Econ 4721 Midterm 2

How much is $200 to be received in exactly one year worth to you today if the interest rate is 12% This same $200 received in one year would be worth (same amount/more/less) ______ to you today if the interest rate rose to 17%

$178.57, less

Would you be more or less willing to buy long-term AT&T bonds under the following circumstances: 1) Trading in these bonds increases, making them easier to sell. 2) You expect a bear market in stock (stock prices are expected to decline). 3) Brokerage commissions on stocks fall. 4) You expect interest rates to rise 5) Brokerage commissions on bonds fall

(1) More willing (2) More willing (3) Less willing (4) Less willing 5) More willing

How can economies of scale help explain the existence of financial intermediaries? A) Financial intermediaries are able to operate with lower transaction costs relative to individual lenders or borrowers. B) Financial intermediaries with their vault technology can specialize in keeping deposits safe. C) Financial intermediaries are relatively large institutions. D) Financial intermediaries have exclusive access to communications technology in the financial sector

(A)

How could higher deposit insurance premiums for banks with riskier assets benefit the economy? A) Risk-based premiums would help mitigate the moral hazard problem; however, it's difficult to monitor the degree of risk in bank assets because often only the bank making the loans knows how risky they are B) Risk-based premiums would eliminate the adverse selection problem. Furthermore, since the technology exists to accurately estimate the riskiness of bank assets, implementing this policy could significantly benefit the economy C) Risk-based premiums would help mitigate the adverse selection problem; however, it's difficult to monitor the degree of risk in bank assets because often only the bank making the loans knows how risky they are

(A)

If junk bonds are "junk," then why would investors buy them? A) Junk bonds can provide high yields. B) Some junk bonds may have a rating of AA- by the credit-rating agencies. C) Junk bonds have lower default risk. D) The theory of portfolio choice predicts that portfolios with junk bonds are more diversified

(A)

If no decent lending opportunity arises in the economy, and the central bank pays an interest rate on reserves that is similar to other low-risk investments, do you think banks will be willing to hold large amounts of excess reserves? A) Yes. Banks will be willing to hold large amounts of excess reserves since these are safe investments. B) No. In managing their assets, banks must attempt to lower risk by diversifying. C) No. The bank must manage the liquidity of its assets so that it can meet deposit outflows.

(A)

Which of the following is a correct statement about the Dodd-Frank Act of 2010? A) The Dodd-Frank Act created a new independent agency the —Consumer Financial Protection Bureau — that is funded and housed within the Federal Reserve. B) This legislation permanently increases the level of federal deposit insurance to $500,000. C) The Dodd-Frank Act created a new subagency — the Consumer Financial Protection Bureau — that is funded and housed within the White House. D) This legislation requires that lenders extend credit to homeowners facing foreclosure

(A)

Why has the trend in bank supervision moved away from a focus on capital requirements to a focus on risk management? A) Since capital requirements do not effectively indicate whether banks are taking on too much risk, risk management allows supervisors to focus more on risk-taking procedures and thus may prevent insolvency in the future. B) Capital requirements may choke off financial innovation that would benefit households and businesses; therefore, banks are more inclined to supervise activities by focusing on risk management. C) With capital requirements, banks are less likely to pursue risky investment activities; however, with a focus on risk management, banks can pursue riskier yet more profitable investment strategies.

(A)

Why is it a good idea for macroprudential policies to require countercyclical capital requirements? A) This type of policy reduces lending and helps to mitigate credit bubbles during economic booms. B) This type of policy increases capital requirements during economic downturns to prevent bank failures. C) This type of policy allows for the use of the most appropriate accounting system to evaluate bank capital reserves. D) Macroprudential policies with countercyclical capital requirements always help to solve adverse selection problems.

