FSU Finance Exam 2

How valuable are published reports by investment advisors?

Based on EMH, recommendations from investment advisors cannot help beat the market.

Stage two banking crisis explanation

Deteriorating balance sheets lead financial institutions into insolvency. If severe enough, these factors can lead to a bank panic. •Panics occur when depositors are unsure which banks are insolvent, causing all depositors to withdraw all funds immediately •As cash balances fall, FIs must sell assets quickly, further deteriorating their balance sheet •Adverse selection and moral hazard become severe - it takes years for a full recovery

According to the efficient markets hypothesis, picking stocks by throwing darts at the financial page is an inferior strategy compared to employing the advice of financial analysts. a) True b) False

False

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

False

Debt deflation refers to the decline in debt values as creditors agree to lower interest rates as an alternative to defaults. a) True b) False

False

Everyone in a financial market must be well informed about a security if the market is considered efficient a) True b) False

False

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

False

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

False

Federal Reserve monetary policy decisions must be approved by the Secretary of the Treasury before they may be implemented. Group of answer choices a) True b) False

False

Stock prices always rise when favorable earnings reports are released. a) True b) False

False

The efficient markets theory suggests that published reports of financial analysts can guarantee that individuals who use this information will outperform the market. a) True b) False

False

The overwhelming majority of statistical studies indicate that financial analysts do indeed pick financial portfolios that outperform the market average. a) True b) False

False

The study of historical stock prices to identify predictable trends is known as behavioral finance a) True b) False

False

if an investor believes that a company's stock price is going to rise, then she will execute a short sale a) True b) False

False

mutual funds that outperform in the market in one period are highly likely to consistently outperform the market in subsequent periods due to their superior investment strategies a) True b) False

False

technical analysis uses ideas from psychology and sociology to study the movement of stock prices a) True b) False

False

Expectations that are formed soley on the basis of past information are known as rational expectations a) True b) False

False -they are called adaptive expectations

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

Federal Deposit Insurance Corporation

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

Green Book

Do Stock Prices Reflect Publicly Available Information as the EMH predicts they will?

If information is already publicly available, a positive announcement about a company will not, on average, raise the price of its stock because this information is already reflected in the stock price.

Mini-Case: Raj Rajaratnam

In the mid-2000s, Mr. Rajaratnam made millions of dollars for himself and his investors by investing in firms on which he allegedly received inside information. His strategy shows that you can profit from information that the market does not have. But that strategy landed him in jail for insider trading.

financial derivatives

Instruments that have payoffs that are linked to previously issued securities and are extremely useful risk-reduction tools.

Efficient markets prescription for investor what should they not do?

Investors should not try to outguess the market by constantly buying and selling securities. This process does nothing but incur commissions costs on each trade

market fundamentals

Items that have a direct effect on future income streams of the security

credit default swaps

Large fees from writing financial insurance contracts which provide payments to holders of bonds if they default. -Also drove units of insurance companies like AIG to write hundreds of billions of dollars worth of these risky contracts

subprime mortgages

Mortgage loans made to borrowers who do not qualify for loans at the usual rate of interest due to a poor credit history

3.Do stock prices always rise when there is good news?

NO. In an efficient market, stock prices will respond to announcements only when the information being announced is new and unexpected. -So, if good news was expected (or as good as expected), there will be no stock price response. -And, if good news was unexpected (or not as good as expected), there will be a stock price response.

The ________ Fed bank, with about 25 percent of the system's assets, is the most important of the Federal Reserve banks. a) Miami b) Washington, D.C. c) Chicago d) New York e) Los Angeles

New York

Which of the following banks are required to be members of the Federal Reserve System? A) State-chartered banks B) Insured banks C) Banks having over $500 million in assets D) 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? a) Financial analysts' published recommendations b) Hot tips from a stockbroker c) Technical analysis d) None of the above

None of the above

haircuts

Requirements that borrowers have more collateral than the amount of the loan

structured credit products

Securities that are derived from cash flows of underlying assets and are tailored to have particular risk characteristics that appeal to investors with different preferences.

collateralized debt obligations

Securities that pay out cash flows from subprime mortgage- backed securities

Which of the following functions are not performed by any of the twelve regional Federal Reserve banks? a) Issuing new currency b) Check clearing c) Setting interest rates payable on time deposits d) Conducting economic research

Setting interest rates payable on time deposits

Which of the following are duties of the Board of Governors of the Federal Reserve System? a) Setting the maximum interest rates payable on certain types of time deposits under Regulation Q. b) Regulating credit with the approval of the President under the Credit Control Act of 1969. c) Setting margin requirements, the fraction of the purchase price of securities that has to be paid for with cash. d) None of the above has been a duty of the Board since the mid-1980s.

