Instructor Solution Manual For Financial Markets and Institutions, 10th edition Frederic S Mishkin,

Financial Markets and Institutions Instructor's Manual Miskhin and Eakins Financial Markets and Institutions Tenth Edition

Frederic Mishkin Stanley Eakins

Table of Contents 1. Why Study Financial Markets and Institutions? ........ 2 2. Overview of the Financial System ..................... 5

3. What Do Interest Rates Mean, and What Is Their Role in Valuation? ............................................ 8 4. Why Do Interest Rates Change? ....................... 14 5. How Do Risk and Term Structure Affect Interest Rates? .................................................. 22 6. Are Financial Markets Efficient? .................... 29 7. Why Do Financial Institutions Exist? ................ 32 8. Why Do Financial Crises Occur, and Why Are They So Damaging to the Economy? .......................................... 38 9. Central Banks and the Federal Reserve System ........ 43 10. Conduct of Monetary Policy .......................... 47 11. The Money Markets .................................. 54 12. The Bond Market ..................................... 60 13. The Stock Market ................................... 66 14. The Mortgage Markets ............................... 72 15. The Foreign Exchange Market ......................... 82 16. The International Financial System .................. 88 17. Banking and the Management of Financial Institutions ............................................ 93 18. Financial Regulation ............................... 101 19. Banking Industry: Structure and Competition ........ 108 20. The Mutual Fund Industry ........................... 111 21. Insurance Companies and Pension Funds .............. 118 22. Investment Banks, Security Brokers and Dealers, and Venture Capital Firms .................................. 123 23. Risk Management in Financial Institutions .......... 127 24. Hedging with Financial Derivatives ................. 137 Chapters on the Web 25. Financial Crises in Emerging Market Economies ...... 147 26. Savings Associations and Credit Unions ............. 150 27. Finance Companies .................................. 153

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Chapter 1 Why Study Financial Markets and Institutions?

Why Study Financial Markets?

Debt Markets and Interest Rates The Stock Market The Foreign Exchange Market Why Study Financial Institutions?

Structure of the Financial System Financial Crises Central Banks and the Conduct of Monetary Policy The International Financial System Banks and Other Financial Institutions Financial Innovation Managing Risk in Financial Institutions Applied Managerial Perspective How We Will Study Financial Markets and Institutions Exploring the Web Collecting and Graphing Data Web Exercise Concluding Remarks



Overview and Teaching Tips

Before embarking on a study of financial markets and institutions, the student must be convinced that this subject is worth studying. Chapter 1 pursues this goal by showing the student that financial markets and institutions is an exciting field because it focuses on phenomena that affect everyday life. An additional purpose of Chapter 1 is to provide an overview for the entire book, previewing the topics that will be covered in later chapters. The chapter also provides the students with a guide as to how they will be studying financial markets and institutions with a unifying, analytic framework and an applied managerial perspective.

In teaching this chapter, the most important goal should be to get the student excited about the material. I have found that talking about the data presented in the figures helps achieve this goal by showing the students that the subject matter of financial markets and institutions has real-world implications that they should care about. In addition, it is important to emphasize to the students that the course will have an applied managerial perspective, which they will find useful later in their

careers. Going through the web exercise is also a way of encouraging the students to use the web to further their understanding of financial markets and institutions.



Answers to End-of-Chapter Questions

1. Well-performing financial markets tend to allocate funds to its more efficient use, thereby allowing the best investment opportunities to be undertaken. The improvement in the allocation of funds results in a more efficient economy, which stimulates economic growth (and thereby poverty reduction).

2. Businesses would cut investment spending because the cost of financing this spending is now higher, and consumers would be less likely to purchase a house or a car because the cost of financing their purchase is higher.

3. A change in interest rates affects the cost of acquiring funds for financial institutions, as well as changes the income on assets such as loans, both of which affect profits. In addition, changes in interest rates affect the price of assets such as stocks and bonds that the financial institution owns, which can lead to profits or losses.

4. While it is true that there are many interest rates in the economy, like the interest rate paid by a corporate bond or the interest rate charged to a homeowner, it is also true that all of these interest rates tend to move together. Evidence shows that movements in different interest rates over time are in large part explained by the same events, and thereby allow economists to refer to “the” interest rate when trying to determine its movements.

5. The lower price for a firm’s shares means that it can raise a smaller amount of funds, and so investment in plant and equipment will fall.

6. A bond is a debt instrument, which entitles the owner to receive periodic amounts of money (predetermined by the characteristics of the bond) until its maturity date. A common stock, however, represents a share of ownership in the institution that has issued the stock. In addition to its definition, it is not the same to hold bonds or stock of a given corporation, since regulations state that stockholders are residual claimants (i.e., the corporation has to pay all bondholders before paying stockholders).

7. It makes foreign goods more expensive, and so British consumers will buy less foreign goods and more domestic goods.

8. It makes British goods more expensive relative to American goods. American businesses will find it easier to sell their goods in the United States and abroad, and the demand for their products will rise.

9. Changes in foreign exchange rates change the value of assets held by financial institutions and thus lead to gains and losses on these assets. Also, changes in foreign exchange rates affect the profits made by traders in foreign exchange who work for financial institutions.

10. In the mid- to late 1970s, the late 1980s, and the early 1990s, the value of the dollar was low, making travel abroad relatively more expensive; that would have been a good time to vacation in the United States and see the Grand Canyon. As the dollar’s value rose in the early 1980s, travel abroad became relatively cheaper, making it a good time to visit the Tower of London.

11.

In general, people do not lend large amounts of money to one another because of several information problems. In particular, people do not know about the capacity of other people of repaying their debts, or the effort they will provide to repay their debts. Financial intermediaries, in particular commercial banks, tend to solve these problems by acquiring information about potential borrowers and writing and enforcing contracts that encourage lenders to repay their debt and/or maintain the value of the collateral.

12. Savings and loan associations, mutual savings banks, credit unions, insurance companies, mutual funds, pension funds, and finance companies.

13.

The latest financial crisis in the U.S. and Europe occurred in 2007 – 2009. At the beginning it hit mostly the U.S. financial system, but it then quickly moved to Europe, since financial markets are highly interconnected. One specific way in which these markets were related is that some financial intermediaries in Europe held securities backed by mortgages originated in the U.S., and when these securities lost a considerable part of their value, the balance sheet of European financial intermediaries was adversely affected.

14. The profitability of financial institutions is affected by changes in interest rates, stock prices, and foreign exchange rates; fluctuations in these variables expose these institutions to risk.

15. Because the Federal Reserve affects interest rates, inflation, and business cycles, all of which have an important impact on the profitability of financial institutions.



Quantitative Problem

1.

The following table lists foreign exchange rates between U.S. dollars and British pounds during April: Date

U.S. Dollars per GBP

Date

U.S. Dollars per GBP

4/1 4/4 4/5 4/6 4/7 4/8 4/11 4/12 4/13 4/14 4/15

1.9564 1.9293 1.914 1.9374 1.961 1.8925 1.8822 1.8558 1.796 1.7902 1.7785

4/18 4/19 4/20 4/21 4/22 4/25 4/26 4/27 4/28 4/29

1.7504 1.7255 1.6914 1.672 1.6684 1.6674 1.6857 1.6925 1.7201 1.7512

Which day would have been the best day to convert $200 into British pounds?

Which day would have been the worst day? What would be the difference in pounds?

Solution: The best day is 4/25. At a rate of $1.6674/pound, you would have £119.95. The worst day is 4/7. At $1.961/pound, you would have £101.99, or a difference of £17.96.

Chapter 2 Overview of the Financial System Function of Financial Markets Structure of Financial Markets Debt and Equity Markets Primary and Secondary Markets Exchanges and Over-the-Counter Markets Money and Capital Markets Internationalization of Financial Markets

International Bond Market, Eurobonds, and Eurocurrencies Global Box: Are U.S. Capital Markets Losing Their Edge?

World Stock Markets Function of Financial Intermediaries: Indirect Finance Transaction Costs Following the Financial News: Foreign Stock Market Indexes Global Box: The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison Risk Sharing Asymmetric Information: Adverse Selection and Moral Hazard Economies of Scope and Conflicts of Interest Types of Financial Intermediaries Depository Institutions Contractual Savings Institutions Investment Intermediaries Regulation of the Financial System Increasing Information Available to Investors Ensuring the Soundness of Financial Intermediaries Financial Regulation Abroad



Overview and Teaching Tips

Chapter 2 is an introductory chapter that contains the background information on the structure and operation of financial markets that is needed in later chapters of the book. This chapter allows the instructor to branch out to various choices of later chapters, thus allowing different degrees of coverage of financial markets and institutions.

The most important point to transmit to the student is that financial markets and financial intermediaries are crucial to a well-functioning economy because they channel funds from those who do not have a productive use for them to those who do. Some instructors will want to teach this chapter in detail, and those who focus on international issues will want to spend some time on the section ―Internationalization of Financial Markets.‖ However, those who slant their course to public policy issues may want to give this chapter a more cursory treatment. No matter how much class time is devoted to this chapter, we have found that it is a good reference chapter for students. You might want to tell them that if in later chapters they do not recall what particular financial intermediaries do and who regulates them, they can refer back to this chapter, especially to tables, such as Tables 2.1 and 2.3.



Answers to End-of-Chapter Questions

1. Examples of how financial markets allow consumers to better time their purchases include:  The purchase of a durable good, like a car or furniture  Paying for tuition  Paying the cost of repairing a flooded basement In all three cases, consumers were able to pay for a good or service (education or the reparation of a flooded basement) without having to wait to save enough and only then being able to afford such goods and services.

2. Yes, I should take out the loan, because I will be better off as a result of doing so. My interest payment will be $4,500 (90% of $5,000), but as a result, I will earn an additional $10,000, so I will be ahead of the game by $5,500. Since Larry’s loan-sharking business can make some people better off, as in this example, loan sharking may have social benefits. (One argument against legalizing loan sharking, however, is that it is frequently a violent activity.)

3. Yes, because the absence of financial markets means that funds cannot be channeled to people who have the most productive use for them. Entrepreneurs then cannot acquire funds to set up businesses that would help the economy grow rapidly.

4. The principal debt instruments used were foreign bonds which were sold in Britain and denominated in pounds. The British gained because they were able to earn higher interest rates as a result of lending to Americans, while the Americans gained because they now had access to capital to start up profitable businesses such as railroads.

5. If the yen-denominated bond is sold in Tokyo, then it is not considered a Eurobond. If the bond is sold in New York, then it is considered a Eurobond.

6. You would rather hold bonds, because bondholders are paid off before equity holders, who are the residual claimants.

7. Because you know your family member better than a stranger, you know more about the borrower’s honesty, propensity for risk taking, and other traits. There is less asymmetric information than with a stranger and less likelihood of an adverse selection problem, with the result that you are more likely to lend to the family member.

8. Maria cannot participate in a hedge fund since this type of mutual fund requires minimum contributions of $100,000 and sometimes more. This type of financial intermediary is targeted to specific savers that have a less cautious perception of risks, using the collected funds to buy assets that earn high returns, but are quite risky.

9. Loan sharks can threaten their borrowers with bodily harm if borrowers take actions that might jeopardize paying off the loan. Hence borrowers from a loan shark are less likely to engage in moral hazard.

10. They might not work hard enough while you are not looking or may steal or commit fraud.

11. Yes, because eliminating moral hazard requires enforcement even if there is no information asymmetry. Even if you know that a borrower is taking actions that might jeopardize paying off the loan, you must still stop the borrower from doing so. Because that may be costly, you may not spend the time and effort to reduce moral hazard, and so moral hazard remains a problem.

12. True. If there are no information or transaction costs, people could make loans to each other at no cost and would thus have no need for financial intermediaries.

13. Because the costs of making the loan to your neighbor are high (legal fees, fees for a credit check, and so on), you will probably not be able to earn 5% on the loan after your expenses even though it has a 10% interest rate. You are better off depositing your savings with a financial intermediary and earning 5% interest. In addition, you are likely to bear less risk by depositing your savings at the bank rather than lending them to your neighbor.

14. Financial intermediaries benefit because they can earn profits on the spreads between the returns they earn on risky assets and the payments they make on the assets they have sold.

Households and firms benefit because they can now own assets that have lower risk.

15.

This is a topic for which there is no clear answer. On one side, it would be beneficial to have financial regulations that are identical in all countries to avoid financial market participants migrating their business to countries with fewer regulations. On the other side, all countries are different and designing a common set of financial regulations seems to be a rather difficult task. Most countries would want to maintain at least part of their regulations, so consensus is

difficult to reach.

Chapter 3 What Do Interest Rates Mean, and What Is Their Role in Valuation?

Measuring Interest Rates Present Value Four Types of Credit Market Instruments Yield to Maturity The Distinction Between Real and Nominal Interest Rates Global Box: Negative Interest Rates? Japan First, Then the United States, Then Europe The Distinction Between Interest Rates and Returns Mini-Case Box: With TIPS, Real Interest Rates Have Become Observable in the United States Maturity and the Volatility of Bond Returns: Interest-Rate Risk Reinvestment Risk Summary Mini-Case Box: Helping Investors to Select Desired Interest-Rate Risk The Practicing Manager: Calculating Duration to Measure Interest-Rate Risk Calculating Duration Duration and Interest-Rate Risk



Overview and Teaching Tips

In our years of teaching financial markets and institutions, we have found that students have trouble with what we consider to be easy material because they do not understand what an interest rate is—that it is negatively associated with the price of a bond, that it differs from the return on a bond, and that there is an important distinction between real and nominal interest rates.

This chapter spends more time on these issues than does any other competing textbook. Our experience has been that giving this material so much attention is well rewarded. After putting more emphasis on this material in my financial markets and institutions course, we witnessed a dramatic improvement in students’ understanding of portfolio choice and asset and liability management in financial institutions.

An innovative feature of the textbook is the set of over twenty special applications called, ―The Practicing Manager.‖ These applications introduce students to real-world problems that managers of financial institutions have to solve and make the course both more relevant and exciting to

students. They are not meant to fully prepare students for jobs in financial institutions—it is up to more specialized courses such as bank or financial institutions management to do this—but these applications teach them some of the special analytical tools that they will need when they enter the business world.

This chapter contains the Practicing Manager application on ―Calculating Duration to Measure Interest-Rate Risk.‖ The application shows how to quantify interest-rate risk using the duration concept and is a basic tool for managers of financial institutions. For those instructors who do not want a managerial emphasis in their financial markets and institutions course, this and other Practicing Manager applications can be skipped without loss of continuity.



Answers to End-of-Chapter Questions

1. When comparing amounts of money that are disbursed at different dates, one has to take into consideration the concept of present value of money. To calculate the present value of the $5,500 promised one year from today, one needs to know the annual interest rate. In this case, for an interest rate larger than 10%, one would prefer to accept the $5,000 today (since one can deposit that amount and receive more than $5,500 one year from today).

2.

You would rather be holding long-term bonds because their price would increase more than the price of the short-term bonds, giving them a higher return.

3.

The rate of capital gain is the part of the rate of return formula that incorporates future changes in the price of the bond. The other part of the formula, the current yield, is composed of the coupon payment (completely determined by the bond´s face value and coupon rate) and the price you paid for the bond today. The rate of capital gain incorporates the future price of the bond and is therefore the part of the formula that reflects the consequences of future price changes.

4.

People are more likely to buy houses because the real interest rate when purchasing a house has fallen from 3 percent (=5 percent – 2 percent) to 1 percent (=10 percent – 9 percent). The real cost of financing the house is thus lower, even though mortgage rates have risen. (If the tax deductibility of interest payments is allowed for, then it becomes even more likely that people will buy houses.)



Quantitative Problems

1. Calculate the present value of a $1,000 zero-coupon bond with 5 years to maturity if the required annual interest rate is 6%.

Solution: PV = FV/(1 + i)n where

FV = 1000, i = 0.06, n = 5 PV = 747.25

2. A lottery claims its grand prize is $10 million, payable over 20 years at $500,000 per year. If the first payment is made immediately, what is this grand prize really worth? Use a discount rate of 6%.

Solution: This is a simple present value problem. Using a financial calculator, N = 20; PMT = 500,000; FV = 0; I = 6%; Pmts in BEGIN mode.

Compute PV: PV = $6,079,058.25 3. Consider a bond with a 7% annual coupon and a face value of $1,000. Complete the following table: Years to Maturity

Discount Rate

3 3 6 9 9

Current Price

5 7 7 7 9

What relationship do you observe between yield to maturity and the current market value?

Solution: Years to Maturity 3 3 6 9 9

Yield to Maturity

Current Price

5 7 7 5 9

$1,054.46 $1,000.00 $1,000.00 $1,142.16 $ 880.10

When yield to maturity is above the coupon rate, the band’s current price is below its face value. The opposite holds true when yield to maturity is below the coupon rate. For a given maturity, the bond’s current price falls as yield to maturity rises.

For a given yield to maturity, a bond’s value rises as its maturity increases. When yield to maturity equals the coupon rate, a bond’s current price equals its face value regardless of years to maturity.

4. Consider a coupon bond that has a $1,000 par value and a coupon rate of 10%. The bond is currently selling for $1,150 and has 8 years to maturity. What is the bond’s yield to maturity?

Solution: To calculate the bond’s yield to maturity using a financial calculator, N  8; PMT  1000  0.10  100; FV  1000; PV  1150 Compute I: I  7.44 5. Suppose that a commercial bank wants to buy Treasury Bills.

These instruments pay $5,000 in one year and are currently selling for $5,012. What is the yield to maturity of these bonds? Is this a typical situation? Why? Solution: The yield to maturity of these bonds solves the following equation: 5,000/(1+i) = 5,012. After some algebra, the yield to maturity happens to be around – 0.24%. This is not a typical situation. In normal times banks will not choose to pay more than the face value of a discount bond, since that implies negative yields to maturity. This example illustrates situations as the ones described in the Global Box in this chapter.

6. What is the price of a perpetuity that has a coupon of $50 per year and a yield to maturity of 2.5%? If the yield to maturity doubles, what will happen to its price?

Solution: The price would be $50/.025 = $2000. If the yield to maturity doubles to 5%, the price would fall to half its previous value, to $1000 = $50/.05.

7. Property taxes in DeKalb County are roughly 2.66% of the purchase price every year. If you just bought a $100,000 home, what is the PV of all the future property tax payments?

Assume that the house remains worth $100,000 forever, property tax rates never change, and that a 9% discount rate is used for discounting.

Solution: The taxes on a $100,000 home are roughly 100,000  0.0266  2,660.

The PV of all future payments  2,660/0.09  $29,555.55 (a perpetuity).

8. Suppose you want to take out a loan and that your local bank wants to charge you an annual real interest rate equal to 3%.

Assuming that the annualized expected rate of inflation over the life of the loan is 1%, determine the nominal interest rate that the bank will charge you. What happens if, over the life of the loan, actual inflation is 0.5%?

Solution: The bank will charge you a nominal interest rate equal to 1% + 3% = 4%. However, if actual inflation turns out to be lower than expected, then you will be worse off than originally planned, since the real cost of borrowing (measured by the real interest rate) turned out to be 4% – 0.5% = 3.5%.

9. Lucia just bought two coupon bonds, one with a face value of $1,000 and the other with a face value of $5,000. Both bonds have a coupon rate of 5% and sold at par today. Calculate both bonds’ current yield and rate of return if Lucia is able to sell these bonds one year later for $100 more than the buying price. Can you estimate what happened to the interest rate over that year?

Solution: The current yield (CY) is calculated as the coupon payment over the selling price of the bond. When a coupon bond sells at par, its current yield equals the coupon rate, since the numerator of the CY is: Face Value x Coupon Rate (always) and the denominator is Face Value (in this particular situation only in which Price = FV). Both bonds have a CY = 5%. If Lucia is able to sell the $1,000 FV coupon bond for $1,100, then the rate of return is: 5% + 10% (since the rate of capital gain is 100/1,000 =10%). The same reasoning yields a RET = 5% + 2% (g = 100/5,000) for the other bond. The interest rate must have fallen over that year for bonds’ prices to increase. Note, however, that it is unlikely that both bonds’ prices increased by the same amount. Other determinants of bonds’ prices (see Chapters 4 and 5) likely explained this effect.

10. You have paid $980.30 for an 8% coupon bond with a face value of $1,000 that matures in five years. You plan on holding the bond for one year. If you want to earn a 9% rate of return on this investment, what price must you sell the bond for? Is this realistic?

Solution: To find the price, solve:

80  Pt 1  980.30  0.09 for Pt 1 . Pt 1  988.53.

980.30 Although this appears possible, the yield to maturity when you purchased the bond was 8.5%. At that yield, you only expect the price to be $983.62 next year.

In fact, the yield would have to drop to 8.35% for the price to be $988.53.

11. Calculate the duration of a $1,000 6% coupon bond with three years to maturity. Assume that all market interest rates are 7%.

Solution: Year Payments PV of Payments Time Weighted PV of Payments Time Weighted PV of Payments Divided by Price

1

2

3

60.00 56.07 56.07 0.06

60.00 52.41 104.81 0.11

1060.00 865.28 2595.83 2.67

Sum 973.76 2.83

This bond has a duration of 2.83 years. Note that the current price of the bond is $973.76, which is the sum of the individual ―PV of payments.‖ 12. Consider the bond in the previous question. Calculate the expected price change if interest rates drop to 6.75% using the duration approximation. Calculate the actual price change using discounted cash flow.

Solution: Using the duration approximation, the price change would be:

P  DUR 

i 0.0025  P  2.83   973.76  6.44.

1 i 1.07

The new price would be $980.20. Using a discounted cash flow approach, the price is 980.23—only $.03 different.

Year Payments PV of payments

1

2

3

Sum

60.00 56.21

60.00 52.65

1060.00 871.3

980.23

13. The duration of a $100 million portfolio is 10 years. $40 million in new securities are added to the portfolio, increasing the duration of the portfolio to 12.5 years. What is the duration of the $40 million in new securities?

Solution: First, note that the portfolio now has $140 million in it. The duration of a portfolio is the weighted average duration of its individual securities. Let D equal the duration of the $40 million in new securities. Then, this implies:

12.5  (100/140  10)  (40/140  D) 12.5  7.1425 + 0.2857 D 18.75  D

The new securities have a duration of 18.75 years.

14. A bank has two, 3-year commercial loans with a present value of $70 million. The first is a $30-million loan that requires a single payment of $37.8 million in 3 years, with no other payments until then. The second is for $40 million. It requires an annual interest payment of $3.6 million. The principal of $40 million is due in 3 years. a. What is the duration of the bank’s commercial loan portfolio? b. What will happen to the value of its portfolio if the general level of interest rates increased from 8% to 8.5%?

Solution: The duration of the first loan is 3 years since it is a zero-coupon loan. The duration of the second loan is as follows: Year Payment PV of Payments Time Weighted PV of Payments Time Weighted PV of Payments Divided by Price

1

2

3

3.60 3.33 3.33 0.08

3.60 3.09 6.18 0.15

43.60 34.61 103.83 2.53

Sum 41.03 2.76

The duration of a portfolio is the weighted average duration of its individual securities.

So, the portfolio’s duration  3/7  (3)  4/7  (2.76)  2.86 If rates increased, i 0.005 P  DUR   P  2.86   70,000,000  926,852.

1 i 1.08 15.

Year

Consider a bond that promises the following cash flows. The required discount rate is 12%.

0 1 2 3 4

Promised Payments

160

170

180

230

You plan to buy this bond, hold it for 2½ years, and then sell the bond. a. What total cash will you receive from the bond after the 2½ years? Assume that periodic cash flows are reinvested at 12%. b. If immediately after buying this bond, all market interest rates drop to 11% (including your reinvestment rate), what will be the impact on your total cash flow after 2½ years?

How does this compare to part (a)? c. Assuming all market interest rates are 12%, what is the duration of this bond?

Solution: a. You will receive $160 reinvested for 1.5 years, and $170 reinvested for 0.5 years. Then you will sell the remaining cash flows, discounted at 12%. This gives you:

160  (1.12)1.5  170  (1.12)0.5 

180 230   $733.69.

0.5 1.12 1.121.5

b. This is the same as part (a), but the rate is now 11%.

160  (1.11)1.5  170  (1.11)0.5 

180 230   $733.74.

0.5 1.11 1.111.5

Notice that this is only $0.05 different from part (a). c.

The duration is calculated as follows: Year Payments PV of Payments Time Weighted PV of Payments Time Weighted PV of Payments Divided by Price

1

2

3

4

160.00 142.86 142.86 0.26

170.00 135.52 271.05 0.49

180.00 128.12 384.36 0.70

230.00 146.17 584.68 1.06

Since the duration and the holding period are the same, you are insulated from immediate changes in interest rates! It doesn’t always work out this perfectly, but the idea is important.

Chapter 4 Why Do Interest Rates Change?

Determinants of Asset Demand Wealth Expected Returns Risk Liquidity Theory of Portfolio Choice Supply and Demand in the Bond Market Demand Curve Supply Curve Market Equilibrium Supply-and-Demand Analysis Changes in Equilibrium Interest Rates Shifts in the Demand for Bonds Shifts in the Supply of Bonds Case: Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect Case: Changes in the Interest Rate Due to a Business Cycle Expansion Case: Explaining the Current Low Interest Rates in Europe, Japan, and the United States The Practicing Manager: Profiting from Interest-Rate Forecasts Following the Financial News: Forecasting Interest Rates

Sum 552.67 2.50

Appendix 1: Models of Asset Pricing Appendix 2: Applying the Asset Market Approach to a Commodity Market: The Case of Gold Appendix 3: Loanable Funds Framework Appendix 4: Supply and Demand in the Market for Money: The Liquidity Preference Framework



Overview and Teaching Tips

As is clear in the preface to the textbook, we believe that financial markets and institutions is taught effectively by emphasizing a few analytic principles and then applying them over and over again to the subject matter of this exciting field. Chapter 4 introduces one of these basic principles: the determinants of asset demand. It indicates that there are four primary factors that influence people’s decisions to hold assets: wealth, expected returns, risk, and liquidity. The simple idea that these four factors explain the demand for assets is, in fact, an extremely powerful one. It is used continually throughout the study of financial markets and institutions and makes it much easier for the student to understand how interest rates are determined, how financial institutions manage their assets and liabilities, why financial innovation takes place, and how prices are determined in the stock market and the foreign exchange market.

One teaching device that we have found helps students develop their intuition is the use of summary tables, such as Table 4.1, in class. We use the blackboard to write a list of changes in variables that affect the demand for an asset and then ask students to fill in the table by reasoning how demand responds to each change. This exercise gives them good practice in developing their analytic abilities. We use this device continually throughout the course and in this book, as is evidenced from similar summary tables in later chapters. We recommend this approach highly.

The rest of Chapter 4 lays out a partial equilibrium approach to the determination of interest rates using the supply and demand in the bond market. An important feature of the analysis in this chapter is that supply and demand is always done in terms of stocks of assets, not in terms of flows. Recent literature in the professional journals almost always analyzes the determination of prices in financial markets with an asset-market approach: that is, stocks of assets are emphasized rather than flows. The reason for this is that keeping track of stocks of assets is easier than dealing with flows. Correctly conducting analysis in terms of flows is very tricky, for example, when we encounter inflation. Thus there are two reasons for using a stock approach rather than a flow approach: (1) it is easier, and (2) it is more consistent with modern treatment of asset markets by financial economists.

Another important feature of this chapter is that it lays out supply and demand analysis of the bond market at a similar level to that found in principles of economics textbooks. The ceteris paribus derivations of supply and demand curves with numerical examples are presented, the concept of equilibrium is carefully developed, the factors that shift the supply and demand curves are outlined, and the distinction between movements along a demand or supply curve and shifts in the curve is clearly drawn. Our feeling is that the step-by-step treatment in this chapter is worthwhile because supply and demand analysis is such a basic tool throughout the study of financial markets and institutions. We have found that even those students who have had excellent training in earlier courses find that this chapter provides a valuable review of supply and demand analysis.

The Practicing Manager application at the end of the chapter shows how interest rate forecasts can be used by managers of financial institutions to increase profits. This application shows students how the analysis they have learned is useful in the real world.

This chapter has an extensive set of appendices on the web to enhance its material. Appendix 1 provides models of asset pricing in case an instructor wants to make use of the capital asset pricing model or the arbitrage pricing model in this course. Appendix 2 shows how the analysis developed in the chapter can be applied to understanding how any asset’s price is determined.

Students particularly like the application to the gold market because this commodity piques almost everybody’s interest. Appendix 3 provides another interpretation of the supply and demand analysis for bonds using a different terminology involving the supply and demand for loanable funds. Appendix 4 provides an alternative approach to interest rate determination developed by John Maynard Keynes, known as the liquidity preference framework.



Answers to End-of-Chapter Questions

1. a. b. c. d. e.

Less, because your wealth has declined More, because its relative expected return has risen Less, because it has become less liquid relative to bonds Less, because its expected return has fallen relative to gold More, because it has become less risky relative to bonds

2. a. b. c. d. e.

More, because your wealth has increased More, because it has become more liquid Less, because its expected return has fallen relative to Polaroid stock More, because it has become less risky relative to stocks Less, because its expected return has fallen

3. Raphael is incorrect. If at the current level of interest rates there is an excess supply of bonds, the supply and demand analysis tells us that interest rates will increase, creating a movement along both the demand curve (in the southeast direction) and the supply curve (in the southwest direction) in order to reach the equilibrium interest rate (and price). The bond’s price will therefore fall and the interest rate will rise to the equilibrium level.

4. Purchasing shares in the pharmaceutical company is more likely to reduce my overall risk because the correlation of returns on my investment in a football team with the returns on the pharmaceutical company shares should be low. By contrast, the correlation of returns on an investment in a football team and an investment in a basketball team are probably pretty high, so in this case there would be little risk reduction if I invested in both.

5. Maria is choosing a bond with higher standard deviation, but also with higher expected return than Jennifer. In order to decide whether Maria or Jennifer is more risk averse, one will need to compare two bonds with the same expected return and different standard deviations of their expected returns. Since a high expected return is a desirable characteristic of a bond and a high volatility of its expected return (high standard deviation) is a non-desirable characteristic, it is not uncommon that highly volatile bonds exhibit higher expected returns, as the bond preferred by Maria.

6. When the Fed sells bonds to the public, it increases the supply of bonds, thus shifting the supply curve B s to the right. The result is that the intersection of the supply and demand curves B s and B d occurs at a lower equilibrium bond price and thus a higher equilibrium interest rate, and the interest rate rises.

7. When the economy booms, the demand for bonds increases: The public’s income and wealth rises while the supply of bonds also increases, because firms have more attractive investment opportunities. Both the supply and demand curves (B d and B s) shift to the right, but as is indicated in the text, the demand curve probably shifts less than the supply curve so the equilibrium interest rate rises. Similarly, when the economy enters a recession, both the supply and demand curves shift to the left, but the demand curve shifts less than the supply curve so that the bond price rises and the interest rate falls. The conclusion is that bond

prices fall and interest rates rise during booms and fall during recessions; that is, interest rates are procyclical.

8. If the government imposes a limit on the amount of daily transactions in the bond market, then bonds will become less liquid with respect to alternative assets. Such a regulation will mean that it will now be more difficult to find buyers and sellers in the bond market, thereby affecting the liquidity of bonds and the demand curve (which will shift to the left), increasing the interest rate and lowering bonds’ prices (for a given supply curve).

9. Interest rates would rise. A sudden increase in people’s expectations of future real estate prices raises the expected return on real estate relative to bonds, so the demand for bonds falls. The demand curve B d shifts to the left, and the equilibrium bond price falls, so the interest rate rises.