(A)

Why would haircuts on collateral increase sharply during a financial crisis? A) There is a decrease in the number of nondepository financial firms. B) There is an increase in the uncertainty over the value of assets. C) There is a lack of credit standards and rules. D) There is an increase in demand for loans. What would be the result of an increase in haircuts on collateral? A) Financial institutions would engage in fire sales on assets. B) With increased collateral requirements, balance sheets of firms and households would greatly improve. C) The shadow banking system would play an even more prominent role in financial markets. D) Increasing haircuts would allow a financial institution to borrow a higher level of funds.

(A)

Would you be more willing to lend to a friend if she put all of her life savings into her business than you would if she had not done so? A) You would be more willing because putting her life savings into her business provides you protection against the problem of moral hazard B) You would be less willing because putting her life savings into a business that can potentially fail makes it more risky for you to loan her money. If the business fails, she will protect her investment before she considers repaying you C) Whether or not she puts her life savings into her business has no bearing on whether she repays the loan or not. Therefore, it should have no effect on your decision to loan her money D) You would be more willing because putting her life savings into her business provides you protection against the problem of adverse selection

(A)

How does the Basel 3 Accord attempt to address the shortfalls of the Basel and Basel 2 Accords? (Check all that apply.) A) Requiring financial institutions to have more stable funding. B) Ensuring that the final documentation for Basel 3 is complex and as detailed as possible. C) Establishing new rules on the use of credit ratings. D) Increasing the quality of capital requirements for financial institutions. E) Allocating assets and off-balance sheets activities into four main categories.

(A) (C) (D)

Along the supply curve for bonds, a decrease in the price of bonds. A) increases the interest rate and decreases the quantity of bonds supplied. B) decreases the interest rate and increases the quantity of bonds supplied. C) decreases the interest rate and decreases the quantity of bonds supplied. D) increases the interest rate and increases the quantity of bonds supplied. If the price of bonds is the equilibrium price, there occurs an excess above. A) demand for bonds, the price of bonds will fall, and the interest rate will rise. B) supply of bonds, the price of bonds will rise, and the interest rate will fall. C) demand for bonds, the price of bonds will rise, and the interest rate will fall. D) supply of bonds, the price of bonds will fall, and the interest rate will rise

(A) (D)

Using the information given in the text, match the following descriptions of risk to the corresponding Standard and Poor's rating (i.e.,AAA, AA, A, BBB, ... D). A) High grade high quality B) high speculative C) upper medium grade D) Prime maximum safety E) Speculative

(A) AA (B) B+( C) A( D) AAA (E) BB

Suppose today you buy a coupon bond that you plan to sell one year later. Which part of the rate of return formula incorporates future changes into the bond's price? A) The rate of capital gain B) the current yield

(A) The rate of capital gain is the part of the rate of return formula that incorporates future changes in the price of the bond

What might lead to poor management when control and ownership are separate, like in many American corporations? A) Principal-agent problem. B) Sarbanes-Oxley problem. C) Free-rider problem. D) Adverse selection. What is the reason for this problem? A) Stockholder meetings are infrequent, and the manager has to wait for these results to get anything done. B) A manager does not have sufficient incentive to maximize the company's profits. C) A manager does not have access to sufficient resources to run the corporation efficiently. D) Owners limit the manager's ability to run the corporation efficiently.

(A), (B)

Collateral reduces the consequences of adverse selection because it A) secures the loan. B) increases the expected losses on the loan. C) increases the lender's losses in the event of a default. D) diverts the interest of the borrower from the outcome of the loan. ______ (Net Worth/Collateral/Dividend) is the difference between what the firm owns and what it owes.

(A), Net worth

Agreements such as ________ are attempts to standardize international banking regulations. A) NAFTA B) the Basel Accord C) GATT D) the Tokyo Round

(B)

If interest rates decline, which would you rather be holding, long-term bonds or short-term bonds? A) Short-term bonds because their price is less sensitive to interest-rate volatility B) Long-term bonds because their price would increase more than the price of short-term bonds C) Long-term bonds because their price is likely to fall D) Short-term bonds because their price would increase more than the price of long-term bonds

(B)

If you are a banker and expect interest rates to rise in the future, would you want to make short-term or long-term loans? A) You would want to make long-term loans to secure the higher interest rate for an extended period of time. B) You would want to make short-term loans so you can reinvest the funds at higher interest rates after their maturity. C) You would want to make short-term loans since there is no guarantee that the interest rate will rise as expected. D) Both short-term and long-term loans will be profitable with an expected interest rate increase.