Setting margin requirements, the fraction of the purchase price of securities that has to be paid for with cash. others: - Approving the discount rate "established" by the Federal Reserve banks. - Representing the United States in negotiations with foreign governments on economic matters. -establishes, within limits, reserve requirements.

Which of the following are not duties of the Board of Governors of the Federal Reserve System? a) Setting margin requirements, the fraction of the purchase price of securities that has to be paid for with cash. b) Setting the maximum interest rates payable on certain types of time deposits under Regulation Q. c) Representing the United States in negotiations with foreign governments on economic matters. d) Approving the discount rate "established" by the Federal Reserve banks.

Setting the maximum interest rates payable on certain types of time deposits under Regulation Q.

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

Success of buy-and-hold strategy

federal reserve banks

The 12 district banks in the Federal Reserve system

instrument independence

The ability of the central bank to set monetary policy instruments

goal independence

The ability of the central bank to set the goals of monetary policy.

open market operations

The buying and selling of government securities in the open market that affect both interest rates and the amount of reserves in the banking system

federal open market committee

The committee that makes decisions regarding the conduct of open market operations; composed of the seven members of the Board of Governors of the Federal Reserve System, the president of the Federal Reserve Bank of New York, and the presidents of four other Federal Reserve banks on a rotating basis

Americas economy during 2007-2009 crisis (Great Recession)

The crisis and impaired credit markets have caused the worst economic contraction since World War II. •The crisis peaked in September of 2008. •Congress passed a bailout package, but the stock market continued to decline, and credit spreads reached over 500 bps. •The fall in real GDP and increase in unemployment to over 10% in 2009 impacted almost everyone. •Starting in March 2009, a bull market in stocks got under way and credit spreads began to fall.

financial innovation

The development of new financial products and services

financial liberalization

The elimination of restrictions on financial markets -can lead to credit boom

random walk

The movements of a variable whose future changes cannot be predicted because, given today's value, the variable is just as likely to fall as to rise.

Which of the following is true regarding efficient markets? a) Everyone in the market must be well-informed b) Hot tips in the stock market are likely to bring exceptional returns c) Smart money promotes unexploited profit opportunities d) The prices of securities reflect all available information

The prices of securities reflect all available information

financial engineering

The process of researching and developing new financial products and services that would meet customer needs and prove profitable

fire sales

The quick sale of assets to raise necessary funds.

credit spreads

The risk premium: the interest rate on bonds with default risks relative to the interest rate on default-free bonds like U.S. Treasury bonds

bank panic

The simultaneous failure of many banks, as during a financial crisis.

theory of efficiency capital markets

The theory that prices of securities in financial markets fully reflect all available information

fundamental economic values

The values of assets based on realistic expectations of the assets' future income streams.

federal reserve act of 1913

This act created a central banking system, consisting of twelve regional banks governed by the Federal Reserve Board. It was an attempt to provide the United States with a sound yet flexible currency. The Board it created still plays a vital role in the American economy today.

A credit spread is the difference between the interest rate on loans to businesses and the interest rate on completely safe assets that are sure to be paid back. a) True b) False

True

All nationally chartered banks are required to be members of the Fed. a) True b) False

True

During a bank panic, many banks fail in a very short time period. a) True b) False

True

Efficient markets theory includes that one should be skeptical of hot tips? a) True b) False

True

Factors that can lead to worsening conditions in financial markets include increasing interest rates and asset price booms. a) True b) False

True

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. a) True b) False

True

If the efficient markets theory is true, no investor will consistently "beat the market". a) True b) False

True

If the optimal forecast of a return on a financial asset exceeds its equilibrium return, the situation is called an unexploited profit opportunity. a) True b) False

True

In an efficient market, all unexploited profit opportunities will be eliminated. a) True b) False

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. a) True b) False

True

The FOMC issues directives to the trading desk at the New York Fed. a) True b) False

True

If the optimal forecast of a return on a financial asset exceeds its equilibrium return, the situation is called an unexploited profit opportunity. a) True b) False

True -It means that profit earning opportunity is present, but not yet capitalized upon it.

The Board of Governors sets reserve requirements. a) True b) False

True -and sets discount rate

The theory of rational expectations argues that optimal forecasts need not be perfectly accurate. a) True b) False

True -It can deviate from the perfect and accurate forecast.

An important implication of rational expectation theory is that when there is a change in the way a variable behaves, the way expectations of this variable are formed will change as well. a) True b) False

True -With change in variables and its values, the outcome will also change.

deleveraging

When financial institutions cut back on their lending because they have less capital

A situation in which the price of an asset differs from its fundamental market value is called a) a bubble. b) a mean reversion. c) an unexploited profit opportunity. d) a correction.

a bubble.

Bank panics in 1819, 1837, 1857, 1873, 1884, 1893, and 1907 convinced many that a) the Federal Reserve needed greater control over the banking system. b) the Federal Reserve needed greater authority to deal with problem banks. c) a central bank was needed to prevent future financial panics. d) both A and B of the above.

a central bank was needed to prevent future financial panics.

easing of monetary policy

a lowering of the federal funds rate

1. Suppose you read a story in the financial section of the local newspaper that announces the proposed merger of Dell Computer and Gateway. The merger is expected to greatly increase the profitability of Gateway. If you should now decide to invest in Gateway stock, you can expect to earn a. above average returns since you will get to share in the higher profits. b. above average returns since your stock will definitely appreciate as the profits are earned. c. a normal return since stock prices adjust to reflect change profit expectations almost immediately. d. none of the above.

a normal return since stock prices adjust to reflect change profit expectations almost immediately.

Rules used to predict movements in stock prices based on past patterns are, according to the efficient markets theory, a) consistent with the random walk hypothesis. b) a waste of time. c) the most efficient rules to employ. d) profitably employed by all financial analysts.

a waste of time.

Another way to state the efficient market condition is that in an efficient market, a) unexploited profit opportunities will be quickly eliminated b) unexploited profit opportunities will never exist c) arbitrageurs guarantee that unexploited profit opportunities never exist d) both a and c of the above occur

a) unexploited profit opportunities will be quickly eliminated

Banks subject to reserve requirements set by the Federal Reserve System include a) only nationally chartered banks. b) only state-chartered banks. c) only banks with less than $500 million in assets. d) only banks with less than $100 million in assets. e) all banks whether or not they are members of the Federal Reserve System.

all banks whether or not they are members of the Federal Reserve System.

Factors that lead to worsening conditions in financial markets include a) increasing uncertainty in financial markets. b) declining stock prices. c) increases in interest rates. d) all of the above. e) only A and B of the above.

all of the above

Evidence in favor of market efficiency includes a) the random-walk behavior of stock prices. b) whether stock prices reflect publicly available information. c) performance of investment analysts and mutual funds. d) all of the above.

all of the above.

In an advanced economy, a financial crisis can begin in several ways, including a) mismanagement of financial liberalization or innovation. b) an increase in uncertainty caused by failure of financial institutions. c) asset pricing booms and busts. d) all of the above.

all of the above.

The 12 Federal Reserve banks are involved in monetary policy in which of the following ways? a) Their directors select one commercial banker from each bank's district to serve on the Federal Advisory Council. b) They decide which banks can obtain discount loans from the Federal Reserve Bank. c) Their directors establish the discount rate. d) all of the above.

all of the above.

The impact of the 2007-2009 financial crisis was widespread, including a) the first major bank failure in the UK in over 100 years. b) the failure of Bear Stearns, the fifth-largest U.S. investment bank. c) the bailout of Fannie Mae and Freddie Mac by the U.S. Treasury. d) all of the above. e) only B and C of the above.

all of the above.