10.

If many big corporations decide not to issue bonds because of new financial markets regulations, this will affect the supply curve. The impact will translate into a shift to the left in the supply curve, increasing bonds’ prices (lowering interest rates) and lowering the quantity of bonds bought and sold in the market.

11. Yes. The increase in budget deficits increased the supply of bonds and shifts the supply curve BS to the right, which everything else equal would decrease bond prices and raise interest rates. However, the weak economy in the aftermath of the global financial crisis caused investment opportunities to shrink so dramatically that it shifted the supply curve BS to the left by more than the deficits shifted it to the right. The result was that the price of Treasury bonds rose and interest rates on these bonds fell.

12.

When news about accounting scandals in big corporations spreads, people get worried about the quality of the bonds they are either holding or considering to buy. We can expect then that bonds are not as desirable assets as they were before (maybe because the ability of corporations to honor their commitments was overstated). This negatively affects demand for these bonds and shifts the demand curve to the left, raising interest rates and lowering corporate bonds’ prices (for a given supply curve).

13. Yes, interest rates will rise. The lower commission on stocks makes them more liquid than bonds, and the demand for bonds will fall. The demand curve B d will therefore shift to the left, and the equilibrium bond price falls and the interest rate will rise.

14.

If a big commercial partner of the U.S. enters into a recession, this will probably adversely affect the business of many U.S. companies that export goods and services to that country or region (the Eurozone, in this case). This will most likely result in job losses and a decrease in wealth, at the same time that there will be a decrease in investment

opportunities. The first effect will shift the demand for bonds curve to the left, while the latter will shift the supply curve of bonds to the left. The result is that the equilibrium quantity of bonds issued and bought will unambiguously decrease, while the effect on bonds’ prices and the interest rate will appear to be ambiguous. However, this might not be very different from a domestic recession, so one can expect interest rates to decrease.

15. The interest rate on the AT&T bonds will rise. Because people now expect interest rates to rise, the expected return on long-term bonds such as the 8 81 s of 2028 will fall, and the demand for these bonds will decline. The demand curve B d will therefore shift to the left, and the equilibrium bond price falls and the interest rate will rise.

16.

If people in France decide to permanently increase their savings rate, then more wealth will be accumulated over the years. This increase in wealth determines that more bonds will be bought at any given interest rate (or bonds’ price), creating a shift to the right in the demand curve for bonds in France. This European country can therefore expect permanent lower interest rates in the future.

17.

If the government is planning to fund a major infrastructure plan, it will need to get funds, and thereby will probably issue more bonds. Since the government is a major player in the market for bonds, this will most likely result in a shift to the right in the supply curve, lowering the price of bonds and increasing interest rates in the future. If you have the opportunity, it would be wise to lock in now a long-term loan with current low interest rates.

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Quantitative Problems

1.

You own a $1,000-par zero-coupon bond that has 5 years of remaining maturity. You plan on selling the bond in one year and believe that the required yield next year will have the following probability distribution: Probability

Required Yield

0.1 0.2 0.4 0.2 0.1

6.60% 6.75% 7.00% 7.20% 7.45%

a. What is your expected price when you sell the bond? b. What is the standard deviation?

Solution: Probability

Required Yield

Price

Prob  Price

Prob  (Price  Exp. Price)2

0.1

6.60%

$774.41

$ 77.44

12.84776241

0.2 0.4 0.2 0.1

6.75% 7.00% 7.20% 7.45%

$770.07 $762.90 $757.22 $750.02

$154.01 $305.16 $151.44 $ 75.02 $763.07

9.775668131 0.013017512 6.862609541 16.5903224 46.08937999

The expected price is $763.07.

The variance is $46.09, or a standard deviation of $6.79.

2.

Consider a $1,000-par junk bond paying a 12% annual coupon. The issuing company has 20% chance of defaulting this year; in which case, the bond would not pay anything. If the company survives the first year, paying the annual coupon payment, it then has a 25% chance of defaulting in the second year. If the company defaults in the second year, neither the final coupon payment nor par value of the bond will be paid. What price must investors pay for this bond to expect a 10% yield to maturity? At that price, what is the expected holding period return? Standard deviation of returns? Assume that periodic cash flows are reinvested at 10%.

Solution: The expected cash flow at t1  0.20 (0)  0.80 (120)  96 The expected cash flow at t2  0.25 (0)  0.75 (1,120)  840 96 840 The price today should be: P0    781.49 1.10 1.102 At the end of two years, the following cash flows and probabilities exist: Probability

Final Cash Flow

Holding Period Return

0.2 0.2 0.6

$ 0.00 $ 132.00 $1,252.00

100.00% 83.11% 60.21%

Prob  HPR

Prob  (HPR  Exp. HPR)2

20.00% 16.62% 36.12% 0.50%

19.80% 13.65% 22.11% 55.56%

The expected holding period return is almost zero (0.5%). The standard deviation is roughly 74.5% (the square root of 55.56%).

3.

Last month, corporations supplied $250 billion in bonds to investors at an average market rate of 11.8%. This month, an additional $25 billion in bonds became available, and market rates increased to 12.2%. Assuming a Loanable Funds Framework for interest rates, and that the demand curve remained constant, derive a linear equation for the demand for bonds, using prices instead of interest rates.

Solution: First, translate the interest rates into prices. i  11.8% 

1000  P , or P  894.454 P

i  12.2% 

1000  P , or P

We know two points on the demand curve:

P  891.266, Q  275 P  894.454, Q  250

P  891.266

So, the slope 

 P 891.266  894.454   0.12755 Q 275  250

Using the point-slope form of the line, Price  0.12755  Quantity  Constant.

We can substitute in either point to determine the constant. Let’s use the first point: 891.266  0.12755  275 + Constant, or Constant  856.189

Finally, we have:

Bd : Price  0.12755  Quantity  856.189 4.

An economist has estimated that, near the point of equilibrium, the demand curve and supply curve for bonds can be estimated using the following equations: 2 Quantity  940 5 Bs : Price  Quantity  500

Bd : Price 

a. What is the expected equilibrium price and quantity of bonds in this market? b. Given your answer to part (a), which is the expected interest rate in this market?

Solution: a. Solve the equations simultaneously: 2 Q  940 5 [P  Q  500]

P

0

7 Q  440, or Q  314.2857 5

This implies that P  814.2857.

1000  814.2857 b. i  22.8% 814.2857 5.

As in Question 6, the demand curve and supply curve for bonds are estimated using the following equations: 2 Quantity  940 5 Bs : Price  Quantity + 500

Bd : Price 

Following a dramatic increase in the value of the stock market, many retirees started moving money out of the stock market and into bonds. This resulted in a parallel shift in the demand for bonds, such that the price of bonds at all quantities increased $50. Assuming no change in the supply equation for bonds, what is the new equilibrium price and quantity? What is the new market interest rate?

Solution: The new demand equation is as follows: Bd : Price 

2 Quantity  990 5

Now, solve the equations simultaneously:

2 Q  990 5 [P  Q  500] P

0

7 Q  490, or Q  350.00 5

This implies that P  850.00. i

6.

1000  850.00  17.65% 850.00

Following Question 5, the demand curve and supply curve for bonds are estimated using the following equations: B d: Price 

2 Quantity  990 5

B s: Price  Quantity  500 As the stock market continued to rise, the Federal Reserve felt the need to increase the interest rates. As a result, the new market interest rate increased to 19.65%, but the equilibrium quantity remained unchanged. What are the new demand and supply equations?

Assume parallel shifts in the equations.

Solution: Prior to the change in inflation, the equilibrium was Q  350.00 and P  850.00.

The new equilibrium price can be found as follows: i  19.65% 

1000  P , or P

P  835.771

This point (350, 835.771) will be common to both equations. Further since the shift was a parallel shift, the slope of the equations remains unchanged. So, we use the equilibrium point and the slope to solve for the constant in each equation: 2 350  constant, or constant  975.771 5 2 B d: Price  Quantity  975.771 5

B d: 835.771 

and B s: 835.771  350  constant, or constant  485.771 B s: Price  Quantity  485.771

Chapter 5 How Do Risk and Term Structure Affect Interest Rates?

Risk Structure of Interest Rates Default Risk Liquidity Case: The Global Financial Crisis and the Baa-Treasury Spread Income Tax Considerations Summary Case: Effects of the Bush Tax Cut and the Obama Tax Increase on Bond Interest Rates Term Structure of Interest Rates Following the Financial News: Yield Curves Expectations Theory Market Segmentation Theory Liquidity Premium Theory Evidence on the Term Structure Summary Mini-Case Box: The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle Case: Interpreting Yield Curves, 1980–2016 The Practicing Manager: Using the Term Structure to Forecast Interest Rates



Overview and Teaching Tips

Chapter 5 applies the tools the student learned in Chapter 4 to understanding why and how various interest rates differ. In courses that emphasize financial markets, this chapter is important because students are curious about the risk and term structure of interest rates. On the other hand, professors who focus on public policy issues might want to skip this chapter. The book has been designed so that skipping this chapter will not hinder the student’s understanding of later chapters.

A particularly attractive feature of this chapter is that it gives students a feel for the interaction of data and theory. As becomes clear in the discussion of the term structure, theories are modified because they cannot explain the data. On the other hand, theories do help to explain the data, as the case on interpreting yield curves in the 1980–2022 period demonstrates.

This chapter also has two cases that will pique students’ interest because they are so current. First is the effect of the Bush tax cut and the Obama tax increase on bond interest rates. Since the topic of repeal of the Bush tax cut and the Obama tax increase are such a hot political issue, evaluating what impact the repeal might have on interest rates is sure to be of interest to students. Also, students are particularly interested right now in how the recent financial crisis affected the economy, and this chapter has a case that looks at this topic. The case on the global financial crisis and the Baa-Treasury spread applies the analysis in the chapter to show how the recent financial crisis led to a dramatic increase in the spread between interest rates on Baa securities with credit risk relative to U.S. Treasury securities that do not.

The Practicing Manager application at the end of the chapter shows how forecasts of interest rates from the term structure using the theories outlined here can be used by financial institutions managers to set interest rates on their financial instruments.

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Answers to End-of-Chapter Questions

1. The bond with a C rating should have a higher risk premium because it has a higher default risk, which reduces its demand and raises its interest rate relative to that of the Baa bond.

2. U.S. government-issued securities are usually considered to be default free. However, securities issued by other governments usually have a positive risk premium, depending in general on the fiscal imbalances that each country exhibits at a given point in time.

3. During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms.

4. True. When bonds of different maturities are close substitutes, a rise in interest rates for one bond causes the interest rates for others to rise because the expected returns on bonds of different maturities cannot get too far out of line.

5. Historically, mortgage-backed securities were considered lowrisk assets, since homeowners had the highest incentives to pay their mortgages (otherwise they might lose their home).

However, after standards on lending practices decreased during the first years of the new century, many individuals were able to buy a house, but not to make their mortgage payments. This resulted in poor quality mortgage-backed securities that should never have had such good ratings. Both Standard and Poor’s and Moody’s were investigated for assigning such good ratings and therefore misleading investors in buying these instruments. Sometimes credit rating agencies also make mistakes in assigning risks.

6. The flat yield curve at shorter maturities suggests that short-term interest rates are expected to fall moderately in the near future, while the steep upward slope of the yield curve at longer maturities indicates that interest rates further into the future are expected to rise.

Because interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to fall moderately in the near future but to rise later on.

7. The steep upward-sloping yield curve at shorter maturities suggests that short-term interest rates are expected to rise moderately in the near future because the initial, steep upward slope indicates that the average of expected short-term interest rates in the near future is above the current short-term interest rate. The downward slope for longer maturities indicates that short-term interest rates are eventually expected to fall sharply. With a positive risk premium on long-term bonds, as in the liquidity premium theory, a downward slope of the yield curve occurs only if the average of expected short-term interest rates is declining, which occurs only if short-term interest rates far into the future are falling. Since interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to rise moderately in the near future but fall later on.

8. If the trading volume of the corporate bonds market declines, then corporate bonds become less liquid, as it will be more difficult to find buyers and sellers. This drop in liquidity makes these securities less desirable assets, increasing their risk and “liquidity” premium.

9. The government guarantee will reduce the default risk on corporate bonds, making them more desirable relative to Treasury securities. The increased demand for corporate bonds

and decreased demand for Treasury securities will lower interest rates on corporate bonds and raise them on Treasury bonds.

10.

If the federal government decides to guarantee payments on all municipal bonds, then these bonds will effectively be default free. This characteristic will make them very desirable assets, increasing their demand and thereby lowering their interest rates. If this were to happen, then municipal bonds will be even better than U.S. government bonds, since both are default free, but municipal bonds are income tax exempted instruments. In this case, it will not make sense for municipal bonds to be exempted from paying taxes, since this exemption is made precisely to “help” local governments to gain access to funds.

11. Abolishing the tax-exempt feature of municipal bonds would make them less desirable relative to Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise the interest rates on municipal bonds, while the interest rates on Treasury bonds would fall.



Quantitative Problems

1. 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 five years, and plot the resulting yield curves for the following series of one-year interest rates over the next five years: a.

5%, 7%, 7%, 7%, 7% b.

5%, 4%, 4%, 4%, 4% How would your yield curves change if people preferred shorter-term bonds over longerterm bonds?

Solution: a. The yield to maturity would be 5% for a one-year bond, 6% for a two-year bond, 6.33% for a three-year bond, 6.5% for a four-year bond, and 6.6% for a five-year bond. b. The yield to maturity would be 5% for a one-year bond, 4.5% for a two-year bond, 4.33% for a three-year bond, 4.25% for a four-year bond, and 4.2% for a five-year bond.

The upward-sloping yield curve in (a) would be even steeper if people preferred shortterm bonds over long-term bonds because long-term bonds would then have a positive risk premium. The downward-sloping yield curve in (b) would be less steep and might even have a slight positive upward slope if the long-term bonds have a positive risk premium.

2. Government economists have forecasted one-year T-bill rates for the following five years as follows: Year

1-year rate

1

4.25%

2

5.15%

3

5.50%

4

6.25%

5

7.10%

You have a liquidity premium of 0.25% for the next two years and 0.50% thereafter. Would you be willing to purchase a 4-year T-bond at a 5.75% interest rate?

Solution: Your required interest rate on a 4-year bond = Average interest on four 1-year bonds + Liquidity Premium = (4.25% + 5.15% + 5.50% + 6.25%)/4 + 0.5% = 5.29% + 0.50% = 5.79% At a rate of 5.75%, the T-bond is just below your required rate.

3. What is the yield on a $1,000,000 municipal bond with a coupon rate of 8%, paying interest annually, versus the yield of a $1,000,000 corporate bond with a coupon rate of 10% paying interest annually? Assume that you are in the 25% tax bracket.

Solution: Municipal bond coupon payments equal $80,000 per year. No taxes are deducted; therefore, the yield would equal 8%.

The coupon payments on a corporate bond equal $100,000 per year. But you only keep $75,000 because you are in the 25% tax bracket. Therefore your after-tax yield is only 7.5%.

4. Consider the decision to purchase either a 5-year corporate bond or a 5-year municipal bond.

The corporate bond is a 12% annual coupon bond with a par value of $1,000. It is currently yielding 11.5%. The municipal bond has an 8.5% annual coupon and a par value of $1,000. It is currently yielding 7%. Which of the two bonds would be more beneficial to you? Assume that your marginal tax rate is 35%.

Solution: Municipal Bond Purchase Price = $1,061.50 After-tax Coupon Payment = $85 Par Value = $1,000 Calculated YTM = 7% Corporate Bond Purchase Price = $1,018.25 After-tax Coupon Payment = $78 Par Value = $1,000 Calculated YTM = 7.35% The corporate bond offers a higher yield and is the better buy.

5. A municipal and a corporate bond of equal risk, liquidity, and maturity yield 6% and 10% respectively. For which values of marginal tax rates would you prefer to buy the municipal bond?

Solution: For marginal tax rates larger than 40%. These are the marginal tax rates that solve the following inequality: 0.06 ˃ 0.10 × (1 ‒ t) → 0.06 ‒ 0.10 ˃ ‒0.1t → ‒ 0.04 ˃ ‒0.1t

t 

0.04  0.4 0.1

6. One-year T-bill rates are expected to steadily increase by 150 basis points per year over the next 6 years. Determine the required interest rate on a 3-year T-bond and a 6-year T-bond if the current 1-year interest rate is 7.5%. Assume that the Pure Expectations Hypothesis for interest rates holds.

Solution: 3-year bond: Year 1 interest rate = 7.5% Year 2 interest rate = 9.0% Year 3 interest rate = 10.5% Number of years = 3 (7.5% + 9.0% + 10.5%)/3 = 9.0% 6-year bond: Year 1 interest rate = 7.5% Year 2 interest rate = 9.0% Year 3 interest rate = 10.5% Year 4 interest rate = 12% Year 5 interest rate = 13.5% Year 6 interest rate = 15% (7.5% + 9.0% + 10.5% + 12% + 13.5% + 15%)/6 = 11.25% 7.

Short-term (one-year) interest rates over the next 6 years will be 0.5%, 0.6%, 0.7%, 0.76%, 0.80%, and 0.84%. Using the expectations theory, what will be the interest rates on three-, four-, and six-year bonds?

Solution: Three-year bond = (0.5% + 0.6% + 0.7%) / 3 = 0.6%.

Four-year bond = (0.5% + 0.6% + 0.7% + 0.76%) / 4 = 0.64%.

Six-year bond = (0.5% + 0.6% + 0.7% + 0.76% + 0.80% + 0.84%) / 6 = 0.7%.

8. Using the information from the previous question, now assume that the investor prefers holding short-term bonds. A liquidity premium of 10 basis points is required for each year of a bond’s maturity. What will be the interest rates on a 3-year bond, 6-year bond, and 9-year bond?

Solution: To solve this problem, you will need to use the following equation:

i  i e  i e     ite n 1 int  lnt  t t 1 t  2 n 3-year bond = (0.30) + [(3 + 4.5 + 6)]/(3) = 4.8% 6-year bond = (0.60) + [(3 + 4.5 + 6 + 7.5 + 9 + 10.5)]/(6) = 7.35% 9-year bond = (0.90) + [(3 + 4.5 + 6 + 7.5 + 9 + 10.5 + 13 + 14.5 + 16)]/(9) = 10.233% 9. Suppose that the expectations theory is true and that you can buy a three-year bond with an interest rate of 6% or three consecutive one-year bonds with interest rates of 4%, 5%, and 6%. Which option would you choose to undertake?

Solution: The three-year bond is a better option, since the three consecutive short-term bonds yield an average interest rate equal to (4% + 5% + 6%) / 3 = 5%.

10. Little Monsters, Inc., borrowed $1,000,000 for two years from Northern Bank, Inc., at an 11.5% interest rate. The current risk-free rate is 2% and Little Monsters’ financial condition warrants a default risk premium of 3% and a liquidity risk premium of 2%. The maturity risk premium for a two-year loan is 1%, and inflation is expected to be 3% next year. What does this information imply about the rate of inflation in the second year?

Solution: If inflation were expected to remain constant at 3% over the life of the loan, the interest rate on the two-year loan would be 11%. Since the actual two-year interest rate is 11.5%, the one-year interest rate in year 2 must be 12%, since 11.5 = (11 + 12)/2.

The required rate of 12% = Rf + DRP + LP + MRP + Inflation Premium = 2% + 3% + 2% + 1% + Inflation Premium So, the Inflation Premium in year 2 is 4%. But this is an average premium over two years. Inflation Premium 4% = (Year 1 Inflation + Year 2 Inflation)/2 = (3% + x)/2 or x = 5% 11. One-year T-bill rates are 2% currently. If interest rates are expected to go up after 3 years by 2% every year, what should be the required interest rate on a 10-year bond issued today?

2  2  2  2(1.02)  2(1.02)2      2(1.02)7 10  21.165 /10  2.1165% 12. Short-term (one-year) interest rates over the next 3 years are expected to be 2%, 3%, and 3.55%. If you are ready to buy a three-year bond that yields 3%, which is your required liquidity premium for this period?

Solution: I (10-year bond) 

Solution: The minimum liquidity premium required for three years is 0.15%. The liquidity premium solves the following equation:

0.03 

0.02  0.03  0.0355  l3  l3  0.03  0.0285  0.15% 3

13. At your favorite bond store, Bonds-R-Us, you see the following prices: a. 1-year $100 zero selling for $90.19 b. 3-year 10% coupon $1000 par bond selling for $1000 c. 2-year 10% coupon $1000 par bond selling for $1000 Assume that the pure expectations theory for the term structure of interest rates holds, no liquidity or maturity premium exists, and the bonds are equally risky. What is the implied 1year rate two years from now?

Solution: From (a), you know that the 1-year rate today is 10.877%.

Using this information, (c) tells you that: 1000 = 100/1.10877 + 1100/(1 + 2-year rate)2 So, the 2-year rate today is 9.95%.

Using these two rates, (b) tells you that: 1000 = 100/1.10877 + 100/1.09952 + 1100/(1 + 3-year rate)3 So, the 3-year rate today is 9.97% 1-year rate 2 years from now = (3  9.97% – 2  9.95%) = 10.01% 14. You observe the following market interest rates, for both borrowing and lending: One-year rate = 5% Two-year rate = 6% One-year rate one year from now = 7.25%

How can you take advantage of these rates to earn a riskless profit? Assume that the Pure Expectations Theory for interest rates holds.

Solution: Borrow $100 today at the two-year rate. You will be required to pay back $100  (1.06)2, or $112.36, in two years.

Simultaneously, lend the $100 you borrowed at the one-year rate of 5%. A year later, you will have $105. Again, lend the $105 at the one-year rate of 7.25%. At the end of that year, you will have $105  (1.0725) = $112.6125.

Use the $112.6125 to pay off the $112.36 you owe. This leaves $0.2525 in profit.

Recall that this required no cash upfront. As long as the future rate of 7.25% is guaranteed, you can risklessly make a profit.

15. Predict the one-year interest rate three years from today if interest rates are 4%, 4.5%, 4.75%, and 5% for bonds with one to four years to maturity and the respective liquidity premiums are 0%, 0.1%, 0.15%, and 0.2%.

Solution: The one-year interest rate three years from today is 5.4%.

One-year interest rate one year from today solves:

0.045 

0.04  i1,t 1 2

 0.001  i1,t 1  0.048

One-year interest rate two years from today solves:

0.0475 

0.04  0.048  i1,t  2 3

 0.0015  i1,t  2  0.05

One-year interest rate three years from today solves:

0.05 

0.04  0.048  0.05  i1,t 3 4

 0.002  i1,t 3  0.054

Chapter 6 Are Financial Markets Efficient?

The Efficient Market Hypothesis Rationale Behind the Hypothesis Evidence on the Efficient Market Hypothesis Evidence in Favor of Market Efficiency Mini-Case Box: An Exception That Proves the Rule: Raj Rajaratnam and Galleon Case: Should Foreign Exchange Rates Follow a Random Walk?

Evidence Against Market Efficiency Overview of the Evidence on the Efficient Market Hypothesis The Practicing Manager: Practical Guide to Investing in the Stock Market How Valuable are Published Reports by Investment Advisers?

Mini-Case Box: Should You Hire an Ape as Your Investment Adviser?

Should You Be Skeptical of Hot Tips?

Do Stock Prices Always Rise When There Is Good News?

Efficient Markets Prescription for the Investor Why the Efficient Market Hypothesis Does Not Imply that Financial Markets are Efficient Behavioral Finance Case: What Do Stock Market Crashes Tell Us About the Efficient Market Hypothesis?



Overview and Teaching Tips

To fully understand how asset prices are determined, students need to be exposed to efficient markets hypothesis, which describes how information is reflected in the asset prices. The discussion of the evidence on the efficient markets illustrates how much controversy there is in this theory. Students also particularly enjoy the Practicing Manager application which uses efficient markets theory to provide a practical guide to investing in the stock market. This application captures the attention of even the most disinterested student because all of us are interested in how to get rich (or, at least, in how to keep from getting poor). This application also gives students practice using the reasoning that they learned earlier in the chapter. In addition, the theory is confronted with evidence that shows the student important implications for the real world.



Answers to End-of-Chapters Questions

1. False. Expectations can be highly inaccurate and still be rational because optimal forecasts are not necessarily accurate. A forecast is optimal if it is the best possible, even if the forecast errors are large.

2. Although Joe’s expectations are typically quite accurate, they could still be improved by his taking account of a snowfall in his forecasts. Since his expectations could be improved, they are not optimal and hence are not rational expectations.

3. If both returns are similar, this would constitute evidence in favor of the efficient market hypothesis, that states that socalled “expert” advice is not a better predictor of movements in stock prices than a random method. No one can predict a stock price movement if the market is efficient. The only thing that can create a price movement is new information, that by definition no one has.

4. True, as an approximation. If large changes in a stock price could be predicted, then the optimal forecast of the stock return would not equal the equilibrium return for that stock.

In this case, there would be unexploited profit opportunities in the market and expectations would not be rational. Very small changes in stock prices could be predictable, however, and the optimal forecast of returns would equal the equilibrium return. In this case, an unexploited profit opportunity would not exist.

5. No, you shouldn’t buy stocks because the rise in the money supply is publicly available information that will be already incorporated into stock prices. Hence you cannot expect to earn more than the equilibrium return on stocks by acting on the money supply information.

6. Your forecast is still considered to be optimal, since it was made with all available information at the time. The fact that new information that would most probably impact the stock price of ABC Corporation arrived today, is simply out of the forecaster’s control. In this case, your forecast was optimal, but shortly lived.

7. Probably not. Although your broker has done well in the past, efficient markets theory suggests that she has probably been lucky. Unless you believe that your broker has better information than the rest of the market, efficient markets theory indicates that you cannot expect the broker to beat the market in the future.

8. No, if the person has no better information than the rest of the market. An expected price rise of 10% over the next month implies over a 100% annual return on IBM stock, which certainly exceeds its equilibrium return. This would mean that there is an unexploited profit opportunity in the market,

which would have been eliminated in an efficient market. The only time that the person’s expectations could be rational is if the person had information unavailable to the market that allowed him or her to beat the market.

9. If there is a phenomenon that takes place regularly and it is not incorporated into people’s expectations, then these expectations are not optimal (since they are not including all available information). We can conclude that people are not taking into account that stock prices go up every last week of November, because if they did, that price increase would represent a profit opportunity (i.e., someone could buy stock the first week of November and sell it in the last week) and would therefore be quickly exploited. This would therefore constitute evidence against the efficient market hypothesis.

10. False. The people with better information are exactly those who make the market more efficient by eliminating unexploited profit opportunities. These people can profit from their better information.

11. Because inflation is less than expected, expectations of future short-term interest rates would be lowered, and as we learned in Chapter 7, long-term interest rates would fall. The decline in long-term interest rates implies that long-term bond prices would rise.

12. True in principle. Foreign exchange rates are a random walk over a short interval, such as a week, because changes in the exchange rate are unpredictable. If a change were predictable, large unexploited profit opportunities would exist in the foreign exchange market. If the foreign exchange market is efficient, these unexploited profit opportunities cannot exist, and so the foreign exchange rate will approximately follow a random walk.

13.

If the efficient market hypothesis holds, then Marcos’ clients would technically not be at any disadvantage with respect to other clients of the same firm. However, information flows usually have a given hierarchy, in which some individuals get access to information before others. Even though the SEC makes a huge effort to avoid this phenomenon, it is quite difficult to completely eliminate it. Also, stockbrokers’ experience and expertise play a role in their favor.

14.

For your expectations to be optimal, they have to include all available information up to date, including the fact that you have been off by minus 1% the last 6 times. This means that you have to incorporate your mistake or forecast errors in your predictions. Failure to do so indicates that your expectations are not optimal. Of course you can miss the observed inflation rate every time, but you cannot miss consistently (i.e., always predict less than the actual inflation rate).

 Quantitative Problems

1.

A company has just announced a 3-for-1 stock split, effective immediately. Prior to the split, the company had a market value of $5 billion with 100 million shares outstanding.

Assuming that the split conveys no new information about the company, what is the value of the company, the number of shares outstanding, and price per share after the split? If the actual market price immediately following the split is $17.00/share, what does this tell us about market efficiency?

Solution: Prior to the split, each share was worth $5 billion/100 million, or $50/share. If the split conveys no new information, the market value of the company does not change, remaining at $5 billion. But, with the split, every share becomes three shares, so 300 million shares are outstanding. The new price/share is $5 billion/300 million, or $16.67/share.

If the actual price is $17.00/share, the price appears too high. This can be viewed two ways. One possibility is that markets are inefficient—some type of anomaly has occurred, and it’s not clear if the market will correct itself. Another possibility is that the stock split actually conveyed information about the company. Investors may believe (possibly incorrectly) that the price/share is expected to increase significantly, and that is why the firm implemented the stock split.

2.

If the public expects a corporation to lose $5 a share this quarter and it actually loses $4, which is still the largest loss in the history of the company, what does the efficient market hypothesis say will happen to the price of the stock when the $4 loss is announced?

Solution: The stock price will rise. Even though the company is suffering a loss, the price of the stock reflects an even larger expected loss. When the loss is less than expected, efficient markets theory then indicates that the stock price will rise.

Chapter 7 Why Do Financial Institutions Exist?

Basic Facts About Financial Structure Throughout the World Transaction Costs How Transaction Costs Influence Financial Structure How Financial Intermediaries Reduce Transaction Costs Asymmetric Information: Adverse Selection and Moral Hazard The Lemons Problem: How Adverse Selection Influences Financial Structure Lemons in the Stock and Bond Markets Tools to Help Solve Adverse Selection Problems Mini-Case Box: The Enron Implosion How Moral Hazard Affects the Choice Between Debt and Equity Contracts Moral Hazard in Equity Contracts: The Principal-Agent Problem Tools to Help Solve the Principal-Agent Problem How Moral Hazard Influences Financial Structure in Debt Markets Tools to Help Solve Moral Hazard in Debt Contracts Summary Case: Financial Development and Economic Growth Mini-Case Box: The Tyranny of Collateral Case: Is China a Counter-Example to the Importance of Financial Development?

Conflicts of Interest What are Conflicts of Interest and Why Do We Care?

Why Do Conflicts of Interest Arise?

Mini-Case Box: The Demise of Arthur Andersen Mini-Case Box: Credit Rating Agencies and the 2007-2009 Financial Crisis What Has Been Done to Remedy Conflicts of Interest?

Mini-Case Box: Has Sarbanes-Oxley Led to a Decline in U.S. Capital Markets?



Overview and Teaching Tips

The development of a new literature in finance on asymmetric information and financial structure in recent years now enables financial institutions to be taught with basic principles rather than placing emphasis on a set of facts that students may find boring and so will forget after the final exam. This chapter provides an outline of this literature to the student and provides him or her with an understanding of why our financial system is structured the way it is. In addition, it emphasizes the ideas of adverse selection and moral hazard, which are basic concepts that are useful in understanding conflicts of interest in this chapter, financial regulation in Chapter 18, principles of insurance management in Chapter 21, and principles of credit risk management in Chapter 23.

The chapter begins with a discussion of eight basic facts about financial structure. Students find some of these facts to be quite surprising—the relative unimportance of the stock market as a source of financing investment activities, for example—which piques their interest and stimulates them to want to understand the economics behind our financial structure. The next two sections then solve these facts by providing an understanding of how transaction costs and asymmetric information affect financial structure. My experience with teaching this material is that it is very intuitive and so is easy for students to learn. Furthermore, students find the material inherently exciting because it explains phenomena that they know are important in the real world. We have also found that it helps students to learn facts about the financial system because they now have a framework to make sense out of all these facts.