(B)

In 2010 and 2011, the government of Greece risked defaulting on its debt due to a severe budget crisis. Using bond market graphs, determine how default would affect the risk premium between U.S. Treasury debt and Greek debt with comparable maturity. In the case of default, what would happen to the risk premium between U.S. Treasury debt and comparable maturity Greek debt? A) The risk premium would decrease, which corresponds to segment A on the graphs above. B) The risk premium would increase, which corresponds to segment B on the graphs above. C) The risk premium would increase, which corresponds to segment C on the graphs above. D) The risk premium would not change and therefore would equal zero

(B)

Provisions in loan contracts designed to mitigate the moral hazard problem are called: A) proscription bonds B) restrictive covenants C) due-on-sale clauses D) liens

(B)

Compared to bonds with longer maturity, bonds with shorter maturity respond (1) ______ dramatically to changes in interest rates. (A) more (B) less Bonds with a maturity that is as short as the holding period have (2) _____ interest-rate risk.( A) some (B) a lot of (C) no

(B) (C)

Restrictive covenants A) are most common in equity contracts. B) make debt contracts more incentive compatible. C) solve the lemons problem. D) reduce adverse selection. Which of the following is an example of a restrictive covenant in a debt contract? A) periodic accounting reports allowing firms to opt out of B) requiring borrowers to pay a high interest rate C) requiring borrowers to have life insurance D) encouraging borrowers to keep their collateral valuable

(B) (C)

When you deposit your $3500 paycheck in your bank, which was written on an account at a different bank, the immediate impact on your bank's balance sheet is that your bank's cash items in the process of collection rise by $3500 and your bank's A) reserves rise by $3500 B) deposits rise by $3500 C) capital rises by $3500 D) loans rise by $3500 The process of asset transformation is frequently described by saying that banks are in the business of A) borrowing as little as possible. B) lending as much as possible. C) borrowing short and lending long. D) borrowing long and lending short

(B) (C)

Banks generate profits by earning higher returns on their ____________ than they pay in interest on _____________. A) deposits; loans B) liabilities; deposits C) loans; deposits D) deposits; securities

(C)

Because it buys large blocks of stocks or bonds, a (moral hazard/restrictive covenant/secured debt/ mutual fund) can take advantage of lower transaction costs. Financial intermediaries A) do not make it easier for customers to conduct transactions. B) do not take advantage of expertise in computer technology. C) are better able to provide expertise in lowering transaction costs. D) would be better if they offered liquidity services.

(C)

How does an unanticipated decline in the price level cause a drop in lending? A) A decline in the price level lowers the nominal value of loan contracts that have already been made B) A decline in the price level reduces the moral hazard associated with borrowing firms C) A decline in the price level raises the real value of borrowing firms' liabilities while lowering the firms' real net worth D) A decline in the price level does not affect lending

(C)

Which of the following describes the 'lemons problem' as an example of asymmetric information? A) Sellers have less information than buyers and few transactions occur B) Sellers have more information than buyers and more transactions occur C) Buyers have less information than sellers and few transactions occur D) Buyers have more information than sellers and more transactions occur

(C)

Which of the following did not help prevent the financial crisis of 2007-2009 from becoming a depression? A) The use of nonconventional policy by the Federal Reserve to create term auction facilities. B) The creation of new programs, such as lending to investment banks and purchasing commercial paper, by the Federal Reserve. C) The purchase of stock and ownership takeovers of troubled banks by the Federal Reserve. D) The Federal Reserve's use of monetary policy to lower the federal funds rate target.

