately 3000 firms that trade on the NASDAQ stock market. Although this index contains substantially more firms that either the DJIA or the S&P500, it is questionable if it is a broader index since the firms it contains tend to be concentrated in biotech and computer technology. The NASDAQ Composite is a value-weighted index. Although the three averages and indexes tend to move in the same direction, this isn't always the case. When they don't mBove together, we are said to have a 'mixed market." Because of its composition, it's the NASDAQ Composite that tends to be the exception.
Why does the DJIA have a term called the divisor?
The DJIA measures the return (excluding dividends) on a portfolio that holds one share of each stock. The averaging procedure is adjusted for several reasons, including whenever a stock splits or one firm in the DJIA is replaced by another firm. The divisor is used to leave the average unaffected by the event.
Many investment banks practice an 'up or out' policy. New hires are either fired or promoted within a few years. Many large law firms and accounting firms use a similar policy, as do colleges, with respect to their tenure-track faculty. Most firms, however, do not use this policy. In a typical firm, after a probationary period, most employees continue to work for the firm, indefinitely, with no set time before they are considered for promotion. What are the advantages and disadvantages to employees? If there are no advantages to employees, how are investment banks able to find people willing to work for them?
The advantage of the 'up or out' policy to investment banks and other firms is that workers have an incentive to work very hard during their first years with the firm to demonstrate that they are worthy of being promoted. A disadvantage is that risk averse people may not apply for jobs at investment banks or other firms using the up or out policy do to fear of being fired after just a few years. Some people who don't apply may actually be more productive than some people who end up being promoted at these firms. People are willing to work for these firms if they believe that they can quickly demonstrate their high productivity, earn a promotion, and have a secure job. To attract new hires, many 'up and out' firms offer an above-average starting salary.
What became of the large, standalone investment banks during the financial crisis of 2007-2009?
The large stand-alone investment banks either went bankrupt, were taken over, or converted to bank holding companies to obtain access to Federal Reserve lending to survive the financial meltdown.
In what ways does the shadow banking system differ from the commercial banking system?
The shadow banking system is a collection of nonbank financial institutions that channel money from savers to borrowers. Shadow banking firms are less regulated than commercial banks and so can invest in more risky assets and become more highly leveraged than commercial banks. Unlike commercial banks, there is no federal deposit insurance for the investors who provide funds to the shadow banking system.
a. What is leverage? What information from this excerpt indicates that Long-Term Capital Management was highly leveraged? b. What risks did Long-Term Capital Management's high leverage pose to the firm? What risks did it pose to the financial system?
a. Leverage involves using borrowed funds to invest rather than using capital or equity to invest. The excerpt indicates that the Long-Term Capital Management hedge fund used $5 billion in capital to get an additional $125 billion in funds. The $125 billion in funds were then used to control $1.25 trillion in securities. So, Long-Term Capital Management was highly leveraged because it used relatively little capital and a great amount of borrowing to control investments that were many times larger. b. Leverage is a double-edged sword. It can increase profits, but it also magnifies losses. These losses were so massive that they created systemic risk to the rest of the system. If Long-Term Capital Management had defaulted on its loans, many other financial firms would have taken large losses as well.
a. What is underwriting? In what sense is an investment bank that engages in underwriting acting as a financial intermediary? b. Is an investment bank that buys securities with its own capital acting as a financial intermediary? Briefly explain.
a. Underwriting is where investment banks guarantee (typically) a price to the issuing firm for new stocks or bonds and then sell the new issue at a higher price in financial markets or directly to investors (private placement.) Underwriting is financial intermediation because the bank brings together savers and the firms who issue new securities. b. An investment bank that buys securities with its own capital is not acting as a financial intermediary. It is buying securities with the expectation of profit from the yield or from changes in the prices of the securities. Investing in this way does not involve acting as an intermediary by funneling funds from savers to borrowers.