The chapter then discusses two cases. The first examines the role of financial development on economic growth and the second, whether China is a counter-example to the importance of financial development. These cases fit in especially well with courses focusing on public policy since promoting economic growth is one of the major issues for policymakers. These cases can be skipped without loss of continuity, especially for courses focusing on financial institutions.

The chapter contains a final section on ―Conflicts of Interest,‖ which discusses what conflicts of interest are and why we should care about them. Recent corporate and accounting scandals due to conflicts of interest have received tremendous public attention and are thus highly interesting to students because resulting bankruptcies have cost employees of these firms their jobs and their pensions, and because the scandals may have hampered the efficient functioning of the financial system. In addition, the growing concerns about the proliferation and effects of conflicts of interest have resulted in the decision of many business schools to add business ethics courses to their curriculums. This chapter allows the instructor to discuss ethical issues but with the analysis grounded on the asymmetric information concepts featured so prominently in this book.

It is important to emphasize to students that conflicts of interest occur when people who are supposed to act in the interests of the investing public by providing them with reliable information instead have incentives (conflicting interests) to deceive the public to benefit themselves and their corporate clients. The section ends by providing a survey of the different types of conflicts of interest in the financial industry and discusses policies to remedy them.

The chapter has been designed to keep the textbook very flexible. The concepts of adverse selection and moral hazard were explained in Chapter 2 and are explained again in Chapters 18, 21, and 23 so that Chapter 7 does not have to be covered in order to teach these or later chapters.



Answers to End-of-Chapter Questions

1. Financial intermediaries can take advantage of economies of scale and thus lower transaction costs. For example, mutual funds take advantage of lower commissions because the scale of their purchases is higher than for an individual, while banks’ large scale allows them to keep legal and computing costs per transaction low. Economies of scale, which help financial intermediaries lower transaction costs, explain why financial intermediaries exist and are so important to the economy.

2. When a couple dates, they are (explicitly or implicitly) extracting information about the significant other. At the same time, they are sharing information about themselves. This information flow helps both individuals to make better decisions about a probable (or not) future life together. In this way, one can think that this process is formally no different from the one in

which the loan officer tries to choose the right borrower.

3. No. If the lender knows as much about the borrower as the borrower does, then the lender is able to screen out the good from the bad credit risks and so adverse selection will not be a problem. Similarly, if the lender knows what the borrower is up to, then moral hazard will not be a problem because the lender can easily stop the borrower from engaging in moral hazard.

4. Standard accounting principles make profit verification easier, thereby reducing adverse selection and moral hazard problems in financial markets, hence making them operate better.

Standard accounting principles make it easier for investors to screen out good firms from bad firms, thereby reducing the adverse selection problem in financial markets. In addition, they make it harder for managers to understate profits, thereby reducing the principal-agent (moral hazard) problem.

5. One would expect the group of countries with more efficient legal systems to exhibit higher living standards. Legal systems are an important part in the lending process, precisely because they are part of the mechanisms of enforcement of contracts that deal with the moral hazard problem. Costly, slow, and inefficient legal systems do not promote lending and thereby funding of investment opportunities.

6. One would expect corruption measures to be negatively correlated with living standards. Corruption usually deters investment, since it undermines the legal system.

Countries in which corruption is prevalent have trouble encouraging individuals or companies to invest in them.

Corruption affects living standards by undermining the efficiency of the legal system, thereby lowering investment, one fundamental ingredient to economic growth, the basis of higher living standards.

7. Because there is asymmetric information and the free-rider problem, not enough information is available in financial markets. Thus there is a rationale for the government to encourage information production through regulation so that it is easier to screen out good from bad borrowers, thereby reducing the adverse selection problem. The government can also help reduce moral hazard and improve the performance of financial markets by enforcing standard accounting principles and prosecuting fraud.

8. Yes. The person who is putting her life savings into her business has more to lose if the business takes on too much risk or engages in personally beneficial activities that don’t lead to higher profits. So she will act more in the interest of the lender, making it more likely that the loan will be paid off.

9. The bank is trying to solve the moral hazard problem by placing a lien on the house title. In general, the bank does not “keep the house title,” but it places a lien on it instead to prevent the house owner to sell the house without its supervision. In this case, the bank wants to make sure that you do not sell the house, get the money, and never pay back the loan.

10. True. If the borrower turns out to be a bad credit risk and goes broke, the lender loses less because the collateral can be sold to make up any losses on the loan. Thus adverse selection is not as severe a problem.

11. The free-rider problem means that private producers of information will not obtain the full benefit of their information producing activities, and so less information will be produced.

This means that there will be less information collected to screen out good from bad risks, making adverse selection problems worse, and that there will be less monitoring of borrowers, increasing the moral hazard problem.

12. The separation of ownership and control creates a principal-agent problem. The managers (the agents) do not have as strong an incentive to maximize profits as the owners (the principals).

Thus the managers might not work hard, might engage in wasteful spending on personal perks, or might pursue business strategies that enhance their personal power but do not increase profits.

13. Credit rating agencies try to mitigate the problem of adverse selection. By compiling information and evaluating default risks, credit rating agencies help investors to decide which bonds have the highest risks of default and which ones are relatively safer investments. The subprime mortgage crisis undermined the trustworthiness of these agencies, since securities that were assigned good ratings were in fact bad investments.

14. Conflicts of interest arise because higher profits might arise in providing one kind of service if the service provider misuses, provides false information, or conceals information when providing another kind of service.

15.

The issuer of a good quality (low risk) bond would have an incentive to disclose information, whereas the issuer of a bad quality (high risk) bond would not. This is because when information is created and made available, potential bond buyers can make a better decision. The issuer of the bad quality bond will most probably end up receiving a lower price than the average price. Note that in the absence of information, every bond sells at the average price.

16. a.

Research analysts in investment banks might distort their research to please issuers of securities so underwriters in the investment bank can get their business. b. Investment banks might engage in spinning, a form of kickback in which they allocate hot, but underpriced, IPOs to executives in return for their companies’ future business.

17.

When prospective employers ask job applicants to go through a job interview, they are trying to solve the adverse selection problem. Prospective employers want to know more about potential workers, much in the same way loan officers want to know more about potential borrowers. As it is the case with a loan transaction, the information asymmetry does not end here, since if hired, worker and employer will have to solve the moral hazard problem. Usually employers try to solve this problem with paying schemes that encourage workers to provide more effort.

18. a.

Clients may be able to pressure auditors into skewing their opinions in order to get fees for other accounting services. b. Auditors may be auditing information systems or structuring (tax and financial) advice put in place by their non-audit counterparts within the firm, and thus may be reluctant to criticize this advice or systems. c. Auditors may provide overly favorable opinions in order to solicit or retain business.

19. Sarbanes-Oxley requires CEOs and CFOs to certify the financial statements and disclosures of the firm and requires disclosure of off-balance sheet transactions and relationships with special purpose entities. This mandatory disclosure improves the quality of information, but has the disadvantage of being costly. Sarbanes-Oxley also substantially increases supervisory oversight with the PCAOB which can help stop conflicts of interest in the accounting industry. Also by making the audit committee independent of management, audits are likely to be more reliable, an important benefit. However, Sarbanes-Oxley may reduce economies of scope available to accounting firms by preventing them from providing auditing and consulting services to the same client.

20.

Cecilia and Julia are free riders. Even though they have provided no effort, they had accepted the reward of a good grade. Looking into the future, Lucia now has no incentive to work hard, if everybody gets the same grade regardless of their effort. One can expect that Lucia will either not participate or decide to provide no effort at all, with the result that the project will most probably be a failure. It is very difficult to completely eliminate the free-rider problem, both in financial markets and in our everyday lives.



Quantitative Problems

1. You are in the market for a used car. At a used car lot, you know that the blue book value for the cars you are looking at is between $20,000 and $24,000. If you believe the dealer knows as much about the car as you, how much are you willing to pay? Why? Assume that you only care about the expected value of the car you buy and that the car values are symmetrically distributed.

Solution: You are willing to pay the average price. If the distribution of car values is symmetric, you are willing to pay $22,000 for a randomly selected car.

2. Now, you believe the dealer knows more about the cars than you. How much are you willing to pay? Why? How can this be resolved in a competitive market?

Solution: You are willing to pay the average price upfront: $22,000. However, the dealer will know this, and only sell you a car worth between $20,000 and $22,000. But you know this. So you will only pay $21,000. And so on. This ends with you paying $20,000, and the car being worth $20,000.

This is OK for you, but the dealer can never sell cars worth more than $20,000.

The resolution, of course, is to get more information. This may include a test drive, mechanical inspection, warranty, etc.

3. You wish to hire Ricky to manage your Dallas operations. The profits from the operations depend partially on how hard Ricky works, as follows: Probabilities Lazy Worker Hard Worker

Profit  $10,000

Profit  $50,000

60% 20%

40% 80%

If Ricky is lazy, he will surf the Internet all day, and he views this as a zero cost opportunity.

However, Ricky would view working hard as a ―personal cost‖ valued at $1,000. What fixed percentage of the profits should you offer Ricky? Assume Ricky only cares about his expected payment less any ―personal cost.‖ Solution: Let P be the percent of profits you pay Ricky.

If Ricky is lazy, his expected payment is 0.60  10,000 P  0.40  50,000 P  26,000 P If Ricky works hard, his expected payment is 0.20  10,000 P  0.80  50,000 P  1,000  42,000 P  1,000 To induce Ricky to work hard, you need 42,000 P  1,000  26,000 P 16,000 P  1,000 P  0.0625 So, offer Ricky 6.25% of the profits, and this should induce him to work hard.

4. You own a house worth $400,000 on a river. If the river floods moderately, the house will be completely destroyed. This happens about once every 50 years. If you build a seawall, the river would have to flood heavily to destroy your house, and this only happens about once every 200 years. What would be the annual premium for an insurance policy that offers full insurance? For a policy that only pays 75% of the home value? What are your expected costs with and without a seawall?

Do the different policies provide an incentive to be safer (build the seawall)?

Solution: With full insurance: Without a seawall, the expected loss is 400,000  0.02  8,000 With a seawall, the expected loss is 400,000  0.005  2,000 The insurance company will charge the expected loss as a premium. Your expected cost under either scenario each year is the premium.

With partial insurance: Without a seawall, the expected loss is 300,000  0.02  6,000 With a seawall, the expected loss is 300,000  0.005  1,500 The insurance company will charge the expected loss as a premium. Your expected cost each year is: Without a seawall: [0.02  (300,000  400,000)  0.98 (0)]  6,000  8,000 With a seawall: [0.005  (300,000  400,000)  0.98 (0)]  1,500  2,000 Unfortunately, neither insurance policy is better or worse. Although the premiums under the partial insurance policy are lower, the expected cost each year is the same as with full insurance. In either scenario, you will build the seawall if the annual cost of building and maintaining a seawall is less than $6,000/year.

Chapter 8 Why Do Financial Crises Occur, and Why Are They So Damaging to the Economy?

What is a Financial Crisis?

Agency Theory and the Definition of a Financial Crisis

Dynamics of Financial Crises Stage One: Initial Phase Stage Two: Banking Crisis Stage Three: Debt Deflation Case: The Mother of All Financial Crises: The Great Depression Stock Market Crash Bank Panics Continuing Decline in Stock Prices Debt Deflation International Dimensions Case: The Global Financial Crisis of 2007–2009 Causes of the 2007–2009 Financial Crisis Effects of the 2007–2009 Financial Crisis Mini-Case: Collateralized Debt Obligations (CDOs) Residential Housing Prices: Boom or Bust Inside the Fed Box: Was the Fed to Blame for the Housing Price Bubble?

Global Box: The European Sovereign Debt Crisis Height of the 2007-2009 Financial Crisis



Overview and Teaching Tips

Financial crises are inherently interesting because they are so dramatic. This has become even more true with the global financial crisis of 2007–2009, which Alan Greenspan characterized as a once-in-a-century credit tsunami. Indeed, teaching this chapter on financial crises has stimulated student interest more than anything else we have taught in my entire teaching career of over thirty years.

This chapter is an application of the economic analysis of the effects of asymmetric information (adverse selection and moral hazard), that was covered in the previous chapter. This theory is used to outline the six factors that play key roles in financial crises. Your students will really start to get engaged when you outline the dynamics of financial crises through its multiple stages. We have found that Figure 8.1 with its schematics is especially helpful in getting the dynamics across in class.

Students will be most interested in using the analysis to discuss the recent 2007-2009 financial crisis, which is the worst financial crisis to hit the world since the Great Depression. Nonetheless, the case discussing the Great Depression is worth covering because it contains so many lessons for today. Taking students through the data in the figures and telling the war stories of what happened during these crises will make the discussion real world and also drive home the theory of financial crises developed in the chapter.



Answers to End-of-Chapter Questions

1. Asymmetric information problems (adverse selection and moral hazard) are always present in financial transactions but normally do not prevent the financial system from efficiently channeling funds from lender-savers to borrowers. During a financial crisis, however, asymmetric information problems intensify to such a degree that the resulting financial frictions lead to flows of funds being halted or severely disrupted, with harmful consequences for economic activity.

2. When an asset-price bubble bursts and asset prices realign with fundamental economic values, the resulting decline in net worth means that businesses have less skin in the game and so have incentives to take on risk at the lender’s expense. In addition, lower net worth means there is less collateral and so adverse selection increases. The bursting of an assetprice bubble therefore makes borrowers less credit-worthy and causes a contraction in lending and spending. The asset price bust can also lead to a deterioration in financial institutions’ balance sheets, which causes them to deleverage, further contributing to the decline in lending and economic activity.

3. The process of financial innovation and financial liberalization, although potentially beneficial to an economy in the long run, has to be carefully managed in the short run.

This is so because at the beginning of these processes, both investors and regulators do not have the necessary expertise to deal with new financial instruments (financial innovation) and opportunities created (financial liberalization).

Therefore, if both processes are not managed properly, countries that were looking to update and/or increase the efficiency of their financial markets could end up creating the conditions for a financial crisis instead.

4. Financial frictions are a set of conditions that prevent financial markets to effectively assign funds to the best investment opportunities. In general they increase when information asymmetries worsen, preventing lenders from ascertaining the best potential borrowers. Financial frictions are a key element in financial crises because as the channeling of funds through the financial market is interrupted or limited, the economy slows down. This could trigger an asset price decline, increase in uncertainty, and the deterioration in financial institutions’ balance sheets.

5. If financial institutions suffer a deterioration in their balance sheets and they have a substantial contraction in their capital. They will have fewer resources to lend, and lending will decline. The contraction in lending then leads to a decline in investment spending, which slows economic activity. When there are simultaneous failures of financial institutions, there is a loss of information production in financial markets and a direct loss of banks’ financial intermediation. In addition, a decrease in bank lending during a banking crisis decreases the supply of funds available to borrowers, which leads to higher interest rates, which increases asymmetric information problems and lead to a further contraction in lending and economic activity.

6. A failure of a major financial institution, which leads to a dramatic increase in uncertainty in financial markets, makes it hard for lenders to screen good from bad credit risks. The resulting inability of lenders to solve the adverse selection problem makes them less willing to lend, which leads to a decline in lending, investment, and aggregate economic activity.

7.

Credit spreads measure the difference between interest rates on corporate bonds and Treasury bonds of similar maturity that have no default risk. The rise of credit spreads during a financial crisis (as occurred during the Great Depression and again during 2007– 2009) reflects the escalation of asymmetric information problems that make it harder to judge the riskiness of corporate borrowers and weaken the ability of financial markets to channel funds to borrowers with productive investment opportunities.

8. Some countries do not fully advertise the fact that there exists a system of deposit insurance precisely because this

information makes depositors and bank clients less likely to monitor banks’ activities. Not advertising deposit insurance may limit the moral hazard problem created by a system of deposit insurance in which banks accept too much risk. If the early stages of a banking crisis occur, then the authorities can advertise the existence of a system of deposit insurance and then prevent a bank panic.

9.

The process of securitization converts a series of financial instruments (i.e., loans) into marketable securities. This process was extensively used in the U.S. financial system starting in the 1970’s. However, in the early 2000’s, the type of loans which were used to create marketable securities was of dubious quality, a characteristic which was directly translated into these marketable securities. The process of securitization by itself was not the sole responsibility of the Great Recession. The fact that funds were lent to less than prime borrowers and that such loans (mostly mortgages) were securitized was a contributing factor of such a crisis.

10. Supporters of the idea that the Fed was responsible for the Great Recession financial crisis argue that it helped to create the conditions for a housing market bubble by setting the federal funds rate (a benchmark interbank loan rate discussed later in the text) at an extremely low level. This action made funds cheaper to financial intermediaries and they were therefore more willing to lend to homeowners. Another argument in favor of such a hypothesis is that the Fed was not stringent enough in its administrative task of regulating and monitoring financial intermediaries. On the other side, supporters of the Fed’s policy during this period cite other facts that contributed to the housing market bubble, in particular, the lowering of lending standards and funds inflows from India and China coupled with no attractive investment opportunities (so that eventually those funds ended up fueling the housing market bubble). This is still an ongoing and very interesting debate.

11

Weak regulation and supervision mean that financial institutions will take on excessive risk because market discipline is weakened by the existence of a government safety net. When the risky loans eventually go sour, this causes a deterioration in financial institution balance sheets, which then means that these institutions cut back lending and economic activity declines.

12. Both the Great Depression and the Great Recession were preceded by sharp increases in asset prices. During the two episodes, credit spreads widened, the availability of credit shrank, and economic activity sharply declined. The two episodes differ in the source of asset price increases: during the Great Depression, rising stock prices were the trigger, whereas in the recent crisis a housing bubble was the primary trigger. During the Great Depression, many bank failures led to a bank panic, causing more banks to fail. During the recent crisis, even though the banking system was hit hard and bank failures did occur, they were much less pronounced, and no bank panic occurred. Finally, although both episodes resulted in significant declines in GDP and increases in unemployment, this was much more pronounced during the Great Depression, when unemployment peaked at 25% (as opposed to the recent crisis, in which the unemployment rate reached 10.2%). In part, this is the result of Federal Reserve policymakers trying much more aggressively to contain the financial crisis and reverse the decline in economic activity during the recent crisis than was true during the Great Depression.

13. The use of data mining to give households numerical credit scores which can be used to predict defaults and the use of computer technology to bundle together many small mortgage loans cheaply and package them into securities. Together both enable the origination of subprime mortgages, which then can be sold off as securities.

14. Because the agent for the investor, the mortgage originator, has little incentive to make sure that the mortgage is a good credit risk.

15.

False. Deposit insurance is a very good system to prevent bank panics, but these events are just one potential element in a financial crisis. As the events that unfolded during the Great Recession illustrate, financial crises have many aspects evolving at the same time. A system of deposit insurance might help to prevent bank panics, but it is unable to prevent the effects of the asset price decline in the housing market or the spreading of the crisis to international financial markets. Also, deposit insurance creates moral hazard incentives, encouraging risk taking on the part of banks that might make a financial crisis more likely.

16. The decline in housing prices led to many subprime borrowers finding that their mortgages were ―underwater.‖ When this happened, struggling homeowners had tremendous incentives to walk away from their homes and just send the keys back to the lender. Defaults on mortgages shot up sharply, causing losses to financial institutions, which then deleveraged, causing a collapse in lending.

17. The shadow banking system is composed of hedge funds, investment banks, and other nondepository financial firms that are not subject to the tight regulatory frameworks of traditional banks. Due to the light regulation, they had lower capital requirements (if any at all) and were able to take on significantly more risk than other financial firms. They are important because a large amount of funds flowed through the shadow banking system to support low interest rates, which fueled some of the housing bubble. Because of their large presence in financial markets, when credit markets began tightening, funding from the shadow banking system decreased significantly, which further reduced access to needed credit.

18. During a financial crisis, asset prices fall, oftentimes very rapidly and unexpectedly. This leads to the expectation that asset prices may fall further in the future, and increases the uncertainty over the value of assets put up as collateral. As a result, firms accepting collateral assets require larger and larger haircuts, or discounts on the value of collateral in expectation of future lower values. This requires firms to put up increasingly more collateral for the same loans over time. Due to the falling asset prices and rising haircuts, it becomes a ―buyer’s market‖ for these rapidly falling assets; any firms needing to raise funds quickly would then be forced to sell assets at a fraction of their original worth.

19. Regulation and supervision end up being weak because powerful domestic business interests want it that way so they can take more risk, allowing them to earn higher returns, but pass off the losses to the taxpayer if the loans go sour.

20. The global financial crisis led to a sharp contraction in the economies of Europe that led to a decline in tax revenue and government efforts to boost their economies by increasing spending and lowering taxes. In addition, many governments had to absorb losses of banks.

The result was that budget deficits surged, raising doubts about the ability of European governments to pay back their sovereign debt, causing a collapse in sovereign debt prices and a surge in their interest rates.

21. A sovereign debt crisis can cause governments to pursue austerity to balance their budgets, leading to highly contractionary fiscal policy. In addition, losses on sovereign debt held by financial institutions weakens their balance sheets and can be a factor in causing a financial crisis, as discussed in the text.

Chapter 9 Central Banks and the Federal Reserve System Origins of the Federal Reserve System Inside the Fed Box: The Political Genius of the Founders of the Federal Reserve System Structure of the Federal Reserve System Federal Reserve Banks Inside the Fed Box: Special Role of the Federal Reserve Bank of New York Member Banks Board of Governors of the Federal Reserve System Inside the Fed Box: Role of the Research Staff Federal Open Market Committee (FOMC) Why the Chair of the Board of Governors Really Runs the Show Inside the Fed Box: The FOMC Meeting Inside the Fed Box: Green, Blue, Teal, and Beige: What Do These Colors Mean at the Fed? Why the Chairman of the Board of Governors Really Runs the Show Inside the Fed Box: Styles of Federal Reserve Chairs: Bernanke and Yellen versus Greenspan How Independent Is the Fed? Should the Fed Be Independent?

The Case for Independence The Case Against Independence Central Bank Independence and Macroeconomic Performance Throughout the World Explaining Central Bank Behavior Inside the Fed Box: The Evolution of the Fed’s Communication Strategy Structure and Independence of the European Central Bank Differences Between the European System of Central Banks and the Federal Reserve System Governing Council How Independent is the ECB? Structure and Independence of Other Foreign Central Banks Bank of Canada Bank of England Bank of Japan The Trend Toward Greater Independence



Overview and Teaching Tips

As a first step in learning about the conduct of monetary policy, the student needs to understand how the central bank in the United States—the Federal Reserve System—operates. The basic point that should be driven home in class is that although the Federal Reserve System has a complicated bureaucratic structure, in practice, it functions like a single central bank, headquartered in Washington, D.C. Students should enjoy the discussion of how foreign central banks are structured and how foreign central banks are similar or differ from the central bank in the United States.

To help the instructor spice up the discussion of the Federal Reserve, we try to provide an inside view of the Fed by including material on such topics as the political genius of the way the Federal Reserve was set up to preserve its independence, the special role of the Federal Reserve Bank of New York and the research staff in the Federal Reserve System, the role of member banks, how a typical FOMC meeting is conducted, how Ben Bernanke and Janet Yellen’s style differs from Alan Greenspan’s, and how the Fed’s communication strategy has evolved over time. To feature this new material we have included some of it in a set of special interest boxes, titled ―Inside the Fed,‖ which provide insights on how the Federal Reserve System operates, although they are based on information that is entirely in the public domain.

Until recently, the Federal Reserve had no significant rivals in the central banking world. This changed in January 1999 with the startup of the European Central Bank (ECB), which now conducts monetary policy for countries that are members of the European Monetary Union, which in total have a population that exceeds that of the United States and a GDP comparable to that of the United States. Because of growing interest by students in the workings of the European Central Bank, the chapter has an extensive discussion of the structure and independence of the European Central Bank. To motivate this material, we focus on how the ECB is similar to the Federal Reserve and how it differs. The chapter also contains brief descriptions of the structure and independence of three other important central banks of interest to students: the Bank of Canada, the Bank of England, and the Bank of Japan.

Students seem particularly to enjoy the discussion of the theory of bureaucratic behavior and the related issue of whether or not central banks should be independent. Thus we recommend focusing on these topics, rather than the detail of the Fed’s structure, which can be tedious.

In addition to the institutional detail on the Fed that is usually found in financial markets and institutions textbooks, this chapter also tries to provide the student with a feel for what motivates the Fed and other central banks. Furthermore, discussing the theory of bureaucratic behavior shows students that the economic way of thinking is useful in understanding a wider range of problems than they might otherwise have thought.



Answers to End-of-Chapter Questions

1. Because of traditional American hostility to a central bank and centralized authority, the system of 12 regional banks was set up to diffuse power along regional lines.

2. The placement of two banks in the Midwest farm belt might have been engineered to placate farmers, an important voting block in the early twentieth century.

3. Like the U.S. Constitution, the Federal Reserve System, originally established by the Federal Reserve Act, has many checks and balances and is a peculiarly American institution. The ability of the 12 regional banks to affect discount policy was viewed as a check on the centralized power of the Board of Governors, just as states’ rights are a check on the centralized power of the federal government. The provision that there be three types of directors (A, B, and C) representing different groups (professional bankers, businesspeople, and the public) was again intended to prevent any group from dominating the Fed. The Fed’s independence of the federal government and the setting up of the Federal Reserve banks as incorporated institutions were further intended to restrict government power over the banking industry.

4. The Federal Reserve Banks influence the conduct of monetary policy through their administration of the discount facilities at each bank and by having five of their presidents sit on the FOMC, the main policymaking arm of the Fed. 5. The Board of Governors sets reserve requirements and the discount rate; the FOMC directs open market operations. In practice, however, the FOMC helps make decisions about reserve requirements and the discount rate.

6. The 14-year terms do not completely insulate the governors from political influence. The governors know that their bureaucratic power can be reined in by congressional legislation and so must still curry favor with both Congress and the President. Moreover, in order to gain additional power to regulate the financial system, the governors need the support of Congress and the President to pass favorable legislation.

7.

The structure of the European System of Central Banks (ESCB) has many similarities to that of the Federal Reserve System. The ESCB has an Executive Board that is similar to the Board of Governors of the Federal Reserve System, a governing council that has a similar function to that of the Fed’s FOMC, and the ESCB has national central banks just as the Fed has regional Federal Reserve Banks. There are differences between the ESCB and the Fed. First, the budgets of the Federal Reserve Banks are controlled by the Board of Governors, whereas the National Central Banks control their own budgets and the budget of the ECB in Frankfurt. The ECB in the Eurosystem therefore has less power than does the Board of Governors in the Federal Reserve System. Second, the monetary operations of the Eurosystem are conducted by the National Central Banks in each country, so monetary operations are not centralized as they are in the Federal Reserve System. Third, in contrast to the Federal Reserve, the ECB is not involved in supervision and regulation of financial institutions; these tasks are left to the individual countries in the European Monetary Union.

8. The Fed is more independent because its substantial revenue from securities and discount loans allows it to control its own budget.

9. The threat that Congress will acquire greater control over the Fed’s finances and budget.

10.

One of the most important differences between the styles of Greenspan and Bernanke and Yellen arise from the fact that the two latter spent most of the early part of their careers in academia. These years of formal education and research gave Bernanke and Yellen the sense that formal (theoretical and empirical) analysis is very important both to the understanding of current economic conditions and to forecast future movements in relevant macroeconomic variables. Based on that idea, the Fed has recently moved to increase the importance assigned to more formal methods of forecasting,

like models that simulate the effect of an increase/decrease of short-term interest rates. Time will tell if this is a better approach than the one followed by Alan Greenspan, who relied much more on his beliefs.

11.

From a Central Bank’s perspective, it might not be beneficial to be that explicit about its policies. When a Central Bank explicitly conveys the idea that a particular policy will be followed, it is at the same time tying its hands. This happens because the policy announcement becomes a commitment, and failure to honor that compromise would hurt its trustworthiness, a key element in monetary policy.

12. Eliminating the Fed’s independence might make it more shortsighted and subject to political influence. Thus, when political gains could be achieved by expansionary policy before an election, the Fed might be more likely to engage in this activity. As a result, more pronounced political business cycles might result.

13.

William might feel that people in charge of the design and conduct of monetary policy were not elected by the general public, and so are not sufficiently accountable to the public.

Although the Executive and Legislative branches of the U.S. government participate in the appointment process of members of the Board of Governors, presidents of the Federal Reserve Banks are elected by member banks of each district.

14.

The most important argument in favor of the trend toward central bank independence is the growing body of theoretical and empirical evidence that suggests that more independent central banks are able to get better results (in general, lower inflation rates) than less independent central banks.

However, this movement towards more independence is resisted in some countries, precisely because it insulates the conduct of monetary policy from politics.

15. The argument for not releasing the FOMC directives immediately is that it keeps Congress off the Fed’s back, thus enabling the Fed to pursue an independent monetary policy that is less subject to inflation and political business cycles. The argument for releasing the directive immediately is that it would make the Fed more accountable.



Answers to Web Exercises

1.

Biographical data can be found on the web by following the instructions in the text. In August 2016, there were two empty seats at the Board of Governors of the Fed. This is not unusual, as the process of appointment requires the agreement of the Executive and Legislative branches of the U.S. government.

2.

The main argument stated on the ECB’s website to support its political independence is that both theory and practice seem to indicate that political independence of central banks is a key element for them to achieve their goals.

Chapter 10 Conduct of Monetary Policy How Fed Actions Affect Reserves in the Banking System Open Market Operations Discount Lending The Market for Reserves and the Federal Funds Rate Demand and Supply in the Market for Reserves How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate Case: How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds Rate Conventional Monetary Policy Tools Open Market Operations Inside the Fed Box: A Day at the Trading Desk Discount Policy and the Lender of Last Resort Reserve Requirements Interest on Reserves Nonconventional Monetary Policy Tools and Quantitative Easing Liquidity Provision Inside the Fed Box: Fed Lending Facilities During the Global Financial Crisis Asset Purchases Quantitative Easing Versus Credit Easing Forward Guidance Negative Interest Rates on Bank Deposits Monetary Policy Tools of the European Central Bank Open Market Operations Lending to Banks Interest on Reserves Reserve Requirements

The Price Stability Goal and the Nominal Anchor The Role of a Nominal Anchor The Time-Inconsistency Problem Other Goals of Monetary Policy High Employment Economic Growth Stability of Financial Markets Interest-Rate Stability Stability in Foreign Exchange Markets Should Price Stability Be the Primary Goal of Monetary Policy?

Hierarchical vs. Dual Mandates Price Stability as the Primary, Long-Run Goal of Monetary Policy Inflation Targeting Advantages of Inflation Targeting Disadvantages of Inflation Targeting Global Box: The European Central Bank’s Monetary Policy Strategy Inside the Fed Box: Chairman Bernanke and Inflation Targeting Should Central Banks Respond to Asset-Price Bubbles? Lessons from the Global Financial Crisis Two Types of Asset-Price Bubbles The Debate Over Whether Central Banks Try to Pop Bubbles The Practicing Manager: Using a Fed Watcher



Overview and Teaching Tips

Chapter 10 outlines the tools, goals, and strategy of central bank policymaking. The chapter starts by showing how Fed actions affect the reserves in the banking system. Then, by analyzing the market for reserves, shows how monetary policy affects the federal funds rate. It then analyzes how the Fed uses its tools in theory and in practice.

The next part of the chapter starts by laying out modern theories of central banking. It first discusses the price stability goal and the role of a nominal anchor in solving the timeinconsistency problem. It then discusses the other goals of monetary policy and why price stability is now viewed as the primary goal of monetary policy.