(C)

Why does the existence of deposit insurance increase the likelihood that depositors will need deposit protection? A) Insured banks tend to be too conservative, reducing the profitability of the bank B) Insured banks tend to regard deposits as an unattractive source of funds due to depositor demands for safety C) Insured banks tend to pursue greater risks than they otherwise would D) With increased deposit protection, depositors are likely to withdraw large amounts of funds from their accounts

(C)

What is a credit spread? A) The difference between the interest rate on corporate bonds with different maturities. B) The difference between the net worth of a borrower and the amount of the loan the borrower would like to secure. C) The difference between interest rates on loans to households and businesses and interest rates on completely safe assets such as U.S. Treasury bonds. D) The difference between a borrower's credit score and the score of the most credit-worthy borrower. Why do credit spreads rise during financial crises? A) Credit spreads rise because depositors with productive investment opportunities withdraw their funds from banks, which creates an incentive to lend to borrowers with riskier investment opportunities. B) Credit spreads rise because asymmetric information problems increase, making it more difficult to judge the risk of potential borrowers. C) None of the above are correct.

(C) (B)

If a yield curve looks like the one shown in the diagram to the right, what is the market predicting about the movement of future short-term interest rates? The market is predicting that short-term interest rates will A) decrease in the near term, then increase in the long term B) remain relatively constant over the next 30 years C) increase in the near term, then decrease in the long term D) slowly fall over the next 30 years What might the yield curve indicate about the market's predictions for the inflation rate in the future?The market's predictions indicate that inflation will A) remain relatively constant over the next 30 years B) slowly rise over the next 30 years C) increase in the near term, then decrease in the long term D)decrease in the near term, then increase in the long term

(C) (C)

Which of the following statements are likely to be in favor of the idea that the Fed was responsible for the housing price bubble in the mid-2000s in the United States? (Select all that apply.) A) Capital inflows from India and China coupled with no attractive investment opportunities. B) Lowering of lending standards. C) The Fed set the federal funds rate at an extremely low level. D) The Fed was not stringent enough in regulating and monitoring financial intermediaries. Which of the following statements is likely to contradict the idea that the Fed was responsible for the housing price bubble of the mid-2000s in the United States? (Select all that apply.) A) The Fed was not stringent enough in regulating and monitoring financial intermediaries. B) Capital inflows from India and China coupled with no attractive investment opportunities. C) Lowering of lending standards.

(C) (D) (B) (C)

A bank's balance sheet includes several components such as the following except A) cash items in process of collection. B) non-transaction deposits. C) employed workers. D) bank capital. A bank's balance sheet is a list of its ________ (assets/liabilities/federal funds/discount loans) , its uses to which the funds are put.

(C) assets

An institution in our financial structure that helps reduce the moral hazard arising from the principal-agent problem is the: A) pawn broker. B) savings and loan association. C) money market mutual fund. D) venture capital firm.

(D)

How can a bursting of an asset-price bubble in the stock market trigger a financial crisis? A) A reduction in asset prices causes a serious deterioration in borrowing firms' balance sheets B) A reduction in asset prices causes borrowing firms to have less to lose so they are willing to take on additional risk C) A reduction in asset prices causes lenders to become more cautious and reduce the amount of loans they make D) All of the above are correct

(D)

Risk that is related to the uncertainty about future interest-rate movements is called: A) security risk B) liquidity risk C) default risk D) interest-rate risk

(D)

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 impact will translate into a shift... A) to the left in the demand curve, increasing bond's prices (lowering interest rates) and lowering the quantity of bonds bought and sold in the market. B) to the right in the demand curve, decreasing bond's prices (increasing interest rates) and increasing the quantity of bonds bought and sold in the market. C) to the right in the supply curve, decreasing bond's prices (increasing interest rates) and increasing the quantity of bonds bought and sold in the market. D) to the left in the supply curve, increasing bond's prices (lowering interest rates) and lowering the quantity of bonds bought and sold in the market.

(D)

Suppose that people in France decide to permanently increase their savings rate. Predict what will happen to the French bond market in the future. Can France expect higher or lower domestic interest rates? A) decrease in wealth, creating a shift to the left in the demand curve for bonds in France. France can therefore expect permanent higher interest rates in the future. B) increase in wealth, creating a shift to the right in the demand curve for bonds in France. France can therefore expect permanent higher interest rates in the future. C) decrease in wealth, creating a shift to the left in the demand curve for bonds in France. France can therefore expect permanent lower interest rates in the future. D) increase in wealth, creating a shift to the right in the demand curve for bonds in France. France can therefore expect permanent lower interest rates in the future

(D)

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? A) Principal-agent problem. B) Free-rider problem. C) Lemons problem. D) Moral hazard in debt contracts.

(D)

Why are financial intermediaries willing to engage in information collection activities when investors in financial instruments may be unwilling to do so? A: The free-rider problem reduces gains for financial intermediaries more than it does for investors in financial instruments. B) Credit information is asymmetric for investors but not for financial intermediaries. C) Decisions made by financial intermediaries are public knowledge, while investments made with financial instruments are not. D) Banks make private loans; their conclusions on who is creditworthy are not made public.

(D)

Why is it important for the U.S. government to have resolution authority? A) It provides that banks cannot engage in high-risk trading when receiving the benefits of federal deposit insurance. B) Resolution authority solves asymmetric information problems and thus prevents a contagion effect. C) Resolution authority gives the government the authority to increase the level of deposit insurance if necessary. D) Resolution authority allows the government to quickly takeover a failing firm.

(D)

Why is the originate-to-distribute business model subject to the principal-agent problem? A) The mortgage broker has little incentive to ensure the borrower is credit-worthy, since loans will be sold as mortgage-backed securities B) Once the mortgage broker earns his or her fee, the broker does not care if the borrower makes good on his payment C) The more volume the broker originates, the more he or she makes D) All of the above are correct

(D)

With lack of solid information about financial conditions, the failure of one bank can lead to runs on other banks. This is known as: A) adverse selection B) too big to fail C) moral hazard D) the contagion effect

(D)

If a depositor withdraws $100 from his deposit at a bank, then the bank's reserves A. fall by less than $100 B) increase by less than $100 C) increase by $100 D) fall by $100 Other things being the same, a bank with a greater amount of capital A) is less liquid. B) has a higher rate of return on equity to the owners. C) has a lower risk of failure. D) is more liquid

(D) (C)

When the risk that some banks might fail increases, depositors may not have enough information to determine whether their bank is a good one or one of the banks at greater risk to fail. Depositors have an incentive to withdraw their deposits before the bank runs out of funds. If this becomes a widespread occurrence, it is known as: A) moral hazard. B) adverse selection. C) debt deflation. D) a bank panic. Which of the following is not a reason why bank failures worsen financial crises? A) The closing of many banks worsen adverse selection and moral hazard problems. B) As bank panics occur, banks begin to sell so many assets that it can lower asset prices so much that even good banks become insolvent. C) Bank panics reduce the amount of asymmetric information, which makes it more difficult to lend funds.

(D) (C)

Which of the following is not true of a banking system with deposit insurance? A) Depositors are less likely to collect information about the quality of the bank's loans. B) Depositors are less likely to withdraw their money in the event of a crisis. C) Depositors are more likely to deposit their money in a bank. D) The moral hazard problem in banking is reduced. In order to limit the moral hazard incentives for banks to engage in the excessively risky behavior encouraged by deposit insurance, A) banks should pay a premium for the deposit insurance. B) the government should be able to monitor the actions of the depositors. C) a strong, institutional environment must be in place. D) there must be only a few large banks

(D) (C)

Using the T-accounts of the First National Bank and the Second National Bank, describe what happens when Jane Brown writes a $40 check on her account at the First National Bank to pay her friend Joe Green, who in turn deposits the check in his account at the Second National Bank. T-account for the First National Bank: Assets: Reserves --> ____ Liabilities: Checkable deposits --> ____ T-account for the Second National Bank: Assets: Reserves --> ____ Liabilities: Checkable deposits --> ____

-$40 -$40 $40 $40

Rank the following bank assets from most liquid (1) to least liquid (4). Commercial loans Securities Reserves Physical capital

3 2 1 4

Suppose that your marginal tax rate is 30%. Your after-tax return from holding (to maturity) a one-year corporate bond with a yield to maturity of 5% is _______ %. Your marginal income tax rate is 35%. If a corporate bond pays 5%, then the interest rate that an otherwise identical municipal bond have to pay in order for you to be indifferent between holding the corporate bond and the municipal bond is ________%. Which of the following situations would you choose to hold the corporate bond over the municipal bond, assuming that corporate and municipal bonds have the same maturity, liquidity, and default risk? A) corporate bond = 10%, municipal bond = 9%, marginal income tax rate = 20%. B) corporate bond = 10%, municipal bond = 7%, marginal income tax rate = 25%. C) corporate bond = 10%, municipal bond = 7%, marginal income tax rate = 35%. D) corporate bond = 10%, municipal bond = 8%, marginal income tax rate = 25%

4% 3% (B)

If the income tax exemption on municipal bonds were abolished, the interest rates on these bonds would (not change/decrease/increase)

Increase

You are given the following series of one-year interest rates: 3%, 5%, 13%, 15% Assuming that the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to four years, and plot the resulting yield curve. Graph the rates How would your yield curve change if people preferred shorter-term bonds over longer-term bonds? The yield curve would become (inverted/steeper/flatter)

Steeper The points to graph: 3%, 4%, 7%, 9% (a.k.a the avgs)

Segmented markets

The interest rate for each bond with a different maturity is determined by the supply of and demand for that bond, with no effects from expected returns on other bonds with other maturities.

Preferred habitat

The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium (also referred to as a term premium) that responds to supply and demand conditions for that bond.

Expectations theory

The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond.

Calculate the present value of an $800 discount bond with 6 years to maturity if the yield to maturity is 5%.

The present value is $596.97

What is the yield to maturity on a bond that has a price of $4,000 and pays $100 of interest annually forever?

Yield to maturity = 2.50

If you borrow $225 from a friend and in 6 years that friend wants $275 back from you, what is the yield to maturity in the loan?

Yield to maturity = 3.40

What is the real interest rate if the nominal interest rate is 7% and the expected inflation rate is 9% over the course of a year?

i _r = -2.00

The figure to the right depicts the bond market.Explain the effect that a large federal deficit will have on interest rates. 1.) Using the line drawing tool, show the effect of this shock on the bond market. Properly label your line. 2.) Using the point drawing tool, indicate the new equilibrium bond price and quantity. Label the point '2'. Carefully follow the instructions above, and only draw the required objects. The effect of this shock will likely cause interest rates to (remain unchanged/increase/decrease)

increase (Federal deficit causes interest rates to rise and prices subsequently fall --> supply curve will shift down and the right.)

Using the diagram to the right, representative of a primary bond market, show the effects of an increase in household wealth and an increase in expected profitability of investments. 1.) Using the line drawing tool, show the effect on bond demand.Properly label your line. 2) Using the line drawing tool, show the effect on bond supply.Properly label your line. 3) Using the point drawing tool, indicate the new equilibrium bond price and quantity. Label the point '2'. Carefully follow the instructions above, and only draw the required objects. Given how interests typically behave during a business cycle expansion, the effect of this shock is likely to (decrease bond yields /increase bond yields/be uncertain)

increase bond yields (demand curve shift to the right, supply curve shifts to the right. Equilibrium is slightly below the first one.)

The spread between the interest rate on a one-year U.S. Treasury bond and a 20-year U.S. Treasury bond is known as the (risk premium/default risk/term premium/liquidity). According to the expectations theory of the term structure of interest rates, if the one-year bond rate is 3%, and the two-year bond rate is 4%, next year's one-year rate is expected to be A) 6% B) 4% C) 3% D) 5%

term premium, 5%

'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? This statement is _______ (uncertain/true/false) because collateral _______ (increases/negates/reduces) the adverse selection problem.

true, reduces