In an efficient market,

all unexploited profit opportunities will be eliminated. -not everyone in a financial market must be well informed about a security for its price to be driven to the point at which the efficient market condition holds.

Having performed well in the past does not indicate that

an investment advisor or mutual find will perform well in the future and vice versa

behavioral finance

applies concepts from other social sciences, such as anthropology, sociology, and particularly psychology, to understand the behavior of securities prices

Members of the Board of Governors are a) appointed by the president of the United States and confirmed by the Senate as members resign. b) appointed by the newly elected president of the United States, as are cabinet positions. c) chosen by the Federal Reserve Bank presidents. d) never allowed to serve more than seven-year terms.

appointed by the president of the United States and confirmed by the Senate as members resign.

Financial crises a) are major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of many financial and non-financial firms. b) occur when adverse selection and moral hazard problems in financial markets become more significant. c) frequently lead to sharp contractions in economic activity. d) are all of the above. e) are only A and B of the above.

are all of the above.

CDOs (Collateralized Debt Obligations)

are created based on default priorities. the first defaults go to the lowest rated tranches. the highest rated tranches suffer defaults if most of the assets default

Stage Two of a financial crisis in an advanced economy usually involves a ________ crisis. a) banking b) commodities c) currency d) stock market

banking

Stage Two of a financial crisis in an emerging market economy usually involves a ________ crisis.

banking

When asset prices fall following a boom, a) moral hazard may increase in companies that have lost net worth in the bust. b) financial institutions may see the assets on their balance sheets deteriorate, leading to deleveraging. c) both A and B are correct. d) none of the above are correct.

both A and B are correct.

According to the textbook authors, the Fed is a) probably somewhat constrained in its policymaking by the congressional threat to reduce Fed independence. b) more responsive to the political pressures that influence other government agencies. c) remarkably free of the political pressures that influence other government agencies. d) both A and C above

both A and C above

Raj Rajaratnam, a successful investor in the 2000s who consistently beat the market, was able to outperform the market on a consistent basis, indicating that a) securities markets are not efficient b) unexploited profit opportunities were abundant c) investors can outperform the market with inside information d) only b and c of the above

c) investor can outperform the market with inside information

According to the efficient market hypotheses, the expected return is determined by several components, except the a) price of the security today b) expected price of the security for the next period c) cash payment the following period d) average price in the previous period

cash payment the following period

Politicians in a democratic society may be shortsighted because of their desire to win reelection; thus, the political process can a) impart an inflationary bias to monetary policy. b) impart a deflationary bias to monetary policy. c) generate a political business cycle in which, just before an election, expansionary policies are pursued to lower unemployment and interest rates. d) cause both A and C of the above to occur.

cause both A and C of the above to occur.

The ________ of the Board of Governors is the spokesperson for the Fed. a) president b) chairman c) either of the above can be the spokesperson d) neither of the above

chairman

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

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

Performance of Investment Analysts and Mutual Funds should not be able to

consistently beat the market

Leading up to the 2007-2009 Financial Crisis, companies like AIG developed financial products divisions which wrote billions of dollars worth of financial insurance contracts, called ________, which later bankrupted the company. a) CDOs b) credit default swaps c) REMICs d) call options

credit default swaps

The process of deleveraging refers to a) a reduction in debt owed by banks. b) cutbacks in lending by financial institutions. c) both A and B. d) none of the above.

cutbacks in lending by financial institutions.

Evidence in favor of market efficiency includes a) the random-walk behavior of stock prices b) whether stock prices reflect publicly available Information c) performance of investment analysts and mutual funds d) all of the above

d) all of the above

Stage Three of a financial crisis in an advanced economy features A) a general increase in inflation. B) debt deflation. C) an increase in general price levels. D) a full-fledged financial crisis

debt deflation.

beige books

districts "state of the economy"

Early empirical evidence confirms

favorable earnings announcements or announcements of stock splits (a division of a share of stock into multiple shares, which is usually followed by higher earnings) do not, on average, cause stock prices to rise.

According to the efficient market hypothesis, the current price of a financial security a) fully reflects all available relevant information. b) is the discounted net present value of future interest payments. c) is determined by the highest successful bidder. d) is a result of none of the above.

fully reflects all available relevant information.

Suppose legislation requiring the Fed to keep the inflation rate between 1.5% and 2.5% per year is passed by Congress. This law restricts the Fed's a) goal independence. b) instrument independence. c) both A and B of the above. d) neither A nor B of the above.

goal independence.

super senior tranche

highest rated tranches

In addition to having a direct effect on increasing adverse selection problems, increases in interest rates also promote financial crises by ________ firms' and households' interest payments, thereby ________ their cash flow. a) decreasing; increasing b) decreasing; decreasing c) increasing; decreasing d) increasing; increasing

increasing; decreasing

When an unexploited profit opportunity arises on a security (so-called because, on average, people would be earning more than they should, given the characteristics of that security),

investors will rush to buy until the price rises to the point that the returns are normal again.

According to the efficient markets hypothesis, purchasing the reports of financial analysts A) is likely to increase ones returns by an average of 10%. B) is likely to increase ones returns by about 3 to 5%. C) is not likely to be an effective strategy for increasing financial returns. D) is likely to increase ones returns by an average of about 2 to 3%.

is not likely to be an effective strategy for increasing financial returns.

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

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

mezzanine tranche

it bears more risk and has even higher interest

All ________ are required to be members of the Fed. A) state-chartered banks B) nationally chartered banks C) banks with more than $100 million in assets D) banks with more than $500 million in assets

nationally chartered banks

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

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

Performance of Investment Analysts and Mutual Funds should

not be able to consistently beat the market

The "Investment Dartboard"

often beats investment managers.

The Federal Advisory Council has ________ member(s) from each district. a) one b) two c) three d) can have any number of

one

Which of the following led to the U.S. financial crisis of 2007-2009? a) Financial innovation in mortgage markets b) Agency problems in mortgage markets c) An increase in moral hazard at credit rating agencies d) All of the above e) only A and B of the above

only A and B of the above

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

only A and B of the above are true.

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

only A and B of the above.

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

only A and B of the above.

Most financial crises in the United States have begun with a) a steep stock market decline. b) an increase in uncertainty resulting from the failure of a major firm. c) a steep decline in interest rates. d) all of the above. e) only A and B of the above.

only A and B of the above.

If stock is predicted to rise

people will buy to equilibrium level; if stock is predicted to fall, people will sell to equilibrium level

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

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

If stock prices were predictable to either rise or fall

price changed would be zero, which has not been the case historically

When a market bubble occurs, a) market fundamentals and actual security prices converge. b) prices of assets fluctuate rapidly above and below market fundamentals. c) prices of assets rise well above their fundamental values. d) a "thin layer" of trading masks true market movements.

prices of assets rise well above their fundamental values.

small-firm effect

small firms have abnormally high returns

To say that stock prices follow a "random walk" is to argue that a) stock prices rise, then fall, then rise again. b) stock prices tend to follow trends. c) stock prices rise, then fall in a predictable fashion. d) stock prices cannot be predicted based on past trends.

stock prices cannot be predicted based on past trends.

Market Overreaction

stock prices overreact to news announcements investors may purchase a stock after bad earnings reports then sell it a couple of weeks later after it has gone back to a normal level

Mean Reversion

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

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

the January effect.

mortgage backed securities

the ability to cheaply quantify the default risk of the underlying high-risk mortgages and bundle them in standardized debt securities

Efficient markets prescription for investor what should they do?

the investor should pursue a "buy and hold" strategy—purchase stocks and hold them for long periods of time. This will lead to the same returns, on average, but the investor's net profits will be higher because fewer brokerage commissions will have to be paid.

Mutual funds not only do not outperform the market on average, but when they are separated into groups according to whether they had the highest or lowest profits in a chosen period,

the mutual funds that did well in the first period do not beat the market in the second period.

Investment strategies using inside information is

the only "proven method" to beat the market. In the U.S., it is illegal to trade on such information, but that is not true in all countries.

what is an arbitrage?

the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices at which the unit is traded. -Elimination of a riskless profit opportunity in a market

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

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

Technical Analysis

the study past stock price data, searching for patterns such as trends and regular cycles, suggesting rules for when to buy and sell stocks -The EMH suggests that technical analysis is a waste of time -The simplest way to understand why is to use the random-walk result that holds that past stock price data cannot help predict changes -technical analysis cannot predict changes in stock prices

equity tranche

this is the first tranche that suffers losses from defaults

It is frequently a sensible strategy for a small investor, whose costs of managing a portfolio may be high relative to its size,

to buy into a mutual fund rather than individual stocks. Because the EMH indicates that no mutual fund can consistently outperform the market, an investor should not buy into one that has high management fees or that pays sales commissions to brokers but rather should purchase a no-load (commission-free) mutual fund that has low management fees. -Better option would be ETFs instead of mutual funds

Studies of mutual fund performance indicate that mutual funds that outperformed the market in one time period a) usually beat the market in the next three subsequent time periods. b) usually beat the market in the next time period. c) usually beat the market in the next two subsequent time periods. d) usually do not beat the market in the next time period.

usually do not beat the market in the next time period.

bubbles

when the prices of assets rise well above their fundamental values, -A situation in which the price of an asset differs from its fundamental market value

Asset Price Boom & Bust

•A pricing bubble starts, where asset values exceed their fundamental values. •When the bubble bursts and prices fall, corporate net worth falls as well. Moral hazard increases as firms have little to lose. •FIs also see a fall in their assets, leading again to deleveraging.

global financial crisis: rating agency problems

•Agencies consulted with firms on structuring products to achieve the highest rating, creating a clear conflict •Further, the rating system was hardly designed to address the complex nature of the structured debt designs •The result was meaningless ratings that investors had relied on to assess the quality of their investments

Debt deflation explanation

•Consider a firm in 2015 with assets of $100 million (in 2015 dollars), $90 million of long-term liabilities, and so $10 million in net worth. •Price levels fall by 10% in 2016. Real value of assets (in 2015 dollars) remains the same. •Real value of liabilities rise to $99 million (in 2015 dollars), and so net worth falls to just $1 million!

Case: Foreign Exchange Rates

•EMH (efficient market hypothesis) predicts, then, that FX rates should be unpredictable. •Oddly enough, that is exactly what empirical tests show—FX rates are not very predictable.

What part of the world was the first to raise alarm to the Global Financial Crisis (2007-2009)

•Europe was actually first to raise the alarm in the crisis. With the downgrade of $10 billion in mortgage related products, short term money markets froze, and in August 2007, a French investment house suspended redemption of some of its money market funds. Banks and firms began to horde cash. -The end of credit lead to several bank failures. -Northern Rock was one of the first, relying on short-term credit markets for funding. Others soon followed. -By most standards, Europe experienced a more severe downturn that the U.S.

Great depression

•In 1928 and 1929, stock prices doubled in the U.S. The Fed tried to curb this period of excessive speculation with a tight monetary policy. But this lead to a stock market collapse of more than 20% in October of 1929, and losing an additional 20% by the end of 1929. -What might have been a normal recession turned into something far worse, when severe droughts in 1930 in the Midwest led to a sharp decline in agricultural production. -Between 1930 and 1933, one-third of U.S. banks went out of business as these agricultural shocks led to bank failures. -For more than two years, the Fed sat idly by through one bank panic after another -Adverse selection and moral hazard in credit markets became severe. Firms with productive uses of funds were unable to get financing. Credit spreads increased from 2% to nearly 8% during the height of the Depression in 1932.

collapse of several high-profile U.S. investment firms only further deteriorated confidence in the U.S.

•March 2008: Bear Sterns fails and is sold to JP Morgan for 5% of its value only 1 year ago •September 2008: both Freddie and Fannie put into conservatorship after heaving subprime losses. •September 2008: Lehman Brothers files for bankruptcy. Merrill Lynch sold to Bank of America at "fire" sale prices. AIG also experiences a liquidity crisis.

Periods of Uncertainty

•Periods of high uncertainty can lead to crises, such as stock market crashes or the failure of a major financial institution. Examples include: 1857, when the Ohio Life Insurance & Trust Company failed 2008, when AIG, Bear Sterns, and Lehman Bros. failed •With information hard to come by, moral hazard and adverse selection problems increase, reducing lending and economic activity

Was the fed to blame for the housing price bubble?

•Some argue that low interest rates from 2003 to 2006 fueled the housing bubble (the Taylor rule). •In early 2010, Mr. Bernanke rebutted this argument. He argued rates were appropriate. •He also pointed to new mortgage products, relaxed lending standards, and capital inflows as more likely causes. •Bernanke's speech was very controversial, and the debate over whether monetary policy was to blame for the housing price bubble continues to this day.

Great depression deflation/unemployment rate

•The deflation during the period lead to a 25% decline in price levels. •The prolonged economic contraction lead to an unemployment rate around 25%. •The Depression was the worst financial crisis ever in the U.S. It explains why the economic contraction was also the most severe ever experienced by the nation.

Twelve federal reserve banks

-"quasi-public": owned member commercial banks in the district member banks elect six directors, while three directors are appointed by the board of governors -directors represent professional bankers, prominent business leaders and public interest

Other reasons to be skeptical of hot tips

-As soon as the information hits the street, the unexploited profit opportunity it creates will be quickly eliminated. -The stock's price will already reflect the information, and you should expect to realize only the equilibrium return.

Should you be skeptical of hot tips?

-YES. The EMH indicates that you should be skeptical of hot tips since, if the stock market is efficient, it has already priced the hot tip stock so that its expected return will equal the equilibrium return. -Thus, the hot tip is not particularly valuable and will not enable you to earn an abnormally high return.

financial crisis: initial phase

-can being in several ways: credit boom and bust asset price boom and bust increase in uncertainty

global financial crisis: rating agencies

-consulted with firms on structuring products to achieve highest rating, creating clear conflict -rating system was hardly designed to address the complex nature of the structured debt designs -the result was meaningless ratings that investors had relied on to assess the quality of their investments

Structure of the Fed

-design was intended to diffuse power along: region government and private sector interests need of bankers, businesses, and the public -system now includes: 12 banks Board of governors (BOG) Federal open market committee (FOMC) Federal advisory council Member Banks (around 2000) -three policy tools open market operations discount rate reserve requirements

financial crisis: stage two

-deteriorating balance sheets lead financial institutions into insolvency -if severe enough these factors can lead to a bank panic

federal reserve: monetary policy

-establish the discount rate at which member banks may borrow from the fed -determine which bank receive loans -elect one member to the federal advisory council -five of the 12 bank presidents vote in federal open market committee

financial crisis: stage three

-if crisis leads to a sharp decline in prices, debt deflation can occur, where asset prices fall but debt levels do not adjust -leads to increase in adverse selection and moral hazard -eco activity repressed for a long time

senior tranch

-it has a little more risk and pays a higher interest rate

global financial crisis: financial innovation

-less than credit worthy borrowers found ability to purchase homes through subprime lending -financial engineering found new ways to enhance and distribute risk from mortgage lending

Federal open market committee (FOMC)

-make decision regarding Oper market operations -chairman of BOG is also chairman of this committee -most important tool the fed has for controlling money supply -all actions are directed the federal reserved bank of New York, where securities are bough/sold as required

inside the fed: FOMC meeting

-meet 8 times a year -agenda include: reports on open market operation -national economic forecasts are presented -discussion of monetary policy and directives, including views of each member -formal policy directive made -post-meeting announcements

global financial crisis: agency problems

-mortgage originators did not hold actual mortgage but sold the note in the secondary market -mortgage originators earned fees from the volume of the loans produced not the quality -unqualified borrows bought houses they could not afford through either creative mortgage products or outright fraud

Member banks

-national banks are required to be members -state commercial banks may elect to join -currently 1/3 of commercial banks are members

green book

-national forecasts for the next two years

blue book

-projections of monetary aggregates

FRB (Federal Reserve Board) of New york

-responsible for oversight of some of the largest financial institutions -houses open market desk. all of the Feds open market operations are direct through this trading desk -chairman is the only permanent member of the FOMC, serves as VP chairman -only member of the bank for international settlements, provides close contact with other foreign central bankers

Case for independence of the Fed

-the view that political pressure will tend to add inflationary bias to monetary policy. for example, in the short run, high money growth does lead to lower interest rates. in long run however, this also leads to higher inflation -political business cycle - treasury -politician decision making -can pursue unpopular policies

Case against independence for the Fed

-viewed at "undemocratic" -has not always been successful in the past, made mistakes during Great Depression and inflationary periods in the 1960s and 1970s -can succumb to political pressure regardless of any state of independence

evidence on efficient market hypothesis

1. investment analysts and mutual funds don't beat the market 2. stock prices reflect publicly available info: anticipated announcements don't affect stock price 3. technical analysis does not outperform market

CDO Tranche Ranking

1. superior senior tranche 2. senior tranche 3. mezzanine tranche 4. equity tranche

Favorable Evidence on Efficient Market Hypothesis

1.Investment analysts and mutual funds don't beat the market 2.Stock prices reflect publicly available info: anticipated announcements don't affect stock price 3.Technical analysis does not outperform market

Unfavorable evidence on efficient market hypothesis

1.Small-firm effect: small firms have abnormally high returns 2.January effect: high returns in January 3.Market overreaction 4.Excessive volatility 5.Mean reversion 6.New information is not always immediately incorporated into stock prices

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

20th century.

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. a) 49% b) 63% c) 42% d) 55%

49%

U.S. Stock prices (as proxied by the DJIA) fell by ________ from October 2007 to March 2009. a) 50% b) 45% c) 60% d) 55%

50%

The Baa-U.S. Treasury spread was about 2% at the beginning of 1929. By December 1932, the Dow Jones Industrial Average reached a low, and the spread had increased to how much? a) 10% b) 4% c) 8% d) 6%

8%

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

90%

board of governors of the federal reserve system

A board with seven governors (including the chair) that plays an essential role in decision making within the Federal Reserve System.

political business cycle

A business cycle caused by expansionary policies before an election

originate-to-distribute business model

A business model in which the mortgage is originated by a separate party, typically a mortgage broker, and then distributed to an investor as an underlying asset in a security

repurchase agreements

A form of loan in which the borrower simultaneously contracts to sell securities and contracts to repurchase them, either on demand or on a specified date

credit boom

A lending spree when financial institutions expand their lending at a rapid pace

financial crisis

A major disruption in financial markets, characterized by sharp declines in asset prices and the failures of many financial and non- financial firms.

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

tightening of Monterey policy

A rise in the federal funds rate

Efficient Market Hypothesis

A security's price fully reflects all available information in an efficient market. -Stocks trade at their fair market value

debt deflation

A situation in which a substantial decline in the price level sets in, leading to a further deterioration in firms' net worth because of the increased burden of indebtedness.

unexploited profit opportunities

A situation in which an investor can earn a higher-than-normal return.

shadow banking systems

A system in which bank lending is replaced by lending via the securities market

What is a collateralized debt obligation? a) A tranche of an SPV that has been setup based on default risk b) A contract between credit rating agencies c) An agreement to exchange interest payments when one party defaults d) A type of insurance against defaults

A tranche of an SPV (special purpose vehicle) that has been setup based on default risk

Which of the following is an element of the Federal Reserve System? a) The Board of Governors b) The Federal Reserve banks c) The FOMC d) All of the above

All of the above

Which of the following is empirical evidence indicating that the efficient market hypothesis may not always be generally applicable? a) Market overreaction b) Small-firm effect c) January effect d) All of the above

All of the above

Important implications of the efficient market hypothesis include which of the following? a) Future changes in stock prices should, for all practical purposes, be unpredictable. b) Stock prices will respond to announcements only when the information in these announcements is new. c) Sometimes a stock price declines when good news is announced. d) All of the above. e) Only A and B of the above.

All of the above.

January effect

An abnormal rise in stock prices from December to January.

short sales

An arrangement with a broker to borrow and sell securities. The borrowed securities are replaced with securities purchased later. Short sales let investors earn profits from falling securities prices.

asset-price bubble

An increase in asset prices that are driven above their fundamental economic values by investor psychology

Not every investor need be aware of every security and situation.

As long as a few keep their eyes open for unexploited profit opportunities, they will eliminate the profit opportunities that appear because in so doing, they make a profit.

financial frictions

Asymmetric information problems that act as a barrier to financial markets channel- ing funds efficiently from savers to households and firms with productive investment opportunities