The time-inconsistency problem is one of the most important ideas in monetary theory in the last twenty years. I illustrate the time-inconsistency problem by using the example of how many people cannot stick to a diet even though they know this is the right thing for them to do in the long run. Many other examples can bring this idea home to the student. Another good example is the fact that it is optimal not to give in to children when they are behaving badly, but parents still have a tendency to renege on this optimal plan. A third example is that governments usually provide funds to rebuild in coastal areas after a hurricane, even though it is not optimal to build in areas that are likely to be ravaged by hurricanes. You might ask the students to think of other examples in order to hammer home this important concept.

With the theoretical perspective developed in the first part of the chapter, instructors can now go on to discuss the most common strategy employed by central banks to pursue the price-stability goal: inflation targeting. In discussing this strategy, we have found that having a debate about the pros and cons of inflation targeting piques students’ interest.

The recent financial crisis has generated much new thinking on how monetary policy should be conducted. Given the role of asset-price bubbles in the recent financial crisis, one of the most

hotly debated topics in central banking circles right now is how central banks should respond to asset-price bubbles. The material on this subject in the chapter can be used to stage a student debate in class on whether central banks should respond to asset price bubbles. This will help them appreciate the change in thinking that has occurred in central banking in the aftermath of the global financial crisis.

The chapter ends with a Practicing Manager application on using a Fed Watcher. This illustrates to the student that an understanding of how the Fed conducts monetary policy can be used to increase the profitability of a financial institution. This application helps business students see the relevance of studying the Federal Reserve and the conduct of monetary policy.



Answers to End-of-Chapter Questions

1. Many economists and so-called forecasters criticized the Fed for engaging in the QE programs, as they imagined that an increase in the Fed’s balance sheet was a synonym of future inflation. Inflation in the long run is associated with high money supply growth. However, the link between an increase in the Fed’s balance sheet and changes in the money supply requires knowledge about the process of money creation. As changes in the U.S. inflation rate confirm, these individuals evidently had no idea about this process. Banks decided to hold excess reserves and not make loans, thereby the money supply changed by only a fraction of the change in the Fed’s balance sheet, and inflation in the U.S. is still at very low levels.

2. In general a central bank would use a strategy of “forward guidance” when other types of conventional tools of monetary policy cannot affect the economy in the desired way. In practice, this strategy was followed by the Fed during the aftermath of the Great Recession to try to lower long-term interest rates (since the federal funds rate had hit the zero bound). As economic conditions are usually quite abnormal during the implementation of these strategies, it is in general difficult to ascertain their effects: during abnormal economic conditions standard models of agent’s behavior are not good representations of their decision-making process and economists cannot therefore identify the reasons as to why one variable has changed.

3.

False. The FDIC would not be effective in eliminating bank panics without Fed discounting to troubled banks in order to keep bank failures from spreading.

4. Because of the large amount of liquidity in banks and the financial system, this could eventually lead to substantial inflation problems, as liquidity in the form of excess reserves leaves the banking system through bank lending and ends up as deposits or currency in the hands of the public.

But because of the longer maturities of some of the assets held by the Fed, these assets may not be easily drawn off the balance sheet in order to remove liquidity from banks and financial markets. As a result, reverse repos could be used to temporarily but continually remove reserves from the banking system until the longer maturity securities can be drawn off

the balance sheet of the Fed. 5.

It proved to be more widely used because the interest rate on these loans was set through a competitive process, and that interest rate was less (in some cases much less) than the discount rate. In addition, because of the structure of the Term Auction Facility, there was some anonymity in the banks that were accessing these funds, which helped to avoid the stigma associated with discount window lending.

6.

Since short-term interest rates cannot be lowered below the zero bound in this environment, conventional monetary policy would be ineffective. Thus, the main advantage of quantitative easing is that purchases of intermediate and longer-term securities could reduce longer-term interest rates, increase the money supply further, and lead to expansion. One disadvantage of quantitative easing is that it may not actually have the effect of increasing economic activity through greater loans and monetary expansion: If credit and financial markets are significantly damaged, banks may simply hold the extra liquidity as excess reserves, which would not lead to greater loans and monetary expansion.

7. By purchasing particular types of securities, the Fed can impact interest rates and liquidity in particular sectors of credit and financial markets, thereby providing a more surgical provision of liquidity where it may be needed the most (as opposed to typical open market purchases, which add reserves to the general banking system). For example, as a result of the global financial crisis, the Fed purchased a significant amount of mortgage-backed securities from government-sponsored enterprises, which helped to lower mortgage rates and support the housing market.

8.

In general the set of monetary policy tools available to the ECB is quite similar to the one at the Fed’s disposal. The ECB has a discount lending facility, called the marginal lending facility, that is ready to supply funds to member banks at the marginal lending rate. This rate also acts as a ceiling for the overnight market rate, as in the U.S. does the discount rate. The ECB pays bank members an interest rate for their deposits at the ECB, thereby creating a floor for the overnight rate, as the Fed does in the U.S.

9.

The costs are that banks that deserve to go out of business because of poor management may survive because of Fed discounting to prevent panics. This might lead to an inefficient banking system with many poorly-run banks.

10. The rationale behind that idea is to encourage banks to create loans, as opposed to keep their excess reserves idle at central banks. One can think that if banks are somewhat ―forced‖ to create loans when economic conditions are uncertain, it might result in funds being misallocated, and creating another sort of problems. For example, if banks create loans without the desirable mix of liquidity, term, and risk, banks might be in trouble in the future, which also constitutes a problem for central bankers.

11.

Answers will vary.

12. Central bankers might think they can boost output or lower unemployment by pursuing overly expansionary monetary policy, even though in the long run this just leads to higher inflation and no gains on the output or unemployment front. Alternatively, politicians may pressure the central bank to pursue overly expansionary policies.

13. These instructions constitute a dual mandate, to meet both goals with equal importance. One can suppose that there is a short-run conflict between these two goals, while you work on your ability to meet both ends. However, in the long run one can also argue that there is no

conflict between these goals, since at some point you will be able to write a good report on schedule. You should keep in mind that this example does not exactly replicate the specific mandates that central banks face. This is so because the inexistence of long-run conflicts between goals is not a consequence of a central bank’s expertise.

14. Sustained success in the conduct of monetary policy as measured against a pre-announced and well-defined inflation target can be instrumental in building public support for a central bank’s independence and for its policies. Also, inflation targeting is consistent with democratic principles because the central bank is more accountable.

15.

False. Inflation targeting does not imply a sole focus on inflation. In practice, inflation targeters do worry about output fluctuations, and inflation targeting may even be able to reduce output fluctuations. This is because it allows monetary policymakers to respond more aggressively to declines in demand since they don’t have to worry that the resulting expansionary monetary policy will lead to a sharp rise in inflation expectations.

16. False. There is no long-run trade-off between inflation and unemployment, so in the long run a central bank with a dual mandate that attempts to promote maximum employment by pursuing inflationary policies would have no more success at reducing unemployment than one whose primary goal is price stability.

17. If a central bank decides to commit to a given policy, then it would be very costly (in terms of reputation) to deviate from such a policy. A central bank that announces that it will not intervene to eliminate bubbles might be looking to send the correct message to agents (reduce speculation, do not lower lending standards, etc.). However, if the time comes when it has to intervene, then its credibility will decrease and it will not be able to make credible announcements in other areas as well. Central banks do not like to (and should not) tie their hands too much, because after all they are the institutions that should step up and help reduce the impact of financial crises when they occur, and for that they need a lot of maneuvering capacity.

18. The zero lower bound on nominal interest rates makes it harder to implement expansionary policy as actual inflation (and hence short-term interest rates) fall closer to zero. As a result, there is less room to use monetary policy as a stabilization tool in a low inflation environment. In this context, it is argued that a higher inflation target may be appropriate to give policymakers more flexibility. The downside of this of course is that in general higher inflation rates can be costly to society, posing a tradeoff for monetary policymakers in terms of flexibility versus efficiency of monetary policy.

19. There are several reasons why monetary policy may not be effective in eliminating asset price bubbles. The main reason is that asset price bubbles are extremely difficult to identify in real time; in many cases, by the time there is a consensus among policymakers and the public that a bubble exists, it is usually too late to implement policies to effectively deflate the bubble. And even if an asset price bubble is identified in a timely manner, monetary policy is often thought of as too blunt an instrument to be able to deal effectively with most asset price bubbles. In particular, interest rate changes may have some modest short-term effects on reducing the asset price bubble, but the interest rate changes may have far more consequential effects on real economic activity and cause far worse collateral damage.

20. In general, the question of appropriate policy response is one of minimizing loss. Creditdriven bubbles (such as the housing bubble experience that resulted in the global financial

crisis) can be far more devastating to the economy if a crash occurs, than if policymakers acted to reduce the size of the bubble preemptively. In other words, raising interest rates to try to reduce the bubble may cause collateral damage to the economy, but it would result in far less damage than would presumably occur if nothing were done at all and the bubble were allowed to continue to build. On the other hand, non-credit driven bubbles can more easily be dealt with after a crash; since financial markets generally function relatively normally following these types of bubble crashes, conventional monetary policy can be relatively effective at mitigating any recessionary conditions in the aftermath. Acting preemptively to address the bubble is likely to cause more collateral damage than is inflicted by any downturn related to a non-credit driven bubble crashing.

21. Macroprudential regulation is a set of regulations and procedures intended for monitoring risk taken by financial institutions with the goal of potentially reducing this risk in order to avoid the creation of credit bubbles. This approach could be a powerful instrument to prevent credit bubbles, but it has encountered some opposition from the financial industry.

 Quantitative Problems 1.

Consider a bank policy to maintain 12% of deposits as reserves. The bank currently has $10 million in deposits and holds $400,000 in excess reserves. What is the required reserve on a new deposit of $50,000?

Solution: Required reserve ratio  excess reserve ratio  0.12 Excess reserve ratio  400,000/10 M  0.04 Required reserve ratio  0.04  0.12, or required reserve ratio  0.08 The required reserve is: 50,000  0.08  $4,000

2.

Estimates of unemployment for the upcoming year have been developed as follows: Unemployment Economy Probability Rate Bust Average Good Boom

0.15 0.5 0.2 0.15

20% 10% 5% 1%

What is the expected unemployment rate? The standard deviation?

Solution: Economy

Probability

Bust Average Good Boom

0.15 0.5 0.2 0.15

Unemployment Rate Expectation 20% 10% 5% 1% Sum

0.03 0.05 0.01 0.0015 0.0915

Squared Deviation 0.001765838 0.000036125 0.000344450 0.000996338 0.00314275

The expected unemployment rate is 9.15%. The variance is 0.314%, or a standard deviation of 5.6%.

3.

Suppose a bank currently has $150,000 in deposits and $15,000 in reserves. The required reserve ratio is 10% (so this bank holds no excess reserves). If there is a deposit outflow (i.e., someone withdraws funds from her account) for $5,000, would this bank still comply with the Fed´s requirement of keeping 10% of its deposits in the form of reserves? What would be the cost for this bank to comply with this regulation if the bank decides to borrow from another bank to eliminate its reserve shortage? Assume a federal funds rate of 0.25%.

Solution: If there is a deposit outflow equal to $5,000, then the bank now holds $10,000 in reserves and $145,000 in deposits. According to a 10% reserve requirement, the bank has now a reserve shortage equal to $145,000  0.1 – $10,000 = $4,500. If the bank decides to borrow from another bank, then it will have to pay $4,500  0.0025 = $11.25 for a federal fund loan.

4.

Refer to the previous problem. What would be the cost for this bank to comply with its required reserves if the bank decides to borrow from the Fed at a discount rate of 0.75%?

Can you now explain why required reserves serve as insurance against deposit outflows?

Solution: If the bank decides to borrow from the Fed, it will have to pay $4,500  0.0075 = $33.75 for a discount loan. Excess reserves serve as insurance because they enable the bank

to avoid the cost of borrowing reserves when there is a deposit outflow.

5.

The short-term nominal interest rate is 5% with an expected inflation of 2%. Economists forecast that next year’s nominal rate will increase by 100 basis points, but inflation will fall to 1.5%. What is the expected change in real interest rates?

Solution: nominal rate = real rate + expected inflation Year 1: 5% = real rate + 2%, or the real rate = 3% Year 2: 6% = real rate + 1.5%, or the real rate = 4.5% Real rates have increased by 150 basis points.

Chapter 11 The Money Markets The Money Markets Defined Why Do We Need the Money Markets?

Money Market Cost Advantages The Purpose of the Money Markets Mini-Case: Covid and Prime Money Market Fund Withdrawals Who Participates in the Money Markets?

U.S. Treasury Department Federal Reserve System Commercial Banks Businesses Investment and Securities Firms Individuals Money Market Instruments Treasury Bills Case: Discounting the Price of Treasury Securities to Pay the Interest Mini-Case Box: Treasury Bill Auctions Go Haywire Federal Funds Repurchase Agreements Negotiable Certificates of Deposit Commercial Paper Banker’s Acceptances Eurodollars Global Box: Ironic Birth of the Eurodollar Market Comparing Money Market Securities Interest Rates Liquidity How Money Market Securities are Valued



Overview and Teaching Tips

This chapter explores the institutional features of the money markets. The money market is the market for debt securities issued with the original maturities of less than one year and a high degree of liquidity. They are usually sold in large denominations and have low default risk. The chapter shows why money markets are needed and their purpose to the government, firms, financial institutions, and individuals. The money market is an interim investment that provides a higher return than holding cash or money in the bank but less than what is usually expected from long-term investments.

There are several players in the money market which include the U.S. Treasury Department, the Federal Reserve, commercial banks, businesses, investment firms, and individuals. All participants work on both sides of the market except for the U.S. Treasury Department, which is always a demander and never a supplier of the money market. The participants use a variety of money market instruments to diversify their needs. This section shows that most of these securities are short term and low risk. Point out to students the international aspect of the use of Eurodollars so they get a broader view of securities around the world. The securities also have several characteristics that are similar and different. Discuss with the students the characteristics of interest rates, maturity, and liquidity.

The final section deals with how money market securities are valued.



Answers to End-of-Chapter Questions

1. The money markets can be characterized as having securities that trade in one year or less, are of large denomination, and are very liquid.

2.

Low cost coupled with a higher interest rate.

3. Banks have higher costs than the money market, owing to the need to maintain reserve requirements. The lower cost structure of the money markets, coupled with the economies of scale resulting from high volume and large-denomination securities, allows for higher interest rates.

4. Because there’s less regulation and government cost involved in buying and selling money market instruments.

5. Following the Great Depression, regulators were primarily concerned with stopping banks from failing. By removing interest-rate competition, bank risk was substantially reduced.

The problem with these regulations was that when market interest rates rose above the established interest-rate ceiling, investors withdrew their funds from banks.

6. The U.S. Treasury has to maintain its T-bills auctions competitive because these instruments are widely traded. This means that whichever institution that is able to ―corner the market‖ (own a substantial percentage of a T-bill auction) stands ready to earn a substantial return.

This return would be easily earned by charging a price above the competitive price in the secondary market. Potential buyers will have to pay this higher price, since it can only be bought from this institution. This naturally constitutes a violation of regulations that ensure fair competition in financial markets.

7. Businesses both invest and borrow in the money markets. They borrow to meet short-term cash flow needs, often by issuing commercial paper. They invest in all types of money market securities as an alternative to holding idle cash balances.

8. Merrill Lynch initially felt that it could better service its regular customers by making it easier to buy and sell securities from an account held at the brokerage house. The brokerage could offer a market interest rate on these funds by investing them in the money markets.

9. Life insurance companies can invest for the long term because the timing for their liabilities is known with reasonable accuracy. Property and casualty insurance companies cannot predict the natural disasters that cause large payouts on policies.

10. The rapid gap increase between T-bill and CD interest rates between 2008 and 2009 is attributable to the global recession that followed the 2007-2008 financial crisis.

11. In competitive bidding for securities, buyers submit bids. A noncompetitive bidder accepts the average of the rate paid by the competitive bidders.

12. Federal funds are sold by banks to other banks. They are used to invest excess reserves and to raise reserves if a bank is short.

13. The Federal Reserve cannot directly set the federal funds rate of interest. It can influence the interest rate by adding funds to or withdrawing reserves from the economy.

14. A government default on federal debt would force the market to add a default risk premium to all government securities. This would likely raise the interest rate on all government securities.

15. Banker’s acceptances substitute the creditworthiness of a bank for that of a business. When a company sells a product to a company it is unfamiliar with, it often prefers to have the promise of a bank that payment will be made.



Quantitative Problems

1. What would be the underestimation of your earnings as an investor if you use the discount rate instead of the investment rate to measure the return on your investment if you buy a $5,000 T-bill that matures in 91 days for $4,999.55?

Solution: Annualized discount rate = [(5,000 – 4,999.55)/5,000] × (360/91) = 0.035604%.

Annualized investment rate = [(5,000 – 4,999.55)/4,999.55] × (365/91) = 0.036102%.

0.036102% – 0.035604% = 0.000498% Therefore, you would underestimate your return by 0.000498% if you use the discount rate.

2. What is the annualized discount rate and your annualized investment rate on a Treasury bill that you purchase for $9,940 that will mature in 91 days for $10,000?

Solution: Discount Rate Investment Rate



$10,000  $9,940 360   0.02374  2.374% $10,000 91



$10,000  $9,940 365   0.02421  2.421% $9,940 91

3. If you want to earn an annualized discount rate of 3.5%, what is the most you can pay for a 91-day Treasury bill that pays $5,000 at maturity?

Solution:

$5,000  A 360   .035 $5,000 91

$5,000  A  44.24

A  $4,955.76 4. What is the minimum discount rate you will accept if you want to earn at least a 0.25% annualized investment rate on a 182-day $1,000 T-bill?

Solution: In order to obtain at least a 0.25% annualized investment rate, you will have to pay at most $998.754975 for the $1,000 T-bill maturing in 182 days. This price comes from solving the following equation, where P is the price of the T-bill: 0.0025 < [($1,000 ‒ P) / P] × 365/182 → P < 998.754975 Thereby, you should bid a minimum discount rate of 0.246269% (the minimum discount rate that guarantees a price of $998.754975). This discount rate satisfies the following equation: (($1,000 – 998.754975) / $1,000) × 360/182 = 0.00246269 5. The price of 182-day commercial paper is $7,840. If the annualized investment rate is 4.093%, what will the paper pay at maturity?

Solution: Let B  what will be paid at maturity

[( B  $7,840) / ($7,840)]  (365 / 182)  0.04093 [( B  $7,840) / ($7,840)]  2.0055  0.04093 ( B  $7,840)  2.0055  320.89 B  $7,840  160 B  $8,000 6. Your minimum discount rate bid of 0.35% for a $10,000 T-bill that matures in 91 days has been accepted. Calculate your annualized investment rate.

Solution: Since your bid was accepted, you will pay for this T-bill $9,991.16. We can calculate this price using the formula for the discount rate: 0.0035 = [($10,000 – P) / P] × 360/91 → P = $9,991.16 Therefore, your annualized investment rate will be 0.3548611% [($10,000 - $9,991.160) / $9,991.16] × 365/91 = 0.003548611

7.

The price of $8,000 face value commercial paper is $7,930. If the annualized discount rate is 4%, when will the paper mature? If the annualized investment rate is 4%, when will the paper mature?

Solution: Let N  when the paper matures Discount Rate: [($8,000  $7,930) / $8,000)]  (360 / N )  0.04

($70 / $8,000)  (360 / N )  0.04 ($0.00875)  (360 / N )  0.04 (360 / N )  0.04  (1/ $0.00875) (360 / N )  4.571429 N  78.75  79days Investment Rate: [($8,000  $7,930) /($7,930)]  (365 / N )  0.04

($70 / $7,930)  (365 / N )  0.04 (365 / N )  0.04  (1/ 0.008827) 365 / N  4.53155 N  80.55  81days

8. A $5,000 commercial paper issued by CMF Corp. matures in 182 days and sells for $4,995.

The investment rate on same maturity T-bills is currently 0.1%. Would you state that commercial paper issued by CMF Corp. is default free?

Solution: Commercial paper issued by CMF Corp. has an investment rate equal to 0.20075% [($5,000 - $4,995) / 4,995] × 365/182 = 0.0020075% This investment rate is more than double the investment rate of the same maturity T-bill. Therefore, we cannot state that this security is default free (assuming both instruments have the same liquidity).

9. The annualized discount rate on a particular money market instrument is 3.75%. The face value is $200,000 and it matures in 51 days. What is its price? What would be the price if it had 71 days to maturity?

Solution: Let B  the price with 51 days to maturity [($200,000  B) / ($200,000)]  (360 / 51)  0.0375 [($200,000  B)  (360 / 51)  0.0375  $200,000 ($200,000  B)  (360 / 51)  $7,500 ($200,000  B)  $7,500  (51 / 360) $200,000  B  $1,062.50 B  $198,937.50

If 71 days to maturity, then B  $198,520.83.

10. The annualized yield is 3% for 91-day commercial paper and 3.5% for 182-day commercial paper. What is the expected 91-day commercial paper rate 91 days from now?

Solution: Let A  the expected 91-day rate, 91 days from now.

Assume that the 182-day rate is the average of the current 91-day rate and the expected 91-day rate.

(3  A) / 2  3.5 3 A7 A4

11. In a Treasury auction of $2.1 billion par value 91-day T-bills, the following bids were submitted: Bidder

Bid Amount

Price per $100

1 2 3 4 5

$500 million $750 million $1.5 billion $1 billion $600 million

$99.40 $99.01 $99.25 $99.36 $99.39

If only these competitive bids are received, who will receive T-bills, in what quantity, and at what price?

Solution: Bidders 1, 4, and 5 will receive T-bills in the amount requested, all at $99.36.

12. If the Treasury also received $750 million in non-competitive bids, who will receive T-bills, in what quantity, and at what price?

Solution: All competitive bids are accepted at the highest yield paid to competitive bids.

Thus, all $750 million will be accepted at $99.36.

Chapter 12 The Bond Market Purpose of the Capital Market Capital Market Participants Capital Market Trading Types of Bonds Treasury Notes and Bonds Treasury Bond Interest Rates Treasury Inflation-Protected Securities (TIPS) Treasury STRIPS Agency Bonds Case: The 2007–2009 Financial Crisis and the Bailout of Fannie Mae and Freddie Mac Municipal Bonds Risk in the Municipal Bond Market Corporate Bonds Characteristics of Corporate Bonds Types of Corporate Bonds Financial Guarantees for Bonds Oversight of the Bond Markets Current Yield Calculation Current Yield Finding the Value of Coupon Bonds Finding the Price of Semiannual Bonds Investing in Bonds



Overview and Teaching Tips

Chapter 12 examines securities that have an original maturity that is greater than one year. These types of securities are traded in capital markets and the best-known securities are stocks and bonds. This chapter focuses on the characteristics of the bonds while the next chapter extends the capital market discussion to stocks. Capital markets are used for long-term financing and investments. The beginning of the chapter discusses the purpose of and the participants in the capital market so students will get a better understanding of the topic when it is discussed in depth in later sections. We explore two categories of capital markets: bonds and stocks. Show the students Table 12.1 because it gives a clear understanding of the different types of Treasury securities. Treasury securities are free of default risk, but not risk-free, and have a very low interest rate. Bonds issued by local, county, and state governments are municipal bonds and are used to finance public interest projects. Point out to students that municipal bonds are not free of default. Corporate bonds usually have a face value of $1,000 and can be redeemed at anytime.

The chapter concludes by showing how to compute the value of bonds. An example focuses specifically on valuing semiannual bonds. This valuation model can be used to show that interestrate risk will affect the wealth of investors in bonds.



Answers to End-of-Chapter Questions

1. Investors use capital markets for long-term investment purposes. They use money markets, which have lower yields, primarily for temporary or transaction purposes.

2. The primary capital market securities are stocks and bonds. Most of these are purchased and owned by households.

3. Firstly, bonds are safer assets than stock, since they have a higher priority of payment than stock. Should the firm be in trouble or has to be liquidated, bondholders will receive their payments before stockholders. Secondly, bond prices fluctuate less than stock prices, making it a better option for the risk-averse investor.

4. The idea that one individual could profit from the misadventures of another one (without the possibility of suffering a loss) is a concept that most modern societies do not accept. The legal impediment that forbids such a practice comes from an ethical perspective. In general, we do not accept this possibility because we feel that it is incorrect to benefit from the misfortune of another individual. This concept, however, did not translate to the financial market when investors could bet on the default of certain securities, most notable MBS. 5. Treasury bills mature in less than 1 year, Treasury notes mature in 1 to 10 years, and Treasury bonds mature in 10 to 30 years.

6. The risk that a bond’s price will change due to changes in market interest rates is called interest rate risk.

7. TRACE was created to make transactions in the bond market more transparent. Efforts to increase transparency and the flow of good quality information are precisely meant to reduce asymmetric information problems, which usually have negative consequences in financial market transactions. With TRACE, we can expect the prevalence of adverse selection and moral hazard problems to decrease in the bond markets.

8. Firms like having the flexibility to adjust their capital structure by paying off debt they no longer need. They also need to pay off debt to remove restrictive covenants. Call provisions permit both these actions at the issuer’s discretion.

9. A sinking fund contains funds set aside by the issuer of a bond to pay for the redemption of the bond when it matures. Because a sinking fund increases the likelihood that a firm will have the funds to pay off the bonds as required, investors like the feature. As a result, interest rates are lower on securities with sinking funds.

10. All companies that trade securities are required to be members of FINRA precisely to ensure that bond markets transactions comply with all the corresponding regulations. If some companies could trade securities without being under the scrutiny of FINRA, then the bond market would be prone to crisis created by the violation of rules that guide proper trading in securities.

11. Capital market securities may be sold in a public offering or in a private placement. In a public offering, investment bankers register the security with the SEC and market it through a network of brokerage houses. In a private placement, the firm or an investment banker sells the securities to a very limited number of investors, who each buy a large quantity.  Quantitative Problems 1. A bond pays $80 per year in interest (8% coupon). The bond has 5 years before it matures, at which time it will pay $1,000. Assuming a discount rate of 10%, what should be the price of the bond (Review Chapter 3)?

Solution: $924.18

2. Calculate the price of a bond that matures in 8 years, has a face value of $5,000, and has a coupon rate of 2% (paid semiannually) if the market interest rate is 1%. What is the price of the bond if the market interest rate drops to 0.5%?

Solution: In this case the semiannual coupon payment is (5,000 x 0.02)/2 = $50.

The price of the bond when market interest rate is 1% solves the following equation: P

50 50 50    (1  0.005) (1  0.005)2 (1  0.005)2



50 5,000  (1  0.005)16 (1  0.005)16

Using a financial calculator (or an Excel spreadsheet), P = $5,383.50 The price of the bond when market interest rate is 0.5% solves the following equation: P

50 50 50    2 (1  0.0025) (1  0.0025) (1  0.0025)2



50 5,000  16 (1  0.0025) (1  0.0025)16

Using a financial calculator (or an Excel spreadsheet), P = $5,587.44 3. Consider the two bonds described below:

Maturity Coupon Rate (Paid semiannually) Par Value

Bond A

Bond B

15 yrs 10%

20 yrs 6%

$1,000

$1,000

a. If both bonds had a required return of 8%, what would the bonds’ prices be? b. Describe what it means if a bond sells at a discount, a premium, and at its face amount (par value). Are these two bonds selling at a discount, premium, or par? c. If the required return on the two bonds rose to 10%, what would the bonds’ prices be?

Solution: a. Bond A  $1,172.92 Bond B  $802.07 b. Bond A is selling at a premium Bond B is selling at a discount c. Bond A  $1,000 Bond B  $656.82 4. A 2-year $1,000 par zero-coupon bond is currently priced at $819.00. A 2-year $1,000 annuity is currently priced at $1,712.52. If you want to invest $10,000 in one of the two securities, which is a better buy? You can assume: a. the pure expectations theory of interest rates holds, b. neither bond has any default risk, maturity premium, or liquidity premium, and c. you can purchase partial bonds.

Solution: With PV  $819; FV  $1,000; PMT  0; and N  2, the yield to maturity on the two-year zero-coupon bonds is 10.5%. For the two-year annuity, PV  $1,712.52; PMT  $1000; FV  0; and N  2 gives a yield to maturity of 11.00%. The two-year annuities are the better buy.

5.

Consider the following cash flows. All market interest rates are 12%.

Year

0

Cash Flow

1

2

3

4

160

170

180

230

a.

What price would you pay for these cash flows? What total wealth do you expect after 2½ years if you sell the rights to the remaining cash flows? Assume interest rates remain constant. b. Immediately after buying these cash flows, all market interest rates drop to 11%. What is the impact on your total wealth after 2½ years?

Solution: a.

Price 

160 170 180 230     $552.67 2 3 1.12 1.12 1.12 1.12 4

Expected Wealth  160  (1.12)1.5  170  (1.12)5 

180 230   $733.69 5 1.12 1.121.5

b. Expected Wealth  160  (1.11)1.5  170  (1.11).5 

180 230   $733.74 .5 1.11 1.111.5

Since you are holding the cash flows for their duration, you are essentially immunized from interest rate changes (in this simplistic example).

6.

The yield on a corporate bond is 10% and it is currently selling at par. The marginal tax rate is 20%. A par value municipal bond with a coupon rate of 8.50% is available. Which security is a better buy?

Solution: The equivalent tax-free rate  taxable interest rate  (1  marginal tax rate). In this case, 0.10  (1  0.20)  8%. The corporate bond offers a lower after-tax yield given the marginal tax rate, so the municipal bond is a better buy.

7. Suppose a municipal bond offers a yield to maturity of 5% and a same maturity corporate bond offers a 4% yield. For which values of the marginal tax rate would an investor would prefer to buy the corporate bond?

Solution: The marginal tax rate for which an investor would choose to buy the corporate bond satisfies the following equation: 0.05 × (1 – t) > 0.04 → 1- t > 0.04 / 0.05 → 1 – (0.04/0.05) > t → 0.2 > t Therefore, the investor would prefer to buy the corporate bond if she faces a marginal tax rate lower than 20%.

8.

M&E, Inc., has an outstanding convertible bond. The bond can be converted into 20 shares of common equity (currently trading at $52/share). The bond has 5 years of remaining maturity, a $1,000 par value, and a 6% annual coupon. M&E’s straight debt is currently trading to yield 5%. What is the minimum price of the bond?

Solution: The price must exceed the straight bond value or the value of conversion (you will see why in the next question).

If converted, the debt is worth $52  20  $1,040.

Assuming a 5% YTM is correct, the price of straight debt is computed as: PMT  60; N  5; FV  1000; I  5 Compute PV; PV  1,043.29 The bond must be trading for at least $1,043.29.

9. Assume the debt in the previous question is trading at $1,035. How can you earn a riskless profit from this situation (arbitrage)?

Solution: a.

Short 20 shares of M&E at $52/share.

Cash $1,0470 *

($1,035) $5 Convert the bond to shares, and use to close short position.

b. Purchase a convertible bond. c.

Assuming these transactions are completed simultaneously, you make a riskless profit of $5. *Typically, small investors cannot short stock and have use of the proceeds—the broker retains it as collateral. So, this doesn’t quite work. But the idea is correct.

10. Consider two $10,000 face value corporate bonds. One is currently selling for $9,980 and matures in 15 years. The other bond sells for $9,350 and matures in 3 years. Calculate the current yield for both bonds if both have a coupon rate equal to 5%. Which current yield is a better approximation of the yield to maturity? (Assume a yearly coupon payment.)

Solution: Current yield for bond that sells for $9,980 equals 5.01% = 500/9,980. Current yield for bond that sells for $9,350 equals 5.35% = 500/9,350. The first current yield is a better approximation of the yield to maturity of that bond, since the time to maturity is longer and the price of the bond is closer to $10,000.

11. A $5,000 corporate bond with an 8.625% coupon rate sells above par. Is the current yield higher, lower, or equal to the coupon rate? Is the current yield higher, lower, or equal to the yield to maturity?

Solution: Note that you cannot calculate the current yield, since you do not have data on the price of the bond. However, you know that the bond sells for more than $5,000, which means that the current yield will be lower than the coupon rate. Note that you cannot calculate the yield to maturity as you do not have data on the maturity of the bond. However, you know that the yield to maturity equals the coupon rate and the current yield when the bond sells at par. Since this bond sells above par, you can state that the coupon rate is higher than the current yield and higher than the yield to maturity: CR>CY>YTM (if the bond sells above par).

12. A 1-year discount bond with a face value of $1,000 was purchased for $900. What is the yield to maturity? What is the yield on a discount basis?

Solution: 900  1000/(1  YTM), or YTM  11.11% YDB  (1000 – 900)/1000  (360/365)  9.86%

13. A corporate bond sells at par and has a current yield equal to 5.625%. Another bond sells for $10,075, has a face value of $10,000 and has a coupon rate equal to 5.5%. Which bond has a higher yield to maturity?

Solution: The first bond has a yield to maturity equal to its current yield (and to its coupon rate), since it is selling at par. The second bond sells above par and has therefore a yield to maturity lower than its coupon rate. Therefore, the first bond has a higher yield to maturity.

14. Your company owns the following bonds: Bond

Market Value

Duration

A B C

$13 million $18 million $20 million

2 4 3

If general interest rates rise from 8% to 8.5%, what is the approximate change in the value of the portfolio?

Solution: Portfolio duration  2  (13/51)  4  (18/51)  3  (20/51)  3.09   Value  Duration  (i/(1  i))  Original Value   Value  3.09  (0.005/1.08)  $51 million  $729,583

Chapter 13 The Stock Market Investing in Stocks Common Stock vs. Preferred Stock How Stocks Are Sold Computing the Price of Common Stock The One-Period Valuation Model The Generalized Dividend Valuation Model The Gordon Growth Model Price Earnings Valuation Method How the Market Sets Security Prices Errors in Valuation Problems with Estimating Growth Problems with Estimating Risk Problems with Forecasting Dividends Mini-Case: Covid Impact on Stock Markets

Stock Market Indexes Mini-Case Box: History of the Dow Jones Industrial Average Buying Foreign Stocks Regulation of the Stock Market The Securities and Exchange Commission



Overview and Teaching Tips

Because the market for stocks is of such great interest to students, this chapter has been expanded over previous editions. It discusses theories of how stocks are priced and how information is incorporated into stock prices. Laying out the simple models of the one-period valuation model, the generalized dividend model, the Gordon model, and the P/E Valuation Method gives students the tools to understand how stock prices are determined. However, stock market valuation is by no means simple, and this is emphasized to the students in the section on errors in valuation, which outlines why it is so tricky to use these simple models.

Begin this chapter by defining equity and show the difference between stocks which represent ownership and bonds which represent no ownership of the company. Investors receive a return on their investment in one of two ways: (1) price of stock rises or (2) firms issue stockholder dividends. Stock is either common stock or preferred stock. With the increase of international trading, investors have gone to other countries to buy securities. This is a growing market to the United States.

Trading of the capital securities will occur in two types of exchanges: organized exchanges and over-the-counter exchanges. Popular organized exchanges are the New York Stock Exchange (also the largest), the American Stock Exchange, and the London Stock Exchange.

This chapter contains extensive discussion of stock valuation. This provides an excellent opportunity to discuss the efficient market hypothesis presented in Chapter 6.

Students should be instructed on the strengths and weaknesses of the stock indexes as well as the role of the SEC in their regulation.



Answers to End-of-Chapter Questions

1.

The value of any asset is the present value of its future cash flows. The value of a bond is the PV of the interest payments plus the PV of the final payment. Stocks are valued the same way. The price is the PV of the cash flows that stock is expected to generate for the investor.

2.

There are two cash flows from stock, periodic dividends, and a future sales price. Dividends are frequently changed when firm earnings either rise or fall. The future sales price is also difficult to estimate, since it depends on the dividends that will be paid at some date even farther in the future. Bond cash flows also consist of two parts, periodic interest payments and a final maturity payment. These payments are established in writing at the time the bonds are issued and cannot be changed without the firm defaulting and being subject to bankruptcy. Stock prices tend to be more volatile, since their cash flows are more subject to change.

3.

The use of the super display book system in the NYSE has the benefits of both speed and accuracy. Orders to trade stocks are handled electronically and can be executed at a much faster pace and with minimal probability of mistakes. However, being an automated trading system that handles high volumes of trades in a few minutes, one has to consider the potential impact that can have on the market a potential breakdown of this system.

4.

NASDAQ is a computer network that allows traders to monitor stocks traded on the overthe-counter market. It provides current bid and ask prices on about 4,000 actively traded securities.

5.

Weather-related events sometimes have substantial effects in harvests worldwide. Bad harvests can increase input prices (remember that many cereals are used to feed cattle) and reduce earnings for food manufacturing companies. However, you can hedge part of this risk by holding stock of both domestic and food manufacturing companies. So, for example, whenever bad climate conditions reduce earnings for companies located in the northern hemisphere, companies that produce food in the south hemisphere might be increasing their earnings and you have successfully reduced your exposure to climate events.

6.

At least 7 of the 30 firms are involved in high-technology products or services. This has increased the volatility of the Dow index in recent years as these firms were added.



Quantitative Problems

eBay, Inc., went public in September of 1998. The following information on shares outstanding was listed in the final prospectus filed with the SEC.1 In the IPO, eBay issued 3,500,000 new shares. The initial price to the public was $18.00 per share.

The final first-day closing price was $44.88.

1. If the investment bankers retained $1.26 per share as fees, what were the net proceeds to eBay? What was the market capitalization of new shares of eBay? Solution: Net Proceeds to eBay  (18.00  1.26)  3,500,000  $58,590,000.00 Market Cap  44.88  3,500,000  $157,080,000 2. Two common statistics in IPOs are underpricing and money left on the table. Underpricing is defined as percentage change between the offering price and the first day closing price.

Money left on the table is the difference between the first day closing price and the offering price, multiplied by the number of shares offered. Calculate the underpricing and money left on the table for eBay. What does this suggest about the efficiency of the IPO process?

Solution: Underpricing  ((44.88  18.00)/18.00)  149.33% MLOT  (44.88  18.00)  3,500,000  $94,080,000 3. The shares of Misheak, Inc., are expected to generate the following possible returns over the next 12 months: Return

Probability

5% 5% 10% 15% 25%

0.10 0.25 0.30 0.25 0.10

If the stock is currently trading at $25/share, what is the expected price in one year? Assume that the stock pays no dividends.

Solution: The expected return over the next 12 months is calculated as: 0.05  0.10  0.05  0.25  0.10  0.30  0.15  0.25  0.25  0.10  0.10 This suggests that the expected price is $25  (1.10)  $27.50 4. Sine Corp. stock sells for $75.00 and currently pays an annual dividend of $2.50 per share.

Calculate analysts’ projected price one year from today if the expected one year return is currently 3%.

Solution: If the expected one year return on Sine stock is 3%, we can write: (X+$2.50 – $75)/$75 = 0.03, where X is the expected sales price of Sine Stock one year from today. Solving yields X = $74.75.

5. Suppose Microsoft, Inc. was trading at $27.29 per share. At that time, it pays an annual dividend of $0.32 per share, and analysts have set a 1-year target price around $33.30 per share. What is the expected return on this stock?

1

This information is summarized from http://www.sec.gov/Archieves/edgar/data/1065088/0001012870-98-002475.txt

Solution: Expected return 

33.30  0.32  27.29  0.2319  23.2% 27.29

6. LaserAce is selling at $22.00 per share. The most recent annual dividend paid was $0.80.

Using the Gordon Growth model, if the market requires a return of 11%, what is the expected dividend growth rate for LaserAce? Solution: P0 

D0 (1  g) 0.80(1  g) , or 22.00  . Solving, g  7.1% ke  g 0.11  g

7. ANCAP Oil Co. stock has a PE ratio equal to 22, whereas VRC Oil has a PE ratio equal to 20. Both firms’ earnings per share are $1.12. Calculate both firms’ stock prices.

Solution: Using the information provided, ANCAP Oil Co. shares sell for 22 × $1.12 = $24.64 per share. VRC Oil sells for 20 × $1.12 = $22.40 8. Refer to the previous exercise. Calculate the premium paid by investors to hold ANCAP Oil Co. shares instead of VRC Oil. Which company do you think is a safer investment?

Solution: The premium paid is ($24.64/$22.4) – 1 = 10%. Based on this information only, one can argue that investors feel that ANCAP Oil Co.’s dividends represent a safer stream of payments than that of VRC Oil. 9. Gordon & Co.’s stock has just paid its annual dividend $1.10 per share. Analysts believe that Gordon will maintain its historic dividend growth rate of 3%. If the required return is 8%, what is the expected price of the stock next year?

Solution: P1 

D1 (1  g) 1.133(1.03)   $23.34 ke  g 0.08  0.03

10. Macro Systems just paid an annual dividend of $0.32 per share. Its dividend is expected to double for the next four years (D1 through D4), after which it will grow at a more modest pace of 1% per year.

If the required return is 13%, what is the current price?

Solution: P0 

0.64 1.28 2.56 5.12 5.12(1  0.01) 1       $32.91 2 3 4 1.13 1.13 1.13 1.13 0.13  0.01 1.134

11. Nat-T-Cat Industries just went public. As a growing firm, it is not expected to pay a dividend for the first five years. After that, investors expect Nat-T-Cat to pay an annual dividend $1.00 per share (i.e., D6  1.00), with no growth. If the required return is 10%, what is the current stock price?

Solution: P5 

D6 (1  g) 1.00(1.00)   $10.00 ke  g 0.10  0.00

so, P0  P5 /(1.10)5  $6.21

12. Calculate the stock price of OSE Water Co. if the difference between the required rate of return on this investment and the expected growth rate of dividends is 3.6% and dividends per share are $1.728.

Solution: According to the Gordon valuation model, OSE Water Co. stock sells for 1.728/0.036 = $48.

13. Refer to the previous exercise. What is the implicit required rate of return if dividends are expected to grow at a 5% annual rate?

Solution: According to the Gordon valuation model, the implicit required rate of return is: 5% + 3.6% = 8.6%.

14. Consider the following security information for four securities making up an index:

Security 1 2 3 4

Price time  0 time  1 8 22 35 50

13 25 30 55

Shares Outstanding 20 million 50 million 120 million 75 million

What is the change in the value of the index from time  0 to time  1 if the index is calculated using a value-weighted arithmetic mean?

Solution: For a value-weighted arithmetic mean, the change is calculated as follows: First, the market value at time  0 is calculated as:

Security 1 2 3 4

Price time  0 time  1 8 22 35 50

13 25 30 55

Shares Outstanding

Market Value

20 million 50 million 120 million 75 million

$ 160 $1,100 $4,200 $3,750 $9,210

The change is then calculated as: 13  8 160 25  22 1100 30  35 4200 55  50 3750   8  9210  22  9210  35  9210  50  9210   0.0027  

Index1  Index0  1.0027 15. An index had an average (geometric) mean return over 20 years of 3.8861%. If the beginning index value was 100, what was the final index value after 20 years?

Solution:

The actual return over the 20 years is (1.038861)20  2.143625 So, the final index value is 214.3625

16.

Calculate the dividend paid by a share of stock that you buy today for $55 and you expect to sell one year from today at $56 if you want to earn a one year return equal to 3.5%.

Solution: According to the information given, the one-year dividend D solves the following equation: ($56 + D – $55)/$55 = 0.035. Solving this equation yields D = $0.925.

17. The projected earnings per share for Risky Ventures, Inc., is $3.50. The average PE ratio for the industry composed of Risky Ventures’ closest competitors is 21. After careful analysis, you decide that Risky Ventures is a little more risky than average, so you decide a PE ratio of 23 better reflects the market’s perception of the firm. Estimate the current price of the firm’s stock.

Solution:

23  $3.5  $80.50

Chapter 14 The Mortgage Markets What Are Mortgages?

Characteristics of the Residential Mortgage Mortgage Interest Rates Case: The Discount Point Decision Loan Terms Mortgage Loan Amortization Types of Mortgage Loans Insured and Conventional Mortgages Fixed- and Adjustable-Rate Mortgages Other Types of Mortgages Mortgage-Lending Institutions Loan Servicing E-Finance Box: Borrowers Shop the Web for Mortgages Secondary Mortgage Market Securitization of Mortgages What Is a Mortgage-Backed Security?

Types of Pass-Through Securities Subprime Mortgages and CDOs The Real Estate Bubble Mini-Case: Has Covid Led to a Housing Price Bubble?



Overview and Teaching Tips

This chapter deals with a subject that will affect all of us eventually, mortgages. A mortgage is a long-term loan secured by real estate. Individuals are usually the primary borrowers who use

mortgages to finance their homes or small businesses. The characteristics of residential mortgages are covered in depth so students will get a full understanding of the topic at hand. A detailed section covers interest rates on mortgages and how they are determined for different types of rates, terms, and discount points. There is an excellent application in this section to review discount points with the students. One requirement for most mortgages is collateral, which is usually a piece of real property pledged to the lender for security on the loan. In addition, the borrower is required to make a down payment that is determined by the type of mortgage loan.

Computing the payment of mortgage loans is explained in the next section along with an application.

Mortgage loans are available in several different types, including insured and conventional mortgages, fixed- and adjustable-rate mortgages, growing equity mortgages, and second mortgages. Since many institutions do not want to back mortgage loans, the creation of the mortgage-backed security was established. The government created two more institutions to offer new securities backed by both insured and uninsured mortgages. Mortgage pass-throughs are the most common type of these mortgages. GNMA pass-through securities, FHLMC pass-throughs, and private pass-through securities are three types of mortgage pass-through securities that exist.

Over the years, mortgage-backed securities have created several benefits for borrowers and lenders. The securitization of mortgages has also created problems. By putting the investor one more layer removed from the borrower, abuses have occurred in the industry where loans have been made to borrowers, who can’t afford the payments. This practice led to mortgage industry problems beginning in 2006. The category of loans is referred to as subprime loans. The role of subprime mortgages and CDOs is very relevant to the current economic and real estate climate.



Answers to End-of-Chapter Questions

1. In the 1870’s commercial banks could not offer mortgage loans and it was therefore quite difficult to finance the purchase of a house. However, in the years to come mortgage brokers would originate and sell mortgages to commercial banks. This process of financial innovation and changes in banking regulations did not stop. Today, one family can buy a house without having to save most of their lives to do it.

2. Balloon loans require that a large final payment be made to pay off the remaining principal balance. Amortizing loans are structured so that equal monthly payments are made such that the total of all payments cover both interest and principal over the lifetime of the loan.

3. After the further regulation restriction of mortgage lending imposed by the National Banking Act of 1863, mortgage loans were primarily made by brokers. One could track to this time the early beginnings of the originate-to-distribute model applied to mortgage loans, since mortgage brokers were selling these loans to savings banks.

4. Discount points paid when a loan is initiated result in a reduced interest rate. If the borrower plans to hold on to the loan long enough for the value of the reduced interest rate to exceed the up-front cost of the points, it is a good idea to elect to pay them.

5. It is quite probable that you will not be able to get the mortgage loan to buy a house in town if you do not have the land title to provide as collateral to the bank. This might not seem to be a big problem in a few countries. However, in many countries around the world this is precisely the barrier that prevents many farmers to apply for loans to acquire technology (e.g., tractors) and increase their productivity and escape poverty. This problem is sometimes referred to as the ―tyranny of collateral.‖ 6. The down payment means that if the borrower chooses not to make payments on the loan, the borrower will suffer some financial loss. This increases the likelihood that the borrower will continue to make the promised payments.

7. Lenders may require private mortgage insurance.

8. Most mortgage loans are sold to government agencies. These agencies establish criteria for which loans they will accept. If the loans do not meet these criteria, the initiating bank cannot sell them.

9. It would be appropriate to take out a second mortgage only if you have built sufficient equity over the years and therefore the amount of the loan is low relative to the price of the house.

In this case, only the incentives for the borrower are correctly designed; otherwise (i.e., if you have almost nothing to lose) the moral hazard problem indicates that you have an incentive not to pay back this mortgage.

10. The loan is an adjustable-rate mortgage on which the interest rate is set at 2 percentage points above the prevailing Treasury bill rate. The interest rate can increase or decrease no more than 2% in one year and no more than 6% over its life.

11. The goal of the graduated-payment loan is to let the borrower qualify by reducing the first few years’ payments, whereas the goal of the growing-equity loan is to let the borrower pay off early.

12. The IRS allows the interest paid on first and second mortgage loans to be deducted from income before computing the amount of taxes due. This tax shield lowers the effective rate of interest on the mortgages.

13. The bank accepts the home as security and advances money each month. When the borrower dies, the borrower’s estate sells the property to retire the debt.

14. In this case, you could apply for a graduated-payment or a growing-equity mortgage. In both cases, monthly payments rise over the years (usually after 3 to 5 years of constant monthly payments). Since you are expecting to increase your income once you graduate as an MD, then this should not represent a problem to you.

15. The payments on a pool of mortgages are sent by the borrowers to a trustee, who then passes the payments through to holders of securities that are backed by the pass-through.



Quantitative Problems

1. Compute the required monthly payment on a $150,000 30-year fixed-rate mortgage with a nominal interest rate of 8%. What is the balance due at the end of the first year?

Solution: The monthly mortgage payment is computed as: N = 360; I = 8/12; PV = 150,000; FV = 0 Compute PMT; PMT = $1,100.65 Amortization schedule for the first year: Month 1 2 3 4 5 6 7 8 9 10 11 12

Beginning Balance $150,000 $149,899.3531 $149,798.0353 $149,696.042 $149,593.3688 $149,490.011 $149,385.9642 $149,281.2238 $149,175.7851 $149,069.6435 $148,962.7942 $148,855.2327

Payment

Interest Paid

Principal Paid

Ending Balance

$1,100.647 $1,100.647 $1,100.647 $1,100.647 $1,100.647 $1,100.647 $1,100.647 $1,100.647 $1,100.647 $1,100.647 $1,100.647 $1,100.647

$1,000 $999.3290209 $998.6535687 $997.9736134 $997.2891251 $996.6000735 $995.9064282 $995.2081587 $994.505234 $993.7976232 $993.0852949 $992.3682178

$100.6468608 $101.3178399 $101.9932922 $102.6732474 $103.3577358 $104.0467873 $104.7404326 $105.4387021 $106.1416268 $106.8492377 $107.5615659 $108.278643

$149,899.3531 $149,798.0353 $149,696.042 $149,593.3688 $149,490.011 $149,385.9642 $149,281.2238 $149,175.7851 $149,069.6435 $148,962.7942 $148,855.2327 $148,746.954

2. Refer to Problem 1. What is the total amount of interest paid over the life of the loan?

Solution: Over the life of the loan, the total amount paid would be $1,100.647 x 360 = $396,232.92, so the total amount of interest paid will be $396,232.92 – $150,000 = $246,232.92.

3. Compute the face value of a 30-year fixed-rate mortgage with a monthly payment of $1,200, assuming a nominal interest rate of 6%. Compute the face value if the interest rate is now 7%. What is the difference in maximum house prices if both mortgages require 5% down?

Solution: The face value is computed as follows: N = 360; I = 6/12; PV = 1,200; FV = 0; Compute PV; PV = $200,149.94. The maximum house price is $200,149.94/0.95 = $210,684.14.

The face value is computed as follows: N = 360; I = 7/12; PV = 1,200; FV = 0; Compute PV; PV = $180,369.08. The maximum house price is $180,369.08/0.95 = $189,862.19.

The difference in maximum house prices is therefore: $210,684.14 – $189,862.19 = $20,821.95.

4. Consider a $180,000 30-year fixed-rate mortgage with a nominal interest rate of 6%.

Suppose that after paying the first 12 monthly payments, the borrower decides that she cannot pay more than $900 per month. Determine the number of months necessary to pay off the mortgage.

Solution: First, compute the monthly mortgage payment of the original mortgage: N = 360; I = 6/12; PV = $180,000; FV = 0. Compute PMT; PMT = $1,079.19. After the first year, the balance due is $177,789.60, according to the amortization schedule for the first 12 months: Mont h 1 2 3 4 5 6 7 8 9 10 11

Beginning Balance $180,000 $179,820.8091 $179,640.7222 $179,459.7348 $179,277.8425 $179,095.0408 $178,911.3251 $178,726.6908 $178,541.1333 $178,354.648 $178,167.2303

Payment $1,079.19 1 $1,079.19 1 $1,079.19 1 $1,079.19 1 $1,079.19 1 $1,079.19 1 $1,079.19 1 $1,079.19 1 $1,079.19 1 $1,079.19 1 $1,079.19 1

Interest Paid

Principal Paid

$900

$179.1909453

$899.104045 3 $898.203610 8 $897.298674 1 $896.389212 7 $895.475204 1 $894.556625 4 $893.633453 8 $892.705666 3 $891.773239 9 $890.836151 4

$180.0869 $180.9873345 $181.8922712 $182.8017325 $183.7157412 $184.6343199 $185.5574915 $186.485279 $187.4177054 $188.3547939

Ending Balance $179,820.809 1 $179,640.722 2 $179,459.734 8 $179,277.842 5 $179,095.040 8 $178,911.325 1 $178,726.690 8 $178,541.133 3 $178,354.648 $178,167.230 3 $177,978.875 5

$177,978.8755

12

$1,079.19 1

$889.894377 4

$189.2965678

$177,789.578 9

To determine the number of months to pay off the mortgage with a monthly payment of $900: PMT = 900; I = 6/12; PV = 177,789.6; FV = 0. Compute N; N = 882.15, or around 73.5 years!

5. Consider a 30-year fixed-rate mortgage for $200,000 at a nominal rate of 8%. A mortgage broker closes this deal on August 30th. If the broker wants to sell this mortgage to a bank on August 31st and rates have decreased to 7.5%, how much would this broker ask for the mortgage?

Solution: First compute the monthly mortgage payment: N = 360; I = 8/12; PV = $200,000; FV = 0 Compute PMT; PMT = $1,467.53 In a 7.5% market the loan is worth: N = 360; I = 7.5/12; PMT = $1,467.53; FV = 0; Compute PV; PV = $209,882.52.

The value of the mortgage has increased around (($209,882.52 / $200,000) – 1) x 100 = 4.94% 6.

Consider a 30-year, fixed-rate mortgage for $100,000 at a nominal rate of 9%. What is the duration of the loan? If interest rates increase to 9.5% immediately after the mortgage is made, how much is the loan worth to the lender?

Solution: The monthly mortgage payment is computed as: N  360; I  9/12; PV  100,000; FV  0 Compute PMT; PMT  $804.62 The duration calculation is exactly the same as those done in previous chapters.

However, there are 360 payments to consider. Using a spreadsheet package, the duration can be calculated as 108 months, or roughly 9 years. i 0.005  P  9   100,000  $4,128 1 i 1.09 From the interest rate change, the value of the mortgage has dropped by over 4.1%. P  Duration 

7. Consider a 5-year balloon loan for $250,000. The bank requires a monthly payment equal to $1,450, and the interest rate is 6%. How much will the borrower owe when the balloon payment is due?

Solution: Using an Excel spreadsheet we can build the amortization schedule: Mont h

Beginning Balance

1

$250,000.00

2

$249,800.00

3

$249,599.00

4

$249,397.00

5

$249,193.98

Payment $1,450.0 0 $1,450.0 0 $1,450.0 0 $1,450.0 0 $1,450.0 0

Interest Paid

Principal Paid

$1,250.00

$200.00

$1,249.00

$201.00

$1,248.00

$202.01

$1,246.98

$203.02

$1,245.97

$204.03

Ending Balance $249,800.0 0 $249,599.0 0 $249,397.0 0 $249,193.9 8 $248,989.9 5

6

$248,989.95

--

--

55

$237,636.66

56

$237,374.85

57

$237,111.72

58

$236,847.28

59

$236,581.51

60

$236,314.42

$1,450.0 0 -$1,450.0 0 $1,450.0 0 $1,450.0 0 $1,450.0 0 $1,450.0 0 $1,450.0 0

$1,244.95

$205.05

--

--

$1,188.18

$261.82

$1,186.87

$263.13

$1,185.56

$264.44

$1,184.24

$265.76

$1,182.91

$267.09

$1,181.57

$268.43

$248,784.9 0 -$237,374.8 5 $237,111.7 2 $236,847.2 8 $236,581.5 1 $236,314.4 2 $236,045.9 9

Just after making the 60th payment, the borrower must make a balloon payment of $236,046.

8. A 30-year, variable-rate mortgage offers a first-year teaser rate of 2%. After that, the rate starts at 4.5%, adjusted based on actual interest rates. The maximum rate over the life of the loan is 10.5%, and the rate can increase by no more than 200 basis points a year. If the mortgage is for $250,000, what is the monthly payment during the first year? Second year?

What is the maximum payment during the 4th year? What is the maximum payment ever?

Solution: The required payment for the 1st year is computed as: N  360; I  2/12; PV  250,000; FV  0 Compute PMT; PMT  $924.05 The required payment for the 2nd year is computed as: N  348; I  4.5/12; PV  $243,855.29; FV  0 Compute PMT; PMT  $1,255.84 The maximum required payment for the 4th year is computed as: N  324; I  8.5/12; PV  $236,551.31; FV  0 Compute PMT; PMT  $1,865.02 The maximum possible payment would occur in the 5th year if the 10.5% rate is required. The payment would be: N  312; I  10.5/12; PV  $234,187.24; FV  0 Compute PMT; PMT  $2,193.93 9. Consider a 30-year fixed-rate mortgage for $500,000 at a nominal rate of 6%. What is the difference in required payments between a monthly payment and a bimonthly payment (payments made twice a month)?

Solution: The required payment for monthly payments is computed as: N  360; I  6/12; PV  500,000; FV  0 Compute PMT; PMT  $2,997.75 The required payment for bimonthly payments is computed as: N  720; I  6/24; PV  500,000; FV  0 Compute PMT; PMT  $1,498.21 Notice that this saves about $1.33/month. Often, mortgages with bi-monthly payments (automatically debited from your checking account) will offer a lower rate as well.

10. Consider the following options available to a mortgage borrower: Loan Amount Option 1 Option 2 Option 3

$100,000 $150,000 $125,000

Interest Rate 6.75% 6.25% 6.0%

Type of Mortgage

Discount Point

30-yr fixed 30-yr fixed 30-yr fixed

none 1 2

What is the effective annual rate for each option?

Solution: Option 1: (1  0.0675/12)12  1  0.069628 Option 2: First, compute the effective monthly rate based on the points as follows: N  360; I/Y  6.25/12; PV  150,000; compute PMT  923.58 PMT  923.58; N  360; PV  148,500; compute I/Y  0.528789 Based on this, (1  0.00528789)12  1  0.065333

Option 3: First, compute the effective monthly rate based on the points as follows: N  360; I/Y  6/12; PV  125,000; compute PMT  749.44 PMT  749.44; N  360; PV  122,500; compute I/Y  0.515792 (1  0.00515792)12  1  0.063681 11. Two mortgage options are available: a 15-year fixed-rate loan at 6% with no discount points, and a 15-year fixed-rate loan at 5.75% with 1 discount point. Assuming you will not pay off the loan early, which alternative is best for you? Assume a $100,000 mortgage.

Solution: Determine the effective annual rate for each alternative.

15-year fixed-rate loan at 6% with no discount points (1  0.06/12)12 1  0.061678 15-year fixed-rate loan at 5.75% with 1 discount point N  180; I  5.75/12; PV  $100,000; FV  0 Compute PMT; PMT  $830.41 PMT  830.41; N  180; PV  99,000; FV  0 Compute I; I  0.4921841 (1  0.004921841)12 1  0.060687 Based on these, you will pay a lower effective rate by paying points now.

12. Two mortgage options are available: a 30-year fixed-rate loan at 6% with no discount points, and a 30-year fixed-rate loan at 5.75% with one discount point. How long do you have to stay in the house for the mortgage with points to be a better option? Assume a $100,000 mortgage.

Solution: The two loans have the same effective rate at the point of indifference.

30-year fixed-rate loan at 6% with no discount points: This option has an effective monthly rate of 0.5%. Use this to back into N as follows: N  360; PV  99,000; FV  0; I  6/12 Compute PMT; PMT  593.55 I  5.75/12; PV  $100,000; FV  0; PMT  593.55 Compute N; N  345 You will have to live in the house for more than 345 months (28.75 years) for the mortgage with points to be a cheaper option.

13. Two mortgage options are available: a 30-year fixed-rate loan at 6% with no discount points, and a 30-year fixed-rate loan at 5.75% with points. If you are planning on living in the house for 12 years, what is the most you are willing to pay in points for the 5.75% mortgage? Assume a $100,000 mortgage.

Solution: 30-year fixed-rate loan at 6% with no discount points: This option has an effective monthly rate of 0.5%.

I  6.0/12; PV  $100,000; FV  0; N  360 Compute PMT; PMT  599.55 Use this to back into points as follows: I  5.75/12; PV  $100,000; FV  0; N  360 Compute PMT; PMT  583.57 The difference over 12 years is worth: N  244; FV  0; I  6/12; PMT  599.55  583.57 Compute PV; PV  2,249.65

If the points on the 5.75% loan are less than 2.249, the 5.75% mortgage is a cheaper option over the life of the loan.

14. A mortgage on a house worth $350,000 requires what down payment to avoid PMI insurance?

Solution: $350,000 × 20% = $70,000. With this down payment, homeowners are usually allowed to make their own property tax payments, instead of including it with their monthly mortgage payment.

15. Consider a 30-year graduated-payment mortgage on a $250,000 mortgage with yearly payments. The stated interest rate on the mortgage is 6%, but the 1st annual payment is calculated assuming a 3% rate for the life of the loan. Thereafter, the annual payment will grow by 3.151222%. Develop an amortization table for this loan, assuming the initial payment is based on 30 years and the loan pays off in 15 years.

Solution: The payment for the 1st year is calculated as: I  3; PV  $250,000; FV  0; N  30 Compute PMT; PMT  12,754.81 The year 2 payment will be 12,754.81  (1.03151222)  12,156.75 The year 3 payment will be 13,156.75  (1.03151222)  13,571.35 Etc. The amortization table is:

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Beginning Balance

Payment

Interest

Principal

Ending Balance

$250,000.00 $252,245.19 $254,223.16 $255,905.21 $257,260.52 $258,256.00 $258,856.18 $259,022.99 $258,715.63 $257,890.40 $256,500.50 $254,495.79 $251,822.66 $248,423.72 $244,237.61 $239,198.71 $233,236.90 $226,277.26 $218,239.73 $209,038.84 $198,583.32 $186,775.76 $173,512.20 $158,681.72 $142,165.99

$12,754.81 $13,156.74 $13,571.34 $13,999.00 $14,440.14 $14,895.18 $15,364.56 $15,848.74 $16,348.16 $16,863.33 $17,394.73 $17,942.88 $18,508.30 $19,091.54 $19,693.15 $20,313.73 $20,953.86 $21,614.16 $22,295.27 $22,997.85 $23,722.56 $24,470.11 $25,241.22 $26,036.62 $26,857.10

$15,000.00 $15,134.71 $15,253.39 $15,354.31 $15,435.63 $15,495.36 $15,531.37 $15,541.38 $15,522.94 $15,473.42 $15,390.03 $15,269.75 $15,109.36 $14,905.42 $14,654.26 $14,351.92 $13,994.21 $13,576.64 $13,094.38 $12,542.33 $11,915.00 $11,206.55 $10,410.73 $ 9,520.90 $ 8,529.96

($ 2,245.19) ($ 1,977.97) ($ 1,682.05) ($ 1,355.31) ($ 995.49) ($ 600.18) ($ 166.81) $ 307.36 $ 825.23 $ 1,389.91 $ 2,004.70 $ 2,673.13 $ 3,398.94 $ 4,186.11 $ 5,038.90 $ 5,961.81 $ 6,959.65 $ 8,037.53 $ 9,200.89 $10,455.52 $11,807.56 $13,263.56 $14,830.49 $16,515.72 $18,327.14

$252,245.19 $254,223.16 $255,905.21 $257,260.52 $258,256.00 $258,856.18 $259,022.99 $258,715.63 $257,890.40 $256,500.50 $254,495.79 $251,822.66 $248,423.72 $244,237.61 $239,198.71 $233,236.90 $226,277.26 $218,239.73 $209,038.84 $198,583.32 $186,775.76 $173,512.20 $158,681.72 $142,165.99 $123,838.86

26 27 28 29 30 16.

$123,838.86 $103,565.77 $ 81,203.29 $ 56,598.57 $ 29,588.67

$27,703.42 $28,576.42 $29,476.93 $30,405.81 $31,363.96

$ 7,430.33 $ 6,213.95 $ 4,872.20 $ 3,395.91 $ 1,775.32

$20,273.09 $22,362.47 $24,604.73 $27,009.89 $29,588.64

$103,565.77 $ 81,203.29 $ 56,598.87 $ 29,588.67 $ 0.00

Consider a growing equity mortgage on a $250,000 mortgage with yearly payments. The stated interest rate on the mortgage is 6%, but this only applies to the 1st annual payment. Thereafter, the annual payment will grow by 5.5797%.

Develop an amortization table for this loan, assuming the initial payment is based on 30 years and the loan pays off in 15 years.

Solution: The payment for the 1st year is calculated as: I  6; PV  $250,000; FV  0; N  30 Compute PMT; PMT  18,162.23 The year 2 payment will be 18,162.23  (1.055797)  17,175.63 The year 3 payment will be 19,175.63  (1.055797)  20,245.57 Etc. The amortization table is:

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 17.

Beginning Balance

Payment

Interest

Principal

Ending Balance

$250,000.00 $246,837.77 $242,472.41 $236,775.19 $229,606.49 $220,815.00 $210,236.79 $197,694.42 $182,995.84 $165,933.36 $146,282.46 $123,800.53 $ 98,225.54 $ 69,274.57 $ 36,642.33

$18,162.23 $19,175.63 $20,245.57 $21,375.21 $22,567.88 $23,827.10 $25,156.58 $26,560.25 $28,042.23 $29,606.90 $31,258.88 $33,003.03 $34,844.50 $36,788.72 $38,841.42

$15,000.00 $14,810.27 $14,548.34 $14,206.51 $13,776.39 $13,248.90 $12,614.21 $11,861.67 $10,979.75 $ 9,956.00 $ 8,776.95 $ 7,428.03 $ 5,893.53 $ 4,156.47 $ 2,198.54

$ 3,162.23 $ 4,365.36 $ 5,697.22 $ 7,168.70 $ 8,791.49 $10,578.20 $12,542.38 $14,698.58 $17,062.48 $19,650.90 $22,481.93 $25,575.00 $28,950.96 $32,632.24 $36,642.88

$246,837.77 $242,472.41 $236,775.19 $229,606.49 $220,815.00 $210,236.79 $197,694.42 $182,995.84 $165,933.36 $146,282.46 $123,800.53 $ 98,225.54 $ 69,274.57 $ 36,642.33 $ 0.00

Rusty Nail owns his house free and clear, and it’s worth $400,000. To finance his retirement, he acquires a reverse annuity mortgage (RAM) from his bank. The RAM provides a fixed monthly payment over 15 years on 70% of the value of his home at 5%. The payments are made at the beginning of the month. How much does Rusty get each month?

Solution: This is a simple annuity due. The payments are: PV  280,000; I  5/12; N  180; FV  0; Calculator in BEGIN mode.

Compute PMT; PMT  2,205.03

Rusty will get $2,205.03 each month for 15 years. After that, he will owe $280,000. Typically, this forces the sale of the house, unless the contract specifies otherwise.

18. You are working with a pool of 1,000 mortgages. Each mortgage is for $100,000 and has a stated annual interest rate (nominal) of 6.00%. The mortgages are all 30-year fixed rate fully amortizing. Mortgage servicing fees are currently 0.25% annually. Complete the following table: (1) (2) (3) (4) (5) (6) Beginning Required Expected Servicing Balance Payment Interest Principal Prepayment Fees

Month 1 2

100,000,000

500,000

99,551

16,665 33,322

(7) Ending Balance 99,750,430

Solution: (1) (2) (3) (4) (5) (6) (7) Beginning Require Expected Servicin Ending Balance d Interes Princip Prepayme g Balance Mont Paymen t al nt Fees h t 1 2

100,000,00 599,551 500,00 99,551 0 0 99,883,784 599,451 499,41 100,032 9

16,665

20,833

33,322

20,809

99,883,78 4 99,750,43 0

For month 1: The required payment is: PV  100,000,000; I  6/12; N  360; FV  0; Compute PMT; PMT  599,551 Servicing Fees are: 0.0025/12  100,000,000  20,833 Ending Balance  100,000,000 – 99,551 – 16,665  99,883,784 For month 2: The required payment is: PV  99,883,784; I  6/12; N  359; FV  0; Compute PMT; PMT  599,451 Note this is valid with a pool of mortgages. The assumption is that complete mortgages are prepaying and leaving the pool. This will reduce the total monthly payment from the remaining mortgages in the pool.

Servicing Fees are: 0.0025/12  99,883,784  20,809 Ending Balance  99,883,784  100,032  33,322  99,750,430

Chapter 15 The Foreign Exchange Market Foreign Exchange Market What Are Foreign Exchange Rates?

Why Are Exchange Rates Important?

How Is Foreign Exchange Traded?

Exchange Rates in the Long Run Following the Financial News: Foreign Exchange Rates Law of One Price Theory of Purchasing Power Parity Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates Factors That Affect Exchange Rates in the Long Run Exchange Rates in the Short Run: A Supply and Demand Analysis Supply Curve for Domestic Assets Demand Curve for Domestic Assets Equilibrium in the Foreign Exchange Market Explaining Changes in Exchange Rates Shift in the Demand for Domestic Assets Recap: Factors That Change the Exchange Rate Case: Effect of Changes in Interest Rates on the Equilibrium Exchange Rate Case: Brexit and the British Pound The Practicing Manager: Profiting from Foreign Exchange Forecasts



Overview and Teaching Tips

Chapter 15 explains behavior in the foreign exchange market by using a modern asset-market approach to exchange rate determination. This asset-market approach is now the dominant method of analyzing exchange rate movements in the literature, and it has major advantages over the more conventional treatment of the foreign exchange market typically found in financial markets and institutions textbooks.

As the first case in the chapter indicates, the asset-market approach, in contrast to earlier approaches emphasizing import and export demand, can be used to explain a feature of the foreign exchange market that has received much attention in the press in recent years: the high volatility of exchange rates. This phenomenon is not well explained by the earlier flow approach because it does not predict that exchange rates should be highly volatile.

The asset-market approach is developed in several steps. First, the long-run determinants of the exchange rate are laid out, and then the information about the long-run determinants is embedded in a model of the short-run determination of exchange rates. The key idea that must be transmitted to the student is that the demand for domestic currency (say dollar) assets is determined by the relative expected return on these assets.

To help students achieve an intuitive grasp of how the relative expected return on domestic assets, and hence how the demand curve shifts, tell them to put themselves in the shoes of an investor who is thinking about putting his or her money into foreign or domestic assets. When a factor changes, have them ask themselves whether at the same exchange rate, they would earn a higher expected return on domestic assets—if so, the demand curve has shifted to the right. This kind of thinking will help them manipulate the demand curve so they can predict which way the exchange rate changes. Several summary tables in the chapter should help students master the material, and I have found that using them in class helps greatly in clarifying the discussion.

The four cases in the chapter, on the effect of interest rates and money growth on the exchange rate, why exchange rates are so volatile, the relationship between the value of the dollar and interest rates, the global financial crisis and the dollar, and the Practicing Manager discussion of how financial institutions use foreign exchange forecasts to increase profits, can all be used in class to show students that the material they have learned has practical uses.



Answers to End-of-Chapter Questions

1.

Assuming you have to buy euros with U.S. dollars before you travel or that you use a credit card that automatically converts euros into U.S. dollars at the new exchange rate, you would be less willing to visit Rome and Paris, since goods and services will be 15% more expensive to you and your family.

2. False. Although a weak currency has the negative effect of making it more expensive to buy foreign goods or to travel abroad, it may help domestic industry. Domestic goods become cheaper relative to foreign goods, and the demand for domestically-produced goods increases. The resulting higher sales of domestic products may lead to higher employment, a beneficial effect on the economy.

3. The dollar depreciation makes exports cheaper abroad, and so exports increase. On the other hand, the dollar depreciation makes imports more expensive, so imports decline.

4. It predicts that the value of the yen will fall 5% in terms of dollars.

5. In the long run, the fall in the demand for a country’s exports leads to a depreciation of its currency, but the higher tariffs lead to an appreciation. Therefore, the effect on the exchange rate is uncertain.

6. Even though the Japanese price level rose relative to the American, the yen appreciated because the increase in Japanese productivity relative to American productivity made it possible for the Japanese to continue to sell their goods at a profit due to the high value of the yen.

7. The dollar will appreciate. Because expected U.S. inflation falls as a result of the announcement, there will be an expected appreciation of the dollar, and so the expected return on dollar assets will rise. As a result, the demand curve will shift to the right and the equilibrium value of the dollar will rise.

8. The pound depreciates but overshoots, declining by more in the short run than in the long run.

Consider Britain to be the domestic country. The rise in the money supply leads to a higher domestic price level in the long run, which leads to a lower expected future exchange rate. In addition, the rise in the money supply lowers the domestic interest rate on pound assets. Both of these changes lower the expected return on pound assets at any given exchange rate, shifting the demand curve to the left. The short-run outcome is a lower value of the pound.

However, in the long run, the domestic interest rate returns to its previous value, and the demand curve shifts back to the right somewhat. The exchange rate rises to some extent but still remains below its initial level.

9. The Indian rupee will appreciate. The announcement of tariffs will raise the expected future exchange rate for the rupee, and so increase the expected appreciation of the rupee. This means that the demand for rupee-denominated assets will increase, shifting the demand curve to the right, and the rupee exchange rate therefore rises.

10.

When investors decide to buy T-Bills since it is the only safe asset to hold, the demand for U.S. dollar-denominated assets increases sharply and the demand curve shifts to the right. As a result, the U.S. exchange rate increases.

11. The dollar will appreciate. The increase in U.S. productivity raises the expected future exchange rate and thus raises the expected return on dollar assets at any exchange rate. The resulting rightward shift of the demand curve leads to a rise in the equilibrium exchange rate.

12. The peso will depreciate. Consider Mexico to be the domestic country. An increased demand for imports would lower the expected future exchange rate and result in a lower expected appreciation of the peso. The resulting lower expected return on peso assets at any given exchange rate would then shift the demand curve to the left, leading to a fall in the peso exchange rate.

13. The dollar will depreciate. The drop of expected inflation in Europe, which leads to a decline in the foreign interest rate (which is smaller than the drop in expected inflation), leads to a decline in the relative expected return on dollar assets, because the expected euro appreciation is greater than the decline in the foreign interest rate. The result of the decline in the relative expected return on dollar assets is a leftward shift of the demand curve, and the equilibrium U.S. exchange rate falls.

14. The contraction of the European money supply will increase European interest rates and raise the future value of the euro, both of which will decrease the relative expected return on dollar assets.

The demand curve will then shift to the left, and the dollar will depreciate.

15.

This question is open to various answers. One answer is that the news that the UK had voted to leave the European Union would lead to a fall in UK exports to fall, thereby leading to a lower long-run value of the British pound. The result would then be an expected deprecation of the pound, and hence a decline in the demand for pound assets, which would cause the pound to fall in value. Alternatively, the vote to

exit the EU would cause the economy to weaken and so the Bank of England would lower interest rates (as they did), causing the future value of the pound to decline. The expected depreciation would then decrease the demand for pound assets, leading to a decline in the value of the pound.

 1.

Quantitative Problems Calculate the appreciation of the U.S. dollar and the depreciation of the Japanese yen if the exchange rate between the U.S. dollar and the Japanese yen went from 110 ¥/U.S. to 120¥/U.S. Solution: Appreciation of the U.S. dollar: (120 ‒ 110) / 110 = 0.090909 = 9.091% Depreciation of the Japanese yen: (0.00833 ‒ 0.00909) / 0.00909 = ‒8.333% since: 1/110 = 0.00909 and 1/120 = 0.00833 Note that depreciation and appreciation percentages are not exactly the same, but they are usually pretty close (for small changes in exchange rates).

2. An investor in England purchased a 91-day T-bill for $987.65.

At that time, the exchange rate was $1.75 per pound. At maturity, the exchange rate was $1.83 per pound. What was the investor’s holding period return in pounds?

Solution: The bond cost $987.65/$1.75 = £564.37.

At maturity, the $1,000 is worth $1,000/$1.83 = £546.45.

The holding period return is (546.45 ‒ 564.37)/564.37 = ‒ 0.0317.

3. An investor in Canada purchased 100 shares of IBM on January 1st at $93.00/share. IBM paid an annual dividend of $0.72 on December 31st. The stock was sold that day as well for $100.25. The exchange rate is $0.68/Canadian dollar on January 1st and $0.71/Canadian dollar on December 31st. What is the investor’s total return in Canadian dollars?

Solution: The price of each share is $93.00/$0.68 = 136.76 Canadian dollars.

The dividend is $0.72/$0.71 = 1.014 Canadian dollars.

The sale price is $100.25/$0.71 = 141.20 Canadian dollars The return = (141.20 + 1.014 ‒ 136.76)/136.76 = 0.03988 4. The current exchange rate is 0.93 euros per dollar, but you believe the dollar will decline to 0.85 euros per dollar. If a euro-denominated bond is yielding 2%, what return do you expect in U.S. dollars?

Solution: % change in currency = (0.85 – 0.93)/0.93 = ‒0.086 Total investment return = 0.02 ‒ (‒0.086) = 10.6% 5.

The 6-month forward rate between the British pound and the U.S. dollar is $1.75 per pound. If 6month rates are 3% in the United States and 150 basis points higher in England, what is the current exchange rate?

Solution:

6.

If the Canadian dollar to U.S. dollar exchange rate is 1.28 and the British pound to U.S. dollar exchange rate is 0.62, what must the Canadian dollar to British pound exchange rate be?

Solution:

7.

Spot rate = 1.75  (1.045/1.03) = $1.775/£

Spot rate = 1.28  (1/0.62) = 2.0645 Canadian dollars/pound

The New Zealand dollar to U.S. dollar exchange rate is 1.36 and the British pound to U.S. dollar exchange rate is 0.62. If you find that the British pound to New Zealand dollar is trading at 0.49, what would you do to earn a riskless profit?

Solution: Complete the following transactions simultaneously: a. Exchange $1.00 into 1.36 New Zealand dollars. b. Exchange the 1.36 New Zealand dollars into 0.6664 British pounds. c. Exchange the 0.6664 British pounds into $1.0748. d. This yields a riskless $0.0748.

8. A rare French cheese sells for 60.00 euros per pound. Assuming a very similar cheese in Wisconsin sells for 55.00 per pound, what is the exchange rate between the euro and the U.S. dollar, according to the law of one price?

Solution: The exchange rate between the U.S. dollar and the euro according to the law of one price is the exchange rate for which the same good has the same price in all countries in the same currency. In this case, the exchange rate is such that with $55.00, I can buy the same cheese in France, for which I need to pay 60.00 euros. Therefore $55.00 = 60 euros, which is the same as 0.91667 $/euro or 1.0909 euro/$.

9. The Argentinean peso trades at 0.067 peso per U.S. dollar. How many Argentinean pesos would you tip a taxi driver if you give her a $5 bill?

Solution: Each U.S. dollar is worth 1/0.067 = 14.92 Argentine pesos. Therefore, a $5 bill is equivalent to almost 75 pesos.

10.

The annual inflation rate in Venezuela was 200% during 2015. For the same year, the U.S. annual inflation rate was 1%. If the Venezuelan Bolivar traded at 0.10 U.S. dollar in 2015, what was the expected exchange rate between these two currencies for 2016?

Solution: The exchange rate in 2016 is expected to be: 10 × (3.00 / 1.01) = 29.703.

11. The current exchange rate between the United States and Britain is $1.825 per pound. The 6month forward rate between the British pound and the U.S. dollar is $1.79 per pound. What is the percentage difference between current 6-month U.S. and British interest rates?

Solution: % difference = 1.79/1.825 ‒1 So, if current U.S. rates are 5%, the rates in England are 0.05 + 0.019 = 0.069 = 6.9% 12. Suppose a Big Mac sells for 40.90 Norwegian Kroners in Oslo and that the exchange rate is 8.18 Kroners per U.S. dollar. If a Big Mac sells for $4.35 in New York, can you say that the law of one price holds?

Solution: According to the price of the Big Mac in Oslo and New York, 40.90 Kroners should be the same as $4.35. This means that one dollar should be equivalent to 9.40 Kroners.

Since the current exchange rate is 8.18 Kroners per U.S. dollar, then we cannot say that the law of one price holds in this case. The Kroner is overvalued.

13. If the price level recently increased by 20% in England while falling by 5% in the United States, how much must the exchange rate change if PPP holds? Assume that the current exchange rate is 0.55 pounds per dollar.

Solution: £0.55/$  25% = £0.1375/$, or £0.6875/$ 14. A one-year CD in Europe is currently paying 5%, and the exchange rate is currently 0.99 euros per dollar. If you believe the exchange rate will be 1.04 euros per dollar one year from now, what is the expected return in terms of dollars?

Solution: Expected return = 0.05 ‒ [(1.04 - 0.99)/0.99] = 5% ‒ 5.05% = ‒0.05% 15. Short-term rates are 2% in Japan and 4% in the United States. The current exchange rate is 120 yen per dollar. What is the expected forward exchange rate?

Solution: 0.04 = 0.02 – (X ‒ 120)/120 X = 117.6 16. Short-term rates are 2% in Japan and 4% in the United States. The current exchange rate is 120 yen per dollar. If you can enter into a forward exchange rate of 115 yen per dollar, how can you arbitrage the situation?

Solution: a. Borrow $1.00 at 4%. You will owe $1.04 at the end of the period. b. Exchange the $1.00 into ¥120, and lend it at 2%. You will have ¥122.40. c. Enter into the forward agreement. d. At the end of the period, convert the ¥122.40 into dollars at ¥115/$1.00 e. Pay the $1.04 you owe. This leaves $0.0243.

17. The interest rate in the United States is 4% and the euro is trading at 1 euro per dollar. The euro is expected to depreciate to 1.1 euro per dollar. Calculate the interest rate in Germany.

Solution: 0.04  i – [(1.1  1)s/1] 0.04  i  0.1 i  0.14  14%

Chapter 16 The International Financial System Intervention in the Foreign Exchange Market Foreign Exchange Intervention and Reserves in the Banking System Inside the Fed Box: A Day at the Federal Reserve Bank of New York’s Foreign Exchange Desk Unsterilized Intervention

Sterilized Intervention Balance of Payments Global Box: Why the Large U.S. Current Account Deficit Worries Economists Exchange Rate Regimes in the International Financial System Fixed Exchange Rate Regimes How a Fixed Exchange Rate Regime Works The Policy Trilemma Monetary Unions Global Box: Will the Euro Survive?

Currency Boards and Dollarization Global Box: Argentina’s Currency Board Speculative Attacks Managed Float Global Box: Dollarization Case: The Foreign Exchange Crisis of September 1992 The Practicing Manager: Profiting from a Foreign Exchange Crisis Case: How Did China Accumulate Over $3 Trillion of International Reserves?

Capital Controls Controls on Capital Outflows Controls on Capital Inflows The Role of the IMF Should the IMF Be an International Lender of Last Resort?



Overview and Teaching Tips

Chapter 16 shows why international financial transactions have important implications for the conduct of monetary policy. The beginning of the chapter explains how foreign exchange market intervention affects the exchange rate, a country’s international reserves, and the money supply. It then discusses the balance of payments, but this sometimes dry topic can be spiced up for students by a discussion of the material in the box on why large current account deficits worry economists.

The chapter then goes on to discuss how fixed exchange rate systems work. Three applications in this section make the material come alive for students. The first examines the September 1992 foreign exchange crisis, while the second discusses how China has accumulated over $3 trillion of international reserves, a subject of great interest to students. These applications capture the imagination of students because huge profits were made during the 1992 foreign exchange crisis, and they are curious about how a poor country like China became one of the world’s largest holders of international reserves and U.S. Treasury securities. These applications also give students further practice with the model of the foreign exchange market developed in Chapter 15.



Answers to End-of-Chapter Questions

1. The sale of dollars involves a purchase of foreign assets, which means that both reserves in the banking system and international reserves increase. However, the offsetting open market sale means that reserves in the banking system will remain unchanged. There is thus no change in the domestic interest rate and therefore in the expected return on dollar assets, so the demand curve does not shift and the exchange rate also remains unchanged.

2.

The purchase of dollars involves a sale of foreign assets, which means that international reserves fall and the monetary base decreases. The resulting fall in the money supply causes interest rates to rise and lowers the future price level, thereby raising the future expected exchange rate. Both of these effects raise the expected return on dollar assets at any given exchange rate, shifting the demand curve to the right and raising the equilibrium exchange rate.

3.

a. b. c. d. e. f. g.

A receipt in the capital account; a payment in the current account; a receipt in the method of financing; a receipt in the current account; a payment in the current account; a payment in the capital account; and a receipt in the capital account.

4. Since the fixed rate is 1 USD to 2,900 COP (Colombian pesos), a Big Mac should sell for 14,500 COP, the equivalent of 5 USD at the fixed ( E par ) rate. However, a Big Mac sells for more than that, indicating that currently the COP is overvalued (you should be able to get more COP for each USD at exchange counter, enough to buy the same Big Mac you buy in NYC).

5. The central bank of Colombia should undertake an unsterilized foreign market intervention in which it will buy the domestic currency (COP) and sell foreign reserves, in order to decrease reserves of its banking system, increase the domestic interest rate, and shift the expected return on domestic currency denominated assets curve to the right.

6. When a country devaluates its currency, the fixed exchange rate is set at a lower level, meaning that the central bank will no longer exchange domestic currency at the previous (higher) exchange rate. This means that foreigners with the same amount of foreign currency can get more units of domestic currency, thereby making that country’s exports cheaper for them, leading to an increase in the country’s exports. On the other hand, domestic buyers of foreign products now need more units of domestic currency to buy the same amount of foreign currency, so imports become more expensive and imports will decrease. If many of the goods that are taken into consideration to measure the cost of living are imported, then the cost of living (as measured by the percentage change in the CPI) will most probably increase after the devaluation.

7.

The situation would be as depicted in Figure 16.2, Panel (b). The central bank would need to sell domestic currency and buy foreign assets, thus increasing its international reserves and the monetary base. The resulting rise in the money supply would then lead to a decline in the domestic interest rate which would decrease the expected return on dollars and shift the demand curve to the left so that the equilibrium exchange rate would be at par.

8. When a country is engaged in a fixed exchange rate regime, it has a commitment to intervene in the foreign exchange market to maintain the system of fixed exchange rates. However, the combination of a recession and an overvalued currency is quite complicated to solve. The required unsterilized foreign exchange market intervention implies buying the domestic currency, decreasing reserves of the banking system and thereby increasing the domestic interest rate. This increase in domestic interest rates negatively affects the economy, reducing credit and expenditure on durable goods. This is why countries engaged in fixed exchange rate regimes were sometimes reluctant to intervene in the foreign exchange market.

9.

True, because when the exchange rate is falling, the central bank must buy its currency, which lowers its holdings of international reserves and its monetary base. Similarly, when the exchange rate is rising, it must sell its currency, which raises its holdings of international reserves and its monetary base. The necessary central bank intervention to keep its exchange rate fixed thus affects the monetary base and hence the money supply.

10. Countries may implement a contractionary monetary policy when they decide to intervene in the foreign exchange market and buy domestic currency to finance the deficit. The result is that they sell off international reserves and their monetary base falls, leading to a decline in the money supply.

11. False. As seen in the chapter, a reserve currency country, such as the United States, can have its balance of payment deficits financed by foreign central banks, leaving its international reserves unchanged.

12. When other countries buy U.S. dollars to keep their exchange rates from changing vis-à-vis the dollar because of the U.S. deficits, they gain international reserves and their monetary base increases. The outcome is that the money supply in these countries grows faster and leads to higher inflation throughout the world.

13. False. Inflation occurred when the world was under the gold standard before World War I. The gold discoveries in the Klondike and South Africa before World War I led to a continuing increase in the quantity of gold, which caused a more rapid growth in money supplies throughout the world. The result was worldwide inflation.

14. There are no direct effects on the money supply because there is no central bank intervention in a pure flexible exchange rate regime; therefore, changes in international reserves that affect the monetary base do not occur. However, monetary policy can be affected by the foreign exchange market because monetary authorities may want to manipulate exchange rates by changing the money supply and interest rates.

15. Uncertain. Although after 1973, countries no longer must intervene in the foreign exchange market to keep their currencies at a par level and so could pursue more independent monetary policy, they have not chosen to do so; rather, they have continued to engage in substantial intervention in the foreign exchange market. Thus they continue to have substantial fluctuations in international reserves, which affect their money supply.

16. Although capital outflows can harm a country when they lead to a devaluation of the domestic currency, controls in capital outflows are generally not thought to be a good idea.

They are seldom effective in a crisis because the private sector figures out ways to get around them; they may even stimulate further capital outflows because they weaken confidence in the government. They also can lead to corruption and may also encourage governments to procrastinate and not take the steps necessary to reform their financial systems.

17. By keeping out capital inflows, there may be less speculative capital to flow out during a crisis and a lower likelihood that capital inflows will fuel a lending boom and excessive risk-taking on the part of banks. On the other hand, capital controls on inflows keep funds that would be used for productive investment from entering a country. Capital controls on inflows might also produce substantial distortions and misallocations of resources and also lead to corruption.

18. Engaging in a lender-of-last resort operation is likely to weaken the credibility of the central bank and lead to inflation and an even larger depreciation of the domestic currency. Because debt is short-term and denominated in foreign currency in emerging-market countries, the depreciation would lead to a deterioration of balance sheets; thus, the lender-of-last resort operation is likely to make the financial crisis even worse.

19.

In general, IMF loans provided to help countries cope with either financial or currency crises were accompanied by various conditions. These conditions usually meant that recipient governments should increase taxes, increase the domestic interest rate, and reduce expenditures. At the same time, creditors of banking institutions, most of the time

either domestic or foreign banks, were able to collect their debts (even though domestic depositors sometimes were not), and citizens had to cope with the most harsh burden of the crisis. On top of this, the recovery of the recessions created by financial or currency crises were usually very slow and countries saw their social cohesion badly affected.

Eventually, real GDP per capita started to increase again, but the inheritance of these programs has proved a heavy one.

20. The international lender of last resort needs to make it clear that it will extend liquidity only to governments that take measures to prevent excessive risk taking. It can also reduce moral hazard by restricting the ability of governments to bail out stockholders and large uninsured creditors of domestic financial institutions.



Quantitative Problems

1. Calculate the overvaluation of the Thai baht (THB) if you can get 34.6 THB per USD at the exchange counter, but a lunch menu that costs 25 USD in Boston sells for 948.25 THB in Bangkok.

Solution: The implicit exchange rate is 25 USD to 948.25 THB, or 1 USD to 37.93 THB. Using the THB as the domestic currency, the exchange rate is 0.0289 = 1/34.6 and the implicit exchange rate is 0.02636 = 1/37.93. The THB is thereby [(0.0289 / 0.02636) ‒ 1] × 100 = 9.64% overvalued.

2. Suppose that for a given country the demand for imports can be expressed as IM=1,250+0.05E and that the demand for exports can be expressed as X=750-0.08E, where E is the exchange rate (units of foreign currency per unit of domestic currency). Calculate the trade balance when E=200. Calculate the new trade balance if this country devaluates its currency 20%.

Solution: The trade balance when E = 200 is X – IM = 1,250 – 0.08 × 200 – (1,000 + 0.05 × 200) = 1,250 – 16 – 1,000 – 10 = 224. The new trade balance is calculated using an exchange rate equal to 160 = 200 × 0.8. The new trade balance is X – IM = 1,250 – 0.08 × 160 – (1,000 + 0.05 × 160) = 1,250 – 12.8 – 1,000 – 8 = 229.2. The trade balance has improved after the devaluation.

3.

If the interest rate is 4% on euro deposits and 2% on dollar deposits, while the euro is trading at $1.30 per euro, what does the market expect the exchange rate to be one year from now?

Solution: $1.274 per euro. Note that since the exchange rate is quoted as $ per euro, the euro is the domestic currency. The interest parity equation is as follows: 0.04  0.02  ( Ete 1  1.30)/1.30 = > ( Ete 1  1.30)/1.30  0.02 0.04  0.02  

Ete 1  1.30 1.3 (0.02)  1.30  0.026  $1.274 per euro

Another way to get the answer is to recognize that the interest rate differential between implies that the euro is expected to depreciate by 2%, which implies a decline of 2% of 1.30, which is 0.026 over the year to $1.274 per euro.

4.

If the dollar begins trading at $1.30 per euro, with the same interest rates given in Problem 3, and the ECB raises interest rates so that the rate on euro deposits rises by 1 percentage point, what will happen to the exchange rate (assuming that the expected future exchange rate is unchanged)?

Solution: $1.287 per euro. Note that since the exchange rate is quoted as $ per euro, the euro is the domestic currency. From the previous problem, Ete 1  $1.274 per euro and the interest rate on euro deposits rises to 5%. Again using the interest parity equation: 0.05  0.02  (1.274  Et)/Et  (1.274  Et)/Et  0.02  0.05  0.03  Et 1.274  0.03 Et  0.97 Et  1.274  Et  1.274/0.97  $1.287 per euro Another way to get the answer is to recognize that when the interest rate on euro deposits rises by 1%, the euro must have an additional expected depreciation of 1%, which means that the initial level of the euro must fall by 1% from 1.30 to 1.287 per euro.

Chapter 17 Banking and the Management of Financial Institutions The Bank Balance Sheet Liabilities Assets Basic Banking General Principles of Bank Management Liquidity Management and the Role of Reserves Asset Management Liability Management Capital Adequacy Management The Practicing Manager: Strategies for Managing Bank Capital Case: How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis Off-Balance-Sheet Activities Loan Sales Generation of Fee Income Trading Activities and Risk Management Techniques Conflicts of Interest Box: Barings, Daiwa, Sumitomo, and Société Générale: Rogue Traders and the Principal-Agent Problem Measuring Bank Performance Bank’s Income Statement Measures of Bank Performance Recent Trends in Bank Performance Measures



Overview and Teaching Tips

Although this chapter performs the conventional function of outlining what banks (depository institutions) do, and what their balance sheets and income statements look like, it also emphasizes an analytic way of thinking about how banks manage their assets and liabilities to make a profit.

Two tools are used throughout this chapter and the rest of the book—T-accounts and the analysis of the determinants of asset demand, developed in Chapter 4. In teaching this material, it is worth emphasizing to the student that mastery of these two tools will pay high dividends in helping them to learn (and perform well on exams) in this course. Another point to emphasize is that the principles discussed here for bank management also apply to many other financial institutions as well.

The first three sections of the chapter—―The Bank Balance Sheet,‖ ―Basic Banking,‖ and ―General Principles of Bank Management‖—place particular emphasis on the question of why banks hold excess reserves, since banks’ decisions about the amount of excess reserves they hold play an important role in the money supply process.

The subsection, ―Capital Adequacy Management,‖ and the following section, ―Off-Balance-Sheet Activities,‖ discuss issues that have become increasingly important in recent years. Many instructors may therefore want to include this material in their course, yet none of this material is essential to understanding later chapters, so it can be skipped without any loss of continuity. The Practicing Manager application on strategies for managing bank capital illustrates how managers deal with an important managerial issue, while the case on the credit crunch in 2008 particularly piques the interest of students because it shows how changes in banks’ behavior can have major effects on the economy.



Answers to End-of-Chapter Questions

1. If bankers are forced to keep part of their deposits as reserves, they are losing the opportunity to earn interest on these reserves. If the central bank does not pay interest to banks, the latter can interpret this as a “tax,” since the lost earnings are “money left on the table.”

2.

Banks should be willing to hold large amounts of excess reserves. This is exactly what happened during the onset of the global financial crisis started in 2007. Banks were willing to hold much larger amounts of excess reserves once the Fed announced that it will pay interest on reserves (IOR) in September 2008. Although the IOR was very low, it was comparable to other very low rates of safe investments like Tbills.

3. No. When you turn a customer down, you may lose that customer’s business forever, which is extremely costly.

Instead, you might go out and borrow from other banks, corporations, or the Fed to obtain funds so that you can make the customer’s loan. Alternatively, you might sell negotiable CDs or some of your securities to acquire the necessary funds.

4. Because when a deposit outflow occurs, a bank is able to borrow reserves in these overnight loan markets quickly; thus, it does not need to acquire reserves at a high cost by calling in or selling off loans. The presence of overnight loan markets thus reduces the costs associated with deposit outflows, so banks will hold fewer excess reserves.

5. You should want to make short-term loans. Then, when these loans mature, you will be able to make loans at higher interest rates, which will generate more income for the bank.

6. False. If an asset has a lot of risk, a bank manager might not want to hold it even if it has a higher return than other assets. Thus a bank manager has to consider risk as well as the expected return when deciding to hold an asset.

7. True. Banks can now pursue new loan business much more aggressively than in the past because when they see profitable loan opportunities, they can use liability management to acquire new funds and expand the bank’s business.

8. Before this regulation, customers were automatically enrolled in banks’ overdraft protection plans. This meant that debit card transactions would be approved, even if funds were insufficient. However, a bank fee was generated by this transaction. Many customers paid fees in excess of the value of the transaction. After this regulation, customers have to specifically opt-in for an overdraft plan. As many customers do not opt-in, noninterest income was negatively affected.

9.

Interest expenses have large fluctuations because interest rates fluctuate so much; provisions for loan losses fluctuate a lot because when the economy turns down or a particular sector of the economy deteriorates, the potential for loan losses rises dramatically.

10. Because ROE, the return on equity, tells stockholders how much they are earning on their equity investment, while ROA, the return on assets, only provides an indication how well the bank’s assets are being managed.

11.

Increased competition for funds will probably increase interest expenses. Since nothing is said that could affect interest income or assets, we can expect net interest margin to decrease, as the numerator decreases.

12. ROE will fall in half.

13. To lower capital and raise ROE, holding its assets constant, it can pay out more dividends or buy back some of its shares.

Alternatively, it can keep its capital constant but increase the amount of its assets by acquiring new funds and then seeking out new loan business or purchasing more securities with these new funds.

14. The benefit is that the bank now has a larger cushion of bank capital and so is less likely to go broke if there are losses on its loans or other assets. The cost is that for the same ROA, it will have a lower ROE, return on equity.

15. It can raise $1 million of capital by issuing new stock. It can cut its dividend payments by $1 million, thereby increasing its retained earnings by $1 million. It can decrease the amount of its assets so that the amount of its capital relative to its assets increases, thereby meeting the capital requirements.

 1.

Quantitative Problems Angus Bank holds no excess reserves, but complies with the reserve requirement. The required reserves ratio is 9% and reserves are currently $27 million. Determine the amount of deposits, the reserve shortage created by a deposit outflow of $5 million, and

the cost of the reserve shortage if Angus Bank borrows in the federal funds market (assume the federal funds rate is 0.25%).

Solution: Deposits = 27/0.09 = 300. The reserve shortage is calculated as outstanding reserves after the deposit outflow, minus required reserves after the deposit outflow: 22 ‒ 295 × 0.09 = ‒ 4.55 Angus Bank has to borrow $4.55 million. Borrowing from the Fed will cost Angus Bank: 0.0025 × 4.5 = $11,250.

2.

Excess reserves act as insurance against deposit outflows. Suppose that on a yearly basis Malcom Bank holds $12 million in excess reserves and $88 million in required reserves.

Suppose that Malcom Bank can earn 3.5% on its loans and that the interest paid on (total) reserves is 0.2%. What would be the cost of this insurance policy?

Solution: The cost of the insurance policy is the amount of foregone interest income equal to $12 × 0.035 = $0.42 million minus the interest paid on excess reserves = 12 × 0.002 = $0.02 million. Therefore, the yearly cost of holding $12 million in excess reserves is $0.40 million.

3.

Nice Horizon Bank has the following measures of bank profitability: EM = 14 and ROA = 1.05%. Gold Coast Bank measures are EM = 12.3 and ROA = 1.15%.Which bank has a higher ROE? Solution: Nice Horizon Bank: ROE = 1.05% × 14 = 14.7%. Gold Coast Bank ROE: 1.15% × 12.3 = 14.145%. Nice Horizon Bank has a higher ROE.

4.

Refer to the previous exercise. Calculate both banks’ net profit after taxes and equity capital if both banks’ assets are equal to $120 million.

Solution: Nice Horizon Bank: Net profit after taxes = $120 × ROA = 1.05% × 120 = $126 million Equity Capital = $120 / EM = $120 / 14 = $8.57 million.

Gold Coast Bank: Net profit after taxes = $120 × ROA = 1.15% × 120 = $138 million Equity Capital = $120 / EM = $120 /12.3 = $9.75 million.

5.

Victory Bank reports an EM of 25, while Batovi Bank reports an EM equal to 14. Which bank is better prepared to respond against large losses on loans?

Solution: Victory Bank has 1/25 = 0.04 of equity capital as a percentage of assets, while Batovi Bank has 1/14 = 7.13. Batovi Bank is therefore better capitalized than Victory Bank and better suited to take large losses on loans.

6.

A bank is considering two investment portfolios composed of a mix of government securities (federal and municipal securities). The first portfolio has a return of 6% with probability 0.9 and returns of 5% and 7% with 0.05 probability. The second portfolio has a return of 5% with probability 0.5 and a return of 7% with probability 0.5. Which portfolio has the best combination of return, risk, and liquidity?

Solution: The expected return of the first portfolio is: 6% × 0.9 + 5% × 0.05 + 7% × 0.05 = 6%. The expected return of the second portfolio is 5% × 0.5 + 7% × 0.5 = 6%. However, the

variance of the first portfolio´s return is (6‒6)2 × 0.90 + (5‒6)2 × 0.05 + (7‒6)2 × 0.05 = 0.1, while the variance of the second portfolio is (5‒6)2 × 0.50 + (7‒6)2 × 0.50 = 1.0. Since both portfolios have the same liquidity and expected returns, but one has lower risk (lower variance), the bank should choose the first portfolio.

7.

NewBank started its first day of operations with $6 million in capital. $100 million in checkable deposits is received. The bank issues a $25 million commercial loan and another $25 million in mortgages, with the following terms:  Mortgages: 100 standard 30-year, fixed-rate with a nominal annual rate of 5.25% each for $250,000.  Commercial loan: 3-year loan, simple interest paid monthly at 0.75%/month.

If required reserves are 8%, what do the bank balance sheets look like? Ignore any loan loss reserves.

Assets

Liabilities

Required Reserves Excess Reserves Loans 8.

$ 8 million $48 million $50 million

Checkable Deposits Bank Capital

$100 million $ 6 million

NewBank decides to invest $45 million in 30-day T-bills. The T-bills are currently trading at $4,986.70 (including commissions) for a $5,000 face value instrument. How many do they purchase? What does the balance sheet look like?

Solution: The bank can purchase $45 M/$4,986.70, which is about 9,024 T-bills. The actual cost is $44,999,980.80.

After the transaction, the balance sheet is: Assets Required Reserves Excess Reserves T-bills Loans

9.

Liabilities $ 8 million $ 3 million $45 million $50 million

Checkable Deposits Bank Capital

$100 million $ 6 million

On the 3rd day of operations, deposits fall by $5 million. What does the balance sheet look like? Are there any problems?

Solution: The cash leaving the bank comes from reserves, first excess and then required.

Following the outflow, the balance sheet is: Assets Required Reserves T-bills Loans

Liabilities $ 6 million $45 million $50 million

Checkable Deposits Bank Capital

$95 million $ 6 million

With $95 million in deposits, the 0.08  $95 M is required in reserves, or $7.6 million. The bank is short $1.6 million.

10. To meet any shortfall in the previous question, NewBank will borrow the cash in the fed funds market. Management decides to borrow the needed funds for the remainder of the month (now 29 days). The required yield on a discount basis is 2.9%. What does the balance sheet look like after this transaction?

Solution: Assets Required Reserves T-bills Loans

Liabilities $7.6 million $ 45 million $ 50 million

Checkable Deposits Fed Funds Borrowed Bank Capital

$ 95 million $1.6 million $ 6 million

11. The end of the month finally arrives for NewBank, and it receives all the required payments from its mortgages, commercial loan, and T-bills. How much cash was received? How are these recorded?

Solution: The required monthly mortgage payments are: PV = 25 M, I = 5.25/12, N = 360, FV = 0 Compute PMT. PMT = $138,050.93 The loan payment is: $23 M  0.0075 = $187,500.

These are recorded as: Debit Cash

Credit $325,551

Interest Income Loans

$296,875 $ 28,676

The T-bills paid: 9,024  $5,000 = $45,120,000. This is recorded as: Debit Cash

Credit $45,120,000

T-bills Interest Income

$44,999,980.80 $ 120,019.20

12. NewBank also pays off its fed funds borrowed. How much cash is owed? How is this recorded?

Solution:

$ F  $1.6 M 360   0.029 F 29 F = $1,603,746.53 This is recorded as: Debit Fed Funds Interest Expense

Credit $1,600,000 $ 3,746.53

Cash

$1,603,746.53

13. What does the month-end balance sheet for NewBank look like? Calculate this before any income tax consideration.

Solution: Assets Required Reserves Excess Reserves Loans

Liabilities $ 7.6 million $43.84 million $49.97 million

Checkable Deposits Bank Capital

$ 95 million $6.41 million

14. Calculate NewBank’s ROA and NIM for its first month. Assume that net interest equals EBT, and that NewBank is in the 34% tax bracket.

Solution: Interest income Interest expense NIM Income tax Net income

$416,894 $ 3,747 $413,147 $140,470 $272,677

ROA = 272,677/101.41 M = 0.2688% (monthly) 15. Calculate NewBank’s ROE and final balance sheet, including its tax liabilities.

Solution: Assets Required Reserves Excess Reserves Loans

Liabilities $ 7.6 million Checkable Deposits $43.84 million Taxes Payable $49.97 million Bank Capital

$ 95 million $140,470 $ 6.27 million

ROA = 272,677/6,269,530 = 4.35% (monthly) 16. If NewBank was required to establish a loan loss reserve at 0.25% of the loan value for commercial loans, how is this recorded? Recalculate NewBank’s ROE and final balance sheet including its tax liabilities.

Solution: The establishment of the loan loss reserve is: Debit Loan Loss Expense

Credit $62,500

Loan Loss Reserve

$62,500

The new income is: Interest income Interest expense NIM Loan loss expense Taxable income Income tax Net Income

$416,894 $ 3,747 $413,147 $ 62,500 $350,647 $119,220 $231,427

The new balance sheet is: Assets Required Reserves Excess Reserves Loans

Liabilities $ 7.6 million $43.84 million $49.97 million

Checkable Deposits Taxes Payable Loan Loss Reserve Bank Capital

ROE = 231,427/6,228,280 = 3.71% (monthly)

$ 95 million $119,220 $ 62,500 $ 6.23 million

17. If NewBank’s target ROE is 4.5%, how much net fee income must it generate to meet this target?

Solution: The required net income = 0.045  $6 M = $270,000.

Working backwards, we get: Taxable income Income tax Net Income

$409,091 $139,091 $270,000

Since the taxable income was previously $350,647, this means that $58,444 in net fee income (fees generated less expenses) is needed to meet the target.

18. After making payments for three years, one of the mortgage borrowers defaults on the mortgage. NewBank immediately takes possession of the house and sells it at auction for $175,000. Legal fees amount to $25,000. If no loan loss reserve was established for the mortgage loans, how is this event recorded?

Solution: The required monthly mortgage payments are: PV = 250,000, I = 5.25/12, N = 360, FV = 0 Compute PMT. PMT = $1,380.51 The remaining balance on the mortgage after 36 payments is: PMT = $1,380.51, I = 5.25/12, N = 360 – 6, FV = 0 Compute PV. PV = $238,845.64 The transaction is recorded as: Debit Cash Loan Loss Expense

Credit $150,000.00 $88,845.64

Loan

$238,845.64

Chapter 18 Financial Regulation Asymmetric Information As a Rationale for Financial Regulation Government Safety Net Global Box: The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing?

Types of Financial Regulation Restrictions on Asset Holdings Capital Requirements Prompt Corrective Action Financial Supervision: Chartering and Examination Global Box: Where is the Basel Accord Heading After the Global Financial Crisis?

Assessment of Risk Management Disclosure Requirements Consumer Protection Mini-Case Box: Mark-to-Market Accounting and the Global Financial Crisis Restrictions on Competition Macroprudential Versus Microprudential Supervision Mini-Case Box: The Global Financial Crisis and Consumer Protection Regulation Summary E-Finance Box: Electronic Banking: New Challenges for Bank Regulation Global Box: International Financial Regulation Banking Crises Throughout the World in Recent Years ―Déjà Vu All Over Again‖ The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 Dodd-Frank Too-Big-to-Fail and Future Regulation What Can Be Done About the Too-Big-to-Fail Problem?

Other Issues for Future Regulation



Overview and Teaching Tips

This chapter stresses an analytic way of thinking by conducting an analysis using the adverse selection and moral hazard concepts to show why our regulatory system takes the form it does and how it led to a banking crisis. The chapter ends with a discussion of the Dodd-Frank bill and then the toobig-to-fail problem and future regulation. Instead of lecturing on this issue, we have the students themselves speculate on whether the Dodd-Frank bill solves the too-big-to-fail problem and whether it will prevent a crisis like the recent global financial crisis from ever happening again.

This gets them to apply the concepts in this chapter and makes for a very spirited discussion.

Note that Chapter 7 does not need to be covered in order to teach this chapter. However, if Chapter 7 is covered in class, Chapter 18 is a nice application of the analysis in that chapter.

Indeed, the instructor might want to stress in class the counterparts in private financial markets to the methods bank regulators use to cope with adverse selection and moral hazard.



Answers to End-of-Chapter Questions

1. Answers will vary.

2. There would be adverse selection because people who might want to burn their property for some personal gain would actively try to obtain substantial fire insurance policies. Moral hazard could also be a problem because a person with a fire insurance policy has less incentive to take measures to prevent a fire.

3. By encouraging depositors to put their money into the banking system, the creation of the FDIC also contributes to economic growth. This is so, because when savers deposit their funds at financial intermediaries, these institutions look to channel the aforementioned funds to their best use. This efficiency in the allocation of scarce resources benefits the whole economy and contributes to economic growth (i.e., only the best, or more productive investment ideas, are funded).

4. If you have deposited $300,000 at the failed bank, it would be better for you if the FDIC uses the purchase-andassumption method. This way, the bank never closes, and you do not lose a penny. If the payoff method was used, you will get a check for $250,000 and you will have to wait a few years to get around 90 cents per dollar of the remaining $50,000. If your balance was $200,000, you are indifferent as to which method the FDIC would use to handle this failed bank.

5. The benefits of a too-big-to-fail policy are that it makes bank panics less likely. The costs are that it increases the incentives of moral hazard by big banks who know that depositors do not have incentives to monitor the bank’s risk-taking activities. In addition, it is an unfair policy because it discriminates against small banks.

6. Because off-balance-sheet activities do not appear on bank balance sheets, they cannot be dealt with by simple bank capital requirements, which are based on bank assets, such as a leverage ratio. Banking regulators have dealt with this problem by imposing an additional risk-based bank capital requirement that banks set aside additional bank capital for different kinds of off-balance-sheet activities.

7. You probably would not recommend the adoption of a system of deposit insurance in a country with weak institutions, prevalent corruption, and ineffective regulation of the financial sector. The main reason not to implement such a system is that its adoption solves the bank runs problem, but it creates moral hazard incentives for banks to engage in risky lending. Decreasing the moral hazard incentives for risky lending requires stringent financial regulation and supervision, which requires strong (and honest) institutions.

8. Bank supervision involves bank examinations in which examiners assess six areas of the bank represented in the CAMELS rating (capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk). A low score on the CAMELS rating allows the supervisors to declare a bank to be a ―problem bank,‖ making it more subject to frequent examinations and to sanctions to reduce the amount of risk taking it is engaged in. Bank examiners also check that the bank is following the rules and regulations and is not holding securities or loans that are too risky.

All of these measures help ensure that banks are not taking on too much risk, and thus promote a safer and sounder banking system.

9. The Bank Insurance Fund of the FDIC was recapitalized by allowing it to borrow more from the Treasury and by raising insurance premiums. The bill reduced the scope of deposit insurance by limiting brokered deposits and by limiting the too-big-to-fail doctrine by forcing the FDIC to use the least cost method of closing failed banks except under unusual circumstances. The bill has prompt corrective action provisions that require the FDIC to intervene earlier with stronger actions when banks move into one of the weaker of the five classifications based on bank capital. The limiting of deposit insurance and prompt corrective action should reduce moral hazard risk-taking on the part of banks. The bill instructs the FDIC to come up with risk-based premiums, which will increase the premium cost when the banks take on more risk, thus helping to reduce the moral hazard problem. The bill also mandates increased reporting requirements and annual examinations to prevent the banks from taking on too much risk. It also enhances regulation of foreign banks in the U.S. to keep them from operating in the U.S. if they are taking on too much risk.

10. With the advent of new financial instruments, a bank that is quite healthy at a particular point in time can be driven into insolvency extremely rapidly from risky trading in these instruments. Thus, a focus on bank capital at a point in time may not be effective in indicating whether a bank will be taking on excessive risk in the near future. Therefore, to make sure that banks are not taking on too much risk, bank supervisors now are focusing more on whether the riskmanagement procedures in banks keep them from excessive risk taking that might make a future bank failure more likely.

11.

If only one bank holds 70% of all deposits in the United States, it would be a financial catastrophe if this institution fails. We can expect the FDIC and any other competent office to do everything possible to prevent this institution to go bankrupt. However, as banks keep merging (with the consequence of a reduction in the number of banks but an increase in their size), this is precisely the type of problem that regulators might have to face in the future. It is a real challenge for actual and future financial regulations to deal with the problem of huge financial institutions and the potential negative effects that their failure might have in the economy.

12.

Consumer protection regulations in general make sure that all relevant information is disclosed to potential borrowers (including costs and conditions of loans), and forbid discrimination against lenders. Complying with these regulations can be costly for financial intermediaries (both

in terms of the disclosing of information and lost opportunities if they, for example, only lend to richer potential borrowers), and thereby negatively affect their profits. However, by disclosing information and not discriminating, financial intermediaries might attract more potential customers, who will now have a fair chance of getting a loan and to thoroughly understand its conditions.

13. In general, yes. A national banking system will enable banks to diversify their loan portfolios better, thus decreasing the likelihood of bank failures. In addition, it may make banks and hence the economy more efficient and will help increase banks’ profitability, which will make them healthier.

14. The economy would benefit from reduced moral hazard; that is, banks would not want to take on too much risk because doing so would increase their deposit insurance premiums. The problem is, however, that it is difficult to monitor the degree of risk in bank assets because often only the bank making the loans knows how risky they are.

15.

The Dodd-Frank Act of 2010 was vigorously fought against by lobbyist of the financial industry. The legislative branch had to answer to the citizens´ clamor against Wall Street actions and its consequences on the overall economy performance. As a consequence, after a year of discussions and changes in the original bill the result was the Dodd-Frank Act of 2010.

Lobbyists of the financial industry usually argue that new financial regulation increases costs for the financial institutions and thereby reduces its profits.



Quantitative Problems

1. Consider a failing bank. A deposit of $350,000 is worth how much if the FDIC uses the payoff method? How much is the same deposit worth if the purchase-and-assumption method is used?

Which is more costly to taxpayers?

Solution: Under the payoff method, large deposits pay better than $0.90/dollar. In this case, the $350,000 is worth better than $350,000 × 0.90 = $315,000. Under the purchase-andassumption policy, the bank is completely absorbed, and all accounts are worth their full value. Upfront, the second method will have a lower cost to the insurance fund. However, if depositors fear loss under the payoff method, they are less likely to maintain account balances in excess of $250,000 in a single bank.

2. Consider a bank with the following balance sheet: Assets Required reserves $17 million Excess reserves $3 million Municipal bonds $65 million Residential mortgages $70 million Commercial loans $60 million

Liabilities Checkable deposits $205 million Bank capital $10 million

Calculate the bank’s risk-weighted assets.

Solution: Reserves and T-bills have a zero weight. So, $20 million has zero weight. Municipal bonds and Residential mortgages carry a 50% weight. Risk-weighted assets = $135 million × 0.50 = $67.5 million. Commercial loans carry a 100% weight. Risk-weighted assets = $60 million. Total riskweighted assets = $67.5 + $60 = $127.5 million.

3. Refer to the previous problem. Is this bank complying with the risk-weighted capital requirements set by Basel 1?

Solution: Basel 1 required bank capital to be at least 8% of risk-weighted assets: 0.08 × $127.5 = $10.2 million. This bank is not complying with the capital requirements set by Basel 1.

4. Oldhat Financial started its first day of operations with $9 million in capital. $130 million in checkable deposits are received. The bank issues a $25 million commercial loan and another $50 million in mortgages, with the following terms:  Mortgages: 200 standard 30-year, fixed-rate with a nominal annual rate of 5.25% each for $250,000  Commercial loan: 3-year loan, simple interest paid monthly at 0.75%/month If required reserves are 8%, what does the bank balance sheet look like? Ignore any loan loss reserves. How well capitalized is the bank?

Solution: Assets Required Reserves Excess Reserves Loans

Liabilities $10.4 million $53.6 million $75 million

Checkable Deposits Bank Capital

$130 million $ 9 million

The bank is well capitalized, at 9/139 = 6.47% 5. Calculate the risk-weighted assets and risk-weighted capital ratio of Oldhat’s first day.

Solution: Reserves have a zero weight. So, $64 million has zero weight.

Residential mortgages carry a 50% weight. RW Assets = $25 million.

Commercial loans carry a 100% weight. RW Assets = $25 million.

The capital ratio = 9/50 = 18%.

6. The next day, terrible news hits the mortgage markets, and mortgage rates jump to 13%.

What is the market value of Oldhat’s mortgages? What is Oldhat’s ―market value‖ capital ratio?

Solution: When issued, the required payment is: PV  $250,000, I  5.25/12, N  360, FV  0 Compute PMT. PMT  $1,380.51 After the rate increase, the mortgages are worth: PMT  $1,380.51, I  13/12, N  360, FV  0 Compute PV. PV  $124,797.56, or a loss of about 50% of value.

The new ―market value‖ balance sheet is: Assets Required Reserves Excess Reserves Loans

Liabilities

$10.4 million $53.6 million $50 million

Checkable Deposits Bank Capital

$130 million $16 million

However, the loss would not be immediately recognized. No actual accounting transaction would take place.

7. Bank regulators force Oldhat to sell its mortgages to recognize the fair market value. What is the accounting transaction? How does this affect its capital position?

Solution: The sale of each mortgage would be recorded as: Debit Cash Loss

Credit $124,798 $125,202

Mortgages

$250,000

After the fact, the actual balance sheet is: Assets Required Reserves Excess Reserves Loans

Liabilities $10.4 million $78.6 million $25 million

Checkable Deposits Bank Capital

$130 million $16 million

Now, the true state of the bank’s position is realized.

8. Congress allowed Oldhat to amortize the loss over the remaining life of the mortgage. If this technique was used in the sale, how would the transaction have been recorded? What would be the annual adjustment? What does Oldhat’s balance sheet look like? What is the capital ratio?

Solution: The sale of each mortgage would be recorded as: Debit Cash Capitalized Loss

Credit $124,798 $125,202

Mortgages

$250,000

Then, each year for the next 30 years, the loss would be written off: Debit Loss (Expense)

Credit $4,173.40

Capitalized Loss

$4,173.40

After the fact, the actual balance sheet is now: Assets Required Reserves Excess Reserves Capitalized Loss Loans

Liabilities

$10.4 million $78.6 million $25 million $25 million

Checkable Deposits Bank Capital

$130 million $ 9 million

The bank is again well capitalized, at 9/139  6.47% 9. Oldhat decides to invest the $78.6 million in excess reserves in commercial loans. What will be the impact on its capital ratio? Its risk-weighted capital ratio?

Solution: With the commercial loan, the balance sheet is now: Assets Required Reserves Excess Reserves Capitalized Loss Loans

Liabilities

$ 10.4 million $ 0 million $ 25 million $103.6 million

Checkable Deposits Bank Capital

$130 million $9 million

The bank is still well capitalized, at 9/139  6.47%.

For risk-weighted: Reserves have a zero weight. So, $10.4 million has zero weight.

The remaining balance sheet is at 100%, or $128.6 million.

The risk-weighted capital ratio  9/128.6  7%.

10. The bad news about the mortgages is featured in the local newspaper, causing a minor bank run. $6 million in deposits is withdrawn. Examine the bank’s condition.

Solution: The balance sheet is now: Assets Required Reserves Excess Reserves Capitalized Loss Loans

$ 4.4 million $ 0 million $ 25 million $103.6 million

Liabilities Checkable Deposits Bank Capital

$124 million $ 9 million

The bank is still well capitalized, at 9/133  6.76%.

However, the required reserve ratio is 8%, or $9.92 million. The bank is roughly $5.5 million short.

11. Oldhat borrows $5.5 million in the overnight fed funds market. What is the new balance sheet for Oldhat? How well capitalized is the bank?

Solution: The balance sheet is now: Assets Required Reserves Excess Reserves Capitalized Loss Loans

Liabilities $ 9.9 million $ 0 million $ 25 million $103.6 million

Checkable Deposits Fed funds borrowed Bank Capital

$124 million $ 5.5 million $ 9 million

The bank is still well capitalized, at 9/138.5  6.5%

Chapter 19 Banking Industry: Structure and Competition Historical Development of the Banking System Multiple Regulatory Agencies Financial Innovation and the Growth of the Shadow Banking System Responses to Changes in Demand Conditions: Interest Rate Volatility Responses to Changes in Supply Conditions: Information Technology E-Finance Box: Will ―Clicks‖ Dominate ―Bricks‖ in the Banking Industry?

E-Finance Box: Why are Scandinavians So Far Ahead of Americans in Using Electronic Payments and Online Banking?

E-Finance Box: Are We Headed for a Cashless Society?

Securitization and the Shadow Banking System Avoidance of Existing Regulations Mini-Case Box: Bruce Bent and the Money Market Mutual Fund Panic of 2008 The Practicing Manager: Profiting from a New Financial Product: A Case Study of Treasury Strips Financial Innovation and the Decline of Traditional Banking Structure of the U.S. Commercial Banking Industry Restrictions on Branching Response to Branching Restrictions Bank Consolidation and Nationwide Banking E-Finance Box: Information Technology and Bank Consolidation The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 What Will the Structure of the U.S. Banking Industry Look Like in the Future?

Are Bank Consolidation and Nationwide Banking Good Things?

Separation of the Banking and Other Financial Service Industries Erosion of Glass-Steagall The Gramm-Leach-Bliley Financial Services Modernizaton Act of 1999: Repeal of GlassSteagall Implications for Financial Consolidation Separation of the Banking and Other Financial Services Industries Throughout the World Mini-Case Box: The Global Financial Crisis and the Demise of Large, Free-Standing Investment Banks

Thrift Industry Savings and Loan Associations Mutual Savings Banks Credit Unions International Banking Eurodollar Market Structure of U.S. Banking Overseas Foreign Banks in the United States



Overview and Teaching Tips

Chapter 19 supplements Chapter 2 by going into much greater detail about the structure, operation, and regulation of the banking system. This chapter differs from conventional chapters on the banking industry in other financial markets and institutions textbooks by stressing a more dynamic, analytical framework. It uses this framework to explain how regulation has led to the peculiar structure of the American banking industry and how financial innovation and changes in the ability to process information have led to a decline in the traditional banking business and the growth of the shadow banking system.



Answers to End-of-Chapter Questions

1. Two important conditions hindered trade across states before 1863: there was no national currency, and banknotes issued by state banks could become worthless any day. Given these two conditions, individuals interested in conducting their business across states had to use mostly gold as a means of payment, with all the inconveniences attached to that particular type of money.

2. a.

Office of the Controller of the Currency b.The Federal Reserve c.State banking authorities and the FDIC d.The Federal Reserve 3. False. Although there are many more banks in the United States than in Canada, this does not mean that the American banking system is more competitive. The reason for the large number of U.S. banks is anticompetitive regulations such as restrictions on banking.

4. Answers will vary. In general, one could say that the Glass Steagall Act was a good choice in terms of separating a risky industry (the securities industry) from traditional commercial banking. In this sense, the Act of 1933 proved to be a good thing, since the banking industry did not experience many crises during its life (it was repealed in 1999). One could also argue that this Act put U.S. banks at a disadvantage against its foreign competitors in terms of lost opportunities to make profits.

5. Because becoming a bank holding company allows a bank to: a.circumvent branching restrictions since it can own a controlling interest in several banks even if branching is

not permitted, and b.engage in other activities related to banking that can be highly profitable.

6. International banking has been encouraged by giving special tax treatment and relaxed branching regulations to Edge Act corporations and to international banking facilities (IBFs); this was done to make American banks more competitive with foreign banks. The hope is that it will create more banking jobs in the United States.

7.

IBFs encourage American and foreign banks to do more banking business in the United States, thus shifting employment from Europe to the United States.

8. Critics of the process of bank consolidation argue that this process will increase the too-big-to-fail policy. As banks merge and get bigger, they become more interconnected and so expose the financial system to more systemic risk. Therefore, the too-big-to-fail problem also gets bigger.

9. The elimination of reserve requirements would decrease the size of money market mutual funds because banks could then offer higher interest rates on their deposits; funds would flow out of money market mutual funds into banks.

10. The rise of inflation and the resulting higher interest rates on alternatives to checkable deposits meant that banks had a big shrinkage in this low-cost way of raising funds. The innovation of money market mutual funds also meant that the banks lost checking account business. The abolishment of Regulation Q and the appearance of NOW accounts did help decrease disintermediation but raised the cost of funds for American banks, which now had to pay higher interest rates on checkable and other deposits. Foreign banks were also able to tap a large pool of domestic savings, thereby lowering their cost of funds relative to American banks.

11. True. Higher inflation helped raise interest rates, which caused the disintermediation process to occur and which helped create money market mutual funds. As a result, banks lost cost advantages on the liabilities side of their balance sheets and this has led to a less healthy banking industry.

However, improved information technology would still have eroded the banks’ income advantages on the assets side of their balance sheet, so the decline in the banking industry would still have occurred.

12.

Given that the loan originator or mortgage broker is mostly worried about getting the household to accept the terms of the mortgage loan, so that the servicer can sell it to the bundler, then it is easy to see that he or she is not very worried about the financial constraints of this family. The loan originator is mostly worried about getting its fee, since he or she will not suffer any consequences if the household cannot repay its loan. This was one of the major problems at

the origin of the global financial crisis of 2007-2009.

13. Uncertain. The invention of the computer did help lower transaction costs and the costs of collecting information, both of which have made other financial institutions more competitive with banks and have allowed corporations to bypass banks and borrow directly from securities markets. Therefore, computers were an important factor in the decline of traditional banking. However, another source of the decline in the traditional banking industry was the loss of cost advantages for the banks in acquiring funds, and this loss was due to factors unrelated to the invention of the computer, such as the rise in inflation and its interaction with regulations, which produced disintermediation.

14. Brokerage firms began to engage in the traditional banking business of issuing deposit instruments, while foreign bank activities in the United States further eroded the competitive position of U.S. banks. This led to the Federal Reserve’s allowing bank holding companies to enter the underwriting business through a loophole in Glass-Steagall in order to keep them competitive. Finally, legislation in 1999 was passed to repeal Glass-Steagall.

15. One could argue that in some sense the spirit of the Dodd-Frank Act is similar to the spirit that gave rise to the Glass-Steagall Act. Both Acts appeared as a response to serious events in the financial market that resulted in financial system crises with negative effects on the overall economy. Both Acts tried to impose limitations to either the type of business that some institutions could engage in, or to increase regulations to avoid excessive risk taking.

Chapter 20 The Mutual Fund Industry The Growth of Mutual Funds The First Mutual Funds Benefits of Mutual Funds Ownership of Mutual Funds Mutual Fund Structure Open- Versus Closed-End Funds Organizational Structure Case: Calculating a Mutual Fund’s Net Asset Value Investment Objective Classes Equity Funds Bond Funds Hybrid Funds Money Market Funds Index Funds

Fee Structure of Investment Funds Regulation of Mutual Funds Hedge Funds Mini-Case Box: The Long-Term Capital Debacle Conflicts of Interest in the Mutual Fund Industry Sources of Conflicts of Interest Mutual Fund Abuses Conflicts of Interest Box: Many Mutual Funds are Caught Ignoring Ethical Standards Conflicts of Interest Box: SEC Survey Reports Mutual Fund Abuses Widespread Government Response to Abuses



Overview and Teaching Tips

Mutual funds have grown rapidly over the last two decades. Their growth has been partly fueled by increases in the number of investors who are responsible for managing their own retirement. The increased liquidity and diversification they provide, among other factors, have also been important. There are currently over 7596 separate mutual funds with $13 trillion in net assets.

Mutual funds can be organized as either open- or closed-end funds. Closed-end funds issue stock in the fund at an initial offering and do not accept additional funds. Most new funds are organized as open-end funds and issue additional shares when new money is received. The net asset value (NAV) of the shares is computed each day. All trades conducted that day are at the NAV. The primary classes of mutual funds are stock funds, bond funds, hybrid funds, and money market funds. Stock and bond funds can be either actively managed by investment managers or can be structured as index funds that mimic the behavior of some index, such as the S&P 500.

Hedge funds attempt to earn returns by trading on deviations between historical security relationships and current market conditions. These funds are not available to small investors.

The mutual fund industry has been subject to widely publicized scandals for violating SEC regulations and internal policy. Most abuses centered on market timing and late trading by investors receiving privileged treatment in exchange for large deposits with the funds. Conflicts of interest created by fee structures that reward investment managers more for total assets than for returns are partly responsible.

Points to emphasize: Review Figure 20.1, and Figure 20.6 in the context of the market decline in 2000. Discuss how the profitability of the market affects this industry.

The case Net Asset Value discusses the calculation of the NAV. A useful exercise is to show how changes in market values of the assets can change the NAV. Several homework problems are provided to let students practice computing NAV. The chapter details a number of recent high-profile conflict of interest cases. These provide an excellent opportunity to address ethical issues faced by mutual fund managers. Discuss the motivations that lead to the abuses and alternative organizational structures that would reduce these problems. Include in the discussion the long-term implication to the industry of continued conflict of interest abuse. 

Answers to End-of-Chapter Questions 1. Liquidity intermediation, denomination intermediation, ease of diversification, cost advantages, and the growth of defined contribution pension plans.

2. Although you cannot buy large denomination securities on your own, a mutual fund can do it by pooling your savings with other savers’ funds. You will be making use of the denomination intermediation benefit of mutual funds.

3. Even if mutual fund managers cannot outperform the market, individual savers like William choose to buy shares in mutual funds based on other reasons. For example, investors might not have the time to be looking at profitable opportunities and thereby trust that the fund managers will do it for them. In addition, mutual funds pay much lower transaction fees. So, although it is true that individual investors pay fees, they also get to own a portfolio that they could not manage on their own.

4. An open-end mutual fund is continuously issuing new shares as new funds are received.

A closed-end fund only issues shares once.

5. Investors have different objectives, goals, and tastes in securities. Mutual funds attempt to offer a selection of funds to attract as many dollars as possible. Each different fund will have some attribute that separates it from the others in the family.

6. Index funds are not actively managed. They simply hold the stocks in the index. They usually have significantly lower fees than actively managed funds.

7. If you are young and have many years for your initial investment to grow, you would not mind to pay a fixed fee at the beginning of your investment. This is similar to taking a large loss in an investment, which will be more than offset over the years of positive returns. However, if you are not young, you might not have too many years at your disposal for your investment to grow enough to offset the initial payment of the fee. This example is meant to illustrate the power of compounding over the years.

8. Given that mutual funds fees have been steadily decreasing during the last 20 years primarily due to competition between mutual funds, one should conclude that in this case competition has been a good thing. One should also consider that when it comes to the financial industry, sometimes too much competition can encourage financial institutions to accept too much risk.

9. Hedge funds typically require very large investments, do not allow withdrawals, and charge very high fees.

10. Money market interest rates rose in the late 1970s when bank interest rates were capped by Regulation Q. Investors traded the safety of banks for the high returns offered by MMMFs due to the types of securities they held.

11. This is a controversial issue, since some regulators actually have the intention to designate mutual fund companies with assets over $50 billion as SIFIs. In this scenario, mutual funds will have to comply with capital reserves. Critics of this policy argue that mutual funds would then have to raise these funds through fees paid by investors. This would result in higher fees and potentially lower returns, since part of the mutual fund cannot be invested. One should also take into consideration that, in general, opponents of these regulations paint a gloomy scenario precisely to avoid such regulations that might increase stability in the financial system at the cost of lower returns for mutual funds.

12. Investment managers are usually compensated as a percentage of the funds under management. They have an incentive to increase total assets, even when this is done at the expense of shareholder return.

13. Late trading is allowing investors to buy or sell shares in a fund after the 4:00 PM closing time when the fund NAV is set.

14. Market timing occurs when investors take advantage of time zones and the 4:00 PM NAV valuation to engage in arbitrage trading.

15. Increased disclosure, more independent directors, hardening of the 4:00 PM closing time, and fees for early fund withdrawals.



Quantitative Problems

1.

A mutual fund charges a 4.2% front-end load. Determine the maximum annual expense ratio you will be willing to pay if you do not want to pay more than 1.7% in fees per year (assume you will hold the fund for 30 years).

Solution: 4.2%/30 = .14% 1.7% ‒ 0.14% = 1.56%

2.

A mutual fund reported year-end total assets of $2,347,000,000. Determine the expense ratio if total fees amounted to $18,580,000.

Solution: The expense ratio is: $18,580,000 / $2,347,000,000 = 0.79%

3.

A mutual fund offers ―A‖ shares which have a 5% upfront load and an expense ratio of 0.76%. The fund also offers ―B‖ shares which have a 3% back-end load and an expense ratio of 0.87%. Which shares make more sense for an investor looking over an 18-year horizon?

Solution: For the ―A‖ shares, the average annual fee is 5%/18  0.76%  1.0378% For the ―B‖ shares, the average annual fee is 3%/18  0.87%  1.0367% So, the investor is better off with the ―B‖ shares.

4. Calculate the NAV of the following fund assuming 3,500 shares are outstanding. Calculate the percentage change in the NAV of the fund if stock C climbs to $33.41.

Stock

Shares owned

Price

A

500

$5.74

B

6,000

$65.10

C

3,000

$12.04

Cash

n/a

$4,368.40

Solution: (500 × 5.74) + (6000 × 65.10) + (3000 × 12.04) + 4,368.40 = $433,958.40 NAV = $433,958.4 / 3,500 = $123.99 If stock C climbs to $33.41, then (500 × 5.74) + (6000 × 65.10) + (3000 × 33.41) + 4,368.40 = $498,068.40 NAV = $498,068.40 / 3,500 = $142.31 ($142.31 – $123.99) / $123.99 = 14.77% 5. Calculate the NAV of the following fund if 5,000,000 shares are outstanding. Assuming you bought shares in this fund a year ago at $5.06, determine the yield on your investment.

Stock (at current market value)

$15,000,000

Bonds (at current market value)

$12,000,000

Cash

$800,000

Total value of assets

$27,800,000

Liabilities

-$200,000

Net Worth

$27,600,000

Solution: $27,600,000 / 5,000,000 = $5.52 ($5.52‒$5.06) / $5.06 = 9.1% 6. On January 1st, a mutual fund has the following assets and prices at 4:00 p.m.:

Stock

Shares owned

Price

1 2 3 4 5

1,000 5,000 1,000 10,000 3,000

$ 1.97 $48.26 $26.44 $67.49 $ 2.59

Calculate the net asset value (NAV) for the fund. Assume that 8,000 shares are outstanding for the fund.

Solution: NAV 

$1,970  $241,300  $26,440  $674,900  $7,770  $119.05/share 8,000

7. An investor sends the fund a check for $50,000. If there is no front-end load, calculate the new number of shares and price/share. Assume the manager purchases 1,800 shares of stock 3, and the rest is held as cash.

Solution: With the $50,000, the value of the fund is now $952,380  50,000  $1,002,380.

Shares are sold at a price of $119.05, or 420 new shares. There are now 8,420 shares outstanding.

The new fund looks like: Stock

Shares owned

Price

1 2 3 4 5 Cash

1,000 5,000 2,800 10,000 3,000 n/a

$ 1.97 $48.26 $26.44 $67.49 $ 2.59 $ 2408

8. On January 2nd, the prices at 4:00 PM are: Stock

Shares owned

Price

1 2 3 4 5 Cash

1,000 5,000 2,800 10,000 3,000 n/a

$ 2.03 $51.37 $29.08 $67.19 $ 4.42 $ 2408

Calculate the net asset value (NAV) for the fund.

Solution: NAV 

$2,030  $256,850  $81,424  $671,900  $13,260  2,408  $122.08/share 8,420

9. Assume the new investor then sells the 420 shares. What is his profit? What is the annualized return? The fund sells 800 shares of stock 4 to raise the needed funds.

Solution: The 420 shares are worth 420  $122.08  $51,273.60, for a profit of $1,273.60.

The one day return is $1,273.60/50,000  2.54%. Annualized, this is 637% in nominal terms, assuming 250 trading days.

The new fund is: Stock Shares owned 1 2 3 4 5 Cash

1,000 5,000 2,800 9,200 3,000 n/a

Price $ 2.03 $ 51.37 $ 29.08 $ 67.19 $ 4.42 $4,886.40

10. To discourage short-term investing in its fund, the fund now charges a 5% upfront load and a 2% back-end load. The same investor decides to put $50,000 back into the fund. Calculate the new number of shares outstanding. Assume the fund manager buys back as many roundlot shares of stock 4 with the cash.

Solution: With the upfront load, 5% is charged as a commission. The actual funds invested are $50,000  0.95  $47,500.

This represents $47,500/122.08  389.09 new shares.

The manager purchases 700 shares of stock 4.

11. On January 3rd, the prices at 4:00 PM are: Stock

Shares owned

Price

1 2 3 4 5 Cash

1,000 5,000 2,800 9,900 3,000 n/a

$ 1.92 $ 51.18 $ 29.08 $ 67.19 $ 4.51 $5,353.40

Calculate the new NAV. Solution: NAV 

$1,920  $255,900  $81,424  $665,181  $13,530  $5,353.40  $121.98/share 8,389.09

12. Unhappy with the results, the new investor then sells the 389.09 shares. What is his profit?

What is the new fund value?

Solution: The 389.09 shares are worth 389.09  $121.98  $47,461.20. This amount comes out of the fund, leaving the fund with $975,847.20.

The investor must then pay the 2% back-end fee, leaving $47,461.20  0.98  $46,511.98. This represents a loss of $3,488.02, mostly due to fees.

Chapter 21 Insurance Companies and Pension Funds Insurance Companies Fundamentals of Insurance Adverse Selection and Moral Hazard in Insurance Selling Insurance Mini-Case Box: Insurance Agent: The Customer’s Ally Growth and Organization of Insurance Companies Types of Insurance Life Insurance Health Insurance Property and Casualty Insurance Insurance Regulation The Practicing Manager: Insurance Management Screening Risk-Based Premium Restrictive Provisions Prevention of Fraud Cancellation of Insurance Deductibles Coinsurance Limits on the Amount of Insurance Summary Credit Default Swaps Conflicts of Interest Box: The AIG Blowup Pensions Conflicts of Interest Box: The Subprime Financial Crisis and the Monoline Insurers Types of Pensions Defined-Benefit Pension Plans Defined-Contribution Pension Plans Private and Public Pension Plans Mini-Case Box: Power to the Pensions

Regulation of Pension Plans Employee Retirement Income Security Act Individual Retirement Plans The Future of Pension Funds



Overview and Teaching Tips

Insurance companies and pensions are two ways people are saving in nonbank institutions. Since most people are risk-averse, they prefer to buy insurance and take the risk away from themselves.

This chapter explains the fundamentals of insurance by discussing several basic principles. Life insurance and property and casualty insurance are the two most common types of insurance. The section on life insurance provides an in-depth look at the different types and parts of life insurance. One must decide what type they desire to have either for their retirement, death, or both. The largest health insurance company in the nation is Blue Cross/Blue Shield which covers hospital care and doctor services. Property and casualty insurance protect against losses from fire, theft, storm, explosion, and neglect. This type of policy is short term compared to life insurance, which is long term. The characteristics of property and casualty insurance are laid out in detail.

People are retiring earlier and living longer, so pension plans have become a growing investment vehicle. Pension plans can either be defined-benefit or defined-contribution plans and either public or private. Social Security is the largest public pension plan. All plans must follow a set of standards called the Employee Retirement Income Security Act. The Pension Benefit Guarantee Corporation insures most private pension plans.



Answers to End-of-Chapter Questions

1. Camille is risk-averse and will be therefore more prone to buy insurance on her house. We can state this based on the fact that Camille prefers to have $100 with certainty than to play a game with an expected payoff of $100 = $0 × 0.5 + $200 × 0.5 2. Insurance companies do not want people to use insurance as a form of gambling.

3. The insurance company is trying to mitigate the moral hazard problem. In this context, the moral hazard problem is the possibility that the professional tennis player will engage in activities that might harm her ability to keep playing tennis. If this happens during a tennis match, then the insurance company will have to pay the stipulated amount. However, the insurance company will not like to pay this amount if the tennis player injures herself while conducting a risky activity.

4. Adverse selection occurs when a person elects to buy insurance because she knows her risk is greater than the average. Moral hazard occurs when an insured individual fails to protect against loss because he knows that the loss is covered by insurance.

5. Insurance companies protect themselves by requiring inspections and medical examinations, insuring groups rather than individuals, and insisting on a deductible.

6. Independent agents do not represent any particular insurance agency but sell products from a large number of companies. Exclusive agents sell the products of one company exclusively.

7. Most are stock companies.

8. The law of large numbers means that the greater instances of a given risk, the more accurate a prediction can be made. These predictions are tabulated in actuarial tables.

9. Term life insurance pays a death benefit if the policyholder dies; no other benefit is paid.

Whole policies pay a death benefit but also include a savings program that pays out if the policyholder lives.

10. Losses due to fire, theft, storm, explosion, and neglect are covered by property policies.

Casualty policies protect against harm from product failure or accidents.

11. Pay-as-you-go systems consist of money that workers contribute today that pays benefits to current recipients (i.e., pension funds, social security). As technology improves, less workers are needed to do the same job their predecessors performed. Less workers means a decrease in contributions by these workers to the same pension fund their predecessors (who are currently recipients) once contributed to. Additionally, less workers creates a decrease in social security withholding from wages to pay the 12.4% aggregate Social Security employment (6.2%) and employee (6.2%) tax that funds the Social Security pay-as-you-go system.

12. An aging population creates an influx of retiring individuals, resulting in an imbalance between recipients of and contributors to pay-as-you-go systems. With more retirees receiving benefits than workers contributing to fund those benefits, a deficit in the fund develops, which eventually leads to a depletion of the fund balance in a pay-as-you-go system.

13. A more sophisticated public, greater awareness of providing for retirement, and a lack of confidence in Social Security have led to growth in private pension plans.

14. Current workers’ tax payments go to pay the benefits of current retirees.

15. If all currently illegal workers become contributors of Social Security overnight, this will have the positive effect of increasing funds for this system. However, one also has to take into consideration the long-term effect: more people will become beneficiaries as these newly incorporated individuals retire.

 Quantitative Problems 1.

Research indicates that the 1,000,000 cars in your city experience unrecoverable losses of $250,000,000 per year from theft, collisions, and so on. If 30% of premiums are used to cover expenses, what premium must be charged to car owners?

Solution: The average loss per car  $250,000,000/1,000,000 cars  $250/car So, 70% of the premium must equal the payout of $250.

Or, 0.70 Premium  $250 Premium  $250/0.70 Premium  $357.14

2.

Calculate the expected payoff of a game in which you can lose $200 with probability 0.3, win $240 with probability 0.5, and win $700 with probability 0.2.

Solution: Expected loss from losing the game: -$200 × 0.3 = -$60 Expected payoff from winning $240: $240 × 0.5 = $120 Expected payoff from winning $700: $700 × 0.2 = + $140 Overall Expected Payoff = $200

3.

Refer to the previous exercise. Suppose an individual prefers to play the game rather than to accept $200 with certainty. Is this individual risk-averse or a risk lover?

Solution: Individuals who are risk-averse prefer to know with certainty what their wealth will be rather than accepting the risk that their wealth may fall. Considering the individual would rather play the game than accept $200 with certainty, that individual is accepting the risk that he/she might lose $200, which is the opposite of risk-averse, making that individual a risk-lover.

4.

Assume that the monthly payments faced by an insurance company are normally distributed with a mean of $100,000 and a standard deviation of $12,000. Determine the probability that in a given month the company will have to pay more than $124,000.

Solution: x = 124,000 µ = 100,000 σ = 12,000 Z = x - µ/ σ P(Z>=124,000-100,000/12,000) P(Z>=2) = 1 - .97725 P = .02275

5.

Kio Outfitters estimated the following losses and probabilities from past experience: Loss

Probability

$30,000 $15,000 $10,000 $ 5,000 $ 1,000 $ 250 $ 0

0.25% 0.75% 1.50% 2.50% 5.00% 15.00% 75.00%

What is the probability Kio will experience a loss of $5,000 or greater? If an insurance company offers a loss policy with $1,500 deductible, what is the most Kio will pay?

Solution: Losses of less than $5,000 occur 95% of the time. So, 5% of the time, losses will be $5,000 or greater.

With a $1,500 deductible, Kio’s expected losses are: Loss

Probability

$28,500 $13,500 $ 8,500 $ 3,500 $ 1,000 $ 250 $ 0

0.25% 0.75% 1.50% 2.50% 5.00% 15.00% 75.00%

The expected (mean) loss is $475, which is the fair price of insurance.

6.

A client needs assistance with retirement planning. Here are the facts:  The client, Dave, is 21 years old. He wants to retire at 65.  Dave has disposable income of $2,000/month.



The IRA Dave has chosen has an average annual return of 8%.

If Dave contributes half of his disposable income to the account, what will it be worth at 65?

How much would he need to contribute to have $5,000,000 at 65?

Solution: Compute the future value at $1,000 per month: N  44  12; PMT  1,000; I  8/12; PV  0 Compute FV. FV  $4,858,811 Dave is clearly close to his goal already. To determine what he needs to have the $5 M: FV  5,000,000; I  8/12; N  528; PV  0 Compute PMT. PMT  $1,029.

7.

When opening an IRA account, investors have two options. With a regular IRA account, funds added are not taxed initially, but are taxed when withdrawn. With a Roth IRA, the funds are taxed initially, but not when withdrawn. If an investor wants to contribute $15,000 before-tax to an IRA, what will be the difference after 30 years between the two options?

Assume that the investor is currently in the 25% tax bracket, and the IRA will earn 6%/year.

Solution: With the regular IRA, the after-tax final value is: N  30; I  6; PV  15,000; PMT  0 Compute FV. FV  86,152, or 86,152  (1  0.25)  $64,614 after tax.

With the Roth IRA, the after-tax final value is: N  30; I  6; PV  15,000  (1  0.25); PMT  0 Compute FV. FV  $64,614.

So, unless an investor expects to lower tax rates in the future, the two are equivalent. There are other reasons to use a Roth IRA not discussed here.

8.

An employee contributes $200 a year (at the end of the year) to her pension plan. What would be the total contributions and value of the account after 5 years? Assume that the plan earns 15% per year over the period.

Solution: The total contributions are $200  5  $1,000.

The future value of the plan is: N  5; PMT  200; I  15; PV  0 Compute FV. FV  $1,348.47

9.

Paul’s car slid off the icy road, causing $2,500 in damage to his car. He was also treated for minor injuries, costing $1,300. His car insurance has a $500 deductible, after which the full loss is paid.

His health insurance has a $100 deductible and covers 75% of medical cost (total). What was Paul’s out-of-pocket costs from the incident?

Solution: The car will cost Paul $500. The remaining $2,000 is covered.

Paul will pay $400 of the medical expenses – the $100 deductible plus 25% of the remaining $1,200 of expense.

Chapter 22 Investment Banks, Security Brokers and Dealers, and Venture Capital Firms Investment Banks Background Underwriting Stocks and Bonds Equity Sales Mergers and Acquisitions Mini-Case: Twitter Uses Poison Pills to Drive Hard Bargain with Musk Securities Brokers and Dealers Brokerage Services Securities Dealers Mini-Case Box: Example of Using Limit-Order Book Regulation of Securities Firms Relationship Between Securities Firms and Commercial Banks Private Equity Investment Venture Capital Firms Private Equity Buyouts Advantages to Private Equity Buyouts Life Cycle of the Private Equity Buyout



Overview and Teaching Tips

This chapter covers securities firms, which are firms that buy and sell bonds and stocks. This chapter also covers organized exchanges, securities brokers, and dealers. The Securities and Exchange Commission regulates the information that prospective investors receive. When investment bankers underwrite a stock or bond issue, the firm purchases the whole issue and resells it in the market. Giving advice, filing documents, and marketing issues are some of the services provided in underwriting. Investment bankers also deal with mergers and acquisitions and private placements, which is an alternative method of selling securities.

Securities brokers and dealers trade within the secondary market and link buyers to sellers. Dealers actually buy and sell the stocks or bonds, while brokers do not take ownership of them. Brokers offer several services to their customers, including securities orders, margin credit, and other services traditionally offered by commercial banks, like ATMs and debit cards. There are two different types of securities orders, a market order or a limit order. Both are concerned with the price at which one will buy or sell a security. Full-service brokers provide advice on investments and do research for their customers. There is a large fee for this type of service. On the other hand, discount brokers simply place orders when requested. Firms are prohibited from trading on insider information because it is against SEC regulations.

This chapter concludes by discussing the role of venture capital firms in funding start-up firms.

The use of venture capital financing peaked in the early 2000s. The chapter traces the usual progression of a venture capital deal.



Answers to End-of-Chapter Questions

1. Regulators felt that investment banking was riskier and had led to bank failures during the Great Depression.

2. Ipora Bank would accept your business. Pando Bank is not a bank in the ordinary sense; rather, it is an investment bank.

3. When an offering is underwritten, the investment banker purchases the issue at a prespecified price. In a best-efforts issue, the investment banker does not take ownership.

4. Investment bankers offer advice, help with filing documents, and assist with marketing the issue.

5. No, an SEC review simply determines if the proper documents have been filed.

6. If an investment bank decides not to form a syndicate to underwrite an issue of securities, this is probably an indicator that the investment bank is confident that the issue will sell at a higher price than it paid for them. Therefore, one could think that these securities are a good investment. If the investment bank decided not to spread the risk of the underwriting process, it is because it thinks that risks are very low.

7. No. Because an undersubscribed issue is indicative of a security priced too high. Even if it is a good investment, the inherent risk of loss is still present.

8. Company value is based on the use the buyer intends to make of it. In this situation, the buyer is only interested in selling the physical assets, so the value is only one amount.

Therefore, the value of the company’s assets would be the criterion used to value the firm.

9. In a hostile takeover, the target firm does not want control to pass to the acquiring firm, and so its management makes every effort to prevent the takeover from happening. In a merger, both sides work together to expedite the union of the firms.

10. They make a market by standing ready to buy or sell securities.

11. If the stock price subsequently increased, Axel would have to purchase those shares at a higher price and incur a loss, resulting in a decrease in Axel’s profits.

12. Yes, selling the security short.

13. Banks object because legislation prevents banks from entering the brokerage business but does not prevent brokers from entering the banking business.

14. First, the company is not subject to Sarbanes-Oxley regulation. Second, CEOs may feel they have more time and flexibility to make changes than when faced with quarterly profit expectations from public shareholders. Additionally, the CEO may be better motivated due to the compensation structure and both the owners may benefit from favorable tax treatment.



Quantitative Problems

Amazon.com2 issued an initial public offering in May of 1997. Prior to its IPO, the following information on shares outstanding was listed in the final prospectus:

Name and Address Jeffrey P. Bezos c/o Amazon.com, Inc. 1516 Second Avenue, 4th Floor Seattle, WA 98101 L. John Doerr Kleiner Perkins Caufield & Byers 4 Embarcadero Center, Suite 3520 San Francisco, CA 94111 Tom A. Alberg Scott D. Cook Patricia Q. Stonesifer All directors and executive officers as a group (14 persons) Total shares outstanding

Number of Shares Beneficially Owned

Percentage of Shares Outstanding Prior to Offering After Offering

9,885,000

47.5%

41.4%

3,401,376

16.4

14.3

195,000 75,000 75,000 15,688,925

— — — 72.5

— — — 63.5

20,858,702

100.0

—

In the IPO, the firm issued 3,000,000 new shares. The initial price was $18.00 per share with investment bankers retaining $1.26 as fees. The final first-day closing price was $23.50.

1.

What were the total proceeds from this offering? What part was retained by Amazon? What part by the investment bankers? What percent of the offering is this?

Solution: Total proceeds  3,000,000  $18.00  $54,000,000 To Amazon  3,000,000  $16.74  $50,220,000 To the IB  3,000,000  $1.26  $3,780,000, or 7% of the offer price.

2.

Mr. Doerr of Kleiner Perkins Caufield & Byers owned a significant number of shares. What was the market value of these shares at the end of the first day of trading?

Solution: Market value  3,401,376  $23.50  $79.93 million.

3.

What was the market value of Amazon.com following its first day as a publicly-held company?

Solution: Market cap  (20,858,702  3,000,000)  $23.50  $560.68 million.

4.

Refer back to the IPO of eBay presented in the problems for Chapter 13. What were the fees for eBay as a percent of funds raised? Does a pattern emerge?

Solution: For eBay, the offering price was also $18.00, with $1.26 retained by the investment bankers. Or 7% of the offering price.

2

Information summarized from http://www.sec.gov/Archives/edgar/data/1018724/0000891020-97-000868.txt

5.

Suppose the issue of 5,000,000 shares of stock was originally oversubscribed at a price of $15 per share. Calculate the money ―left on the table‖ if you realize that the stock could have been priced at $17.5 per share.

Solution: ($17.5 – $15) × 5,000,000 shares = $12,500,000 left on the table

6.

Xavi decides to short sell 10,000 shares of Guiness Co. stock, currently trading at $7.00 per share. Determine Xavi’s profits if Guiness stock trades at $5.00 per share at the moment in which Xavi has to buy the shares back.

Solution: ($7‒$5) × 10,000 shares = $20,000 gain

7.

Bluestar Airlines has physical assets valued at $12,500,000, and according to industry experts, the net present value of its future earnings amounts to $40.00 per share. Assuming there are 1,000,000 outstanding shares, determine the maximum price per share that a buyer will pay in an equity sale if this buyer is thinking about dismantling the company and selling the assets.

Solution: $12,500,000/1,000,000 shares = $12.5 per share

8.

The limit order book for a security is: Unfilled Limit Orders Buy

Orders

Sell

Orders

25.12 25.20 25.23

100 500 200

25.36 25.38 25.41

300 200 200

The specialist receives the following, in order: a. Market order to sell 300 shares b. Limit order to buy 100 shares at 25.38 c. Limit order to buy 500 shares at 25.30 How, if at all, are these orders filled? What does the limit order book look like after these orders?

Solution: a. is fulfilled with 200 shares @ 25.23 and 100 shares @ 25.20 b. is fulfilled with 100 shares @ 25.36 c. is not filled, and goes into the book After these, the book looks like: Unfilled Limit Orders Buy

Orders

Sell

Orders

25.12 25.20 25.30

100 400 500

25.36 25.38 25.41

200 200 200

Chapter 23 Risk Management in Financial Institutions Managing Credit Risk Screening and Monitoring Long-Term Customer Relationships Loan Commitments Collateral Compensating Balances Credit Rationing Managing Interest-Rate Risk Income Gap Analysis Duration Gap Analysis Example of a Nonbanking Financial Institution Some Problems with Income Gap and Duration Gap Analyses The Practicing Manager: Strategies for Managing Interest-Rate Risk



Overview and Teaching Tips

Risk management has become a major concern for managers of financial institutions in recent years. This chapter provides an introduction to this subject, which is useful for business students who will not take jobs in the financial institutions industry, and it also provides a solid grounding for students who will go on to pursue more advanced courses in risk management in financial institutions.

The section on managing credit risk is an excellent application of the basic concepts of adverse selection and moral hazard to explain managerial practices in the financial institutions industry.

The section on managing interest rate risk introduces students to how interest-rate risk is measured and then uses a Practicing Manager application to outline strategies for how to manage interest-rate risk. If duration GAP analysis is covered, then it is necessary that the Practicing Manