money and banking test 1

Assume that the economy can experience high growth, normal growth, or recession. Under these conditions, you expect the following stock market returns for the coming year: (LO2, LO3) Econ, Prob, Return high growth,0.2,+30% Normal,.07,+12% Recession,0.1,-15% A.)Compute the expected value of a $1,000 investment over the coming year. If you invest $1,000 today, how much money do you expect to have next year? What is the percentage expected rate of return? B.)Compute the standard deviation over the coming year. C.)If the risk-free return is 7 percent, what is the risk premium for a stock market investment? D.)In dollar terms, what is the value at risk?

A.) First, we need to calculate the returns: High growth: return = $1,000 x (1 + 0.30) = $1,300 Normal growth: return = $1,000 x (1 + .12) = $1,120 Recession: return = $1,000 x (1 - .15) = $850 Expected Value = 0.2($1,300) + 0.7($1,120) + 0.1($850) = $1,129 Expected Percentage Return i. $1,000 x (1 + i) = $1,129 Solve for i: i = .129 or 12.9% ii. = .2(.30) + .7(.12) + .1(-.15) = .129 or 12.9 % B.) sd = √0.2($1300−$1120)2+0.7($1120−$1129)2+0.1($850−$1129)2 =$119.67 C.) Risk Premium = 12.9% - 7% = 5.9% D.)VaR = $1,000 x 0.15 = $150 The worst outcome is a loss of 15%

If a bond has a face value of $1,000 and a coupon rate of 4.25%, the bond owner will receive annual coupon payments of:

Coupon Payment = $1000 x 0.0425 = $42.50

Financial innovation has reduced individuals' need to carry cash. Explain How.

Everyone has a number of alternative methods of payment. Electronic forms, like credit and debit cards, are the primary ones that have reduced need to carry cash.

If an investment has a 20% (0.20) probability of returning $1,000; a 30% (0.30) probability of returning $1,500; and a 50% (0.50) probability of returning $1,800; the expected value of the investment is:

Expected Value = .20(1,000) + .30(1500) + .50(1800) = $1550

Identify at least three possible sources for a risk an individual may face in planning for retirement.

In planning for retirement an individual faces at least the following uncertainties: Life span, there is uncertainty regarding how long an individual's life will be. Unexpected inflation, no one knows what the inflation rate will be in the future. This makes earning a targeted real return difficult. Health problems or other unforeseen contingencies can use up funds that were being set aside for retirement.

Consider two scenarios. In the first, the nominal interest rate is 6 percent and the expected rate of inflation is 4 percent. In the second, the nominal interest rate is 5 percent and the expected rate of inflation is 2 percent. In which situation would you rather be a lender? In which would you rather be a borrower?

In the first scenario the real interest rate is 2 percent (the difference between the nominal interest rate and the expected inflation rate) and in the second the real interest rate is 3 percent. As a lender you want a high real return and so would rather lend with the real interest rate at 3 percent (when the nominal rate is 5 percent). As a borrower, you want a low real interest rate and so would rather borrow when the real rate is 2 percent (even though the nominal interest rate is 6 percent).

What are the three characteristics of money?

Means of Payment Unit of Account Store of Value

List the six parts of the financial system

Money Financial Instruments Financial Markets Financial Institutions Government Regulatory Agencies Central Banks

If money growth is related to inflation, what would you expect to happen to the inflation rates of countries that join a monetary union and adopt a common currency such as the euro?

Once countries join a monetary union, they effectively share a common money supply. Given the link between money growth and inflation, you would expect the inflation rates of these countries to converge.

Why do you think the financial system has become more globally integrated over time? Can you think of any downside to this increased integration?

Technological progress is one obvious reason. According to Core Principle 3, information is the basis for decisions. Improvements in technology have allowed for huge volumes of information to be collected and disseminated quickly and cheaply on a global basis, facilitating long distance financial transactions. Increased integration allows for problems that arise in the financial system of one country to spread more quickly and easily to other countries, as we saw during the financial crisis of 2007-2009.

A financial institution offers you a one-year certificate of deposit with an interest rate of 5 percent. You expect the inflation rate to be 3 percent. What is the real return on your deposit?

The real interest rate equals the nominal rate less the expected rate of inflation; therefore 5% - 3% = 2% 4.

List the five core principles of money and banking

Time has Value Risk Requires Compensation Information is the Basis for Decisions Markets Determine Prices and Allocate Resources Stability Improves Welfare

What are the characteristics of commodity money?

Useable by most people in some way Standardized quantity Durable Easily transportable Divisible into smaller units

If time has value, why are financial institutions often willing to extend you a 30-year mortgage at a lower annual interest rate than they would charge for a one-year loan?

With a mortgage, the house you purchase acts as collateral for the loan. In the event you default, the bank can sell the house and recoup its funds. The existence of collateral reduces the risk associated with the loan and so reduces the compensation the bank requires.

Could the dollar still function as the unit of account in a totally cashless society?

Yes. Using dollars and cents to quote prices and record debts does not depend on cash being used as a means of payment. Dollars and cents may still serve as the standard measurement of value even if they are not themselves exchanged.

Under what circumstances might you expect barter to reemerge in an economy that has fiat money as a means of payment?

You might expect an economy to revert to barter when the public loses confidence in the fiat money issued by the government, perhaps because of over-use of the printing presses.

For each of the following events, explain whether it represents systematic risk or idiosyncratic risk and explain why. a. Your favorite restaurant is closed by the county health department. b. The government of Spain defaults on its bonds, causing the breakup of the euro- area. c. Freezing weather in Florida destroys the orange crop. d. Solar flares destroy earth-orbiting communications satellites, knocking out cellphone service worldwide.

a. This is idiosyncratic risk since it is unique to this particular establishment. b. This is a systematic risk that affects entire economies within the euro-area and beyond. c. This is idiosyncratic risk as only one of several orange-growing areas in the country is affected. For example, orange groves in California are not damaged by the Florida freeze. d. This is systematic risk as communications around the globe are disrupted, perhaps until new satellites can be constructed and put into orbit.

The standard deviation is generally more useful than the variance because

standard deviation is calculated in the same units as payoffs and variance isn't.

Assuming that the current interest rate is 3 percent, compute the present value of a five-year, 5 percent coupon bond with a face value of $1,000

𝑃𝐶𝐵= 𝑃𝐶𝑃+𝑃𝐵𝑃=[𝐶(1+𝑖)1+ 𝐶(1+𝑖)2+𝐶(1+𝑖)3+𝐶(1+𝑖)4+ 𝐶(1+𝑖)5+𝐹(1+𝑖)5 𝐶=1,000(0.05)=$50 𝑃𝐶𝐵= =$50/(1.03) + $50/(1.03)2 + $50/(1.03)3 + $50/(1.03)4 + $1050/(1.03)5 = $1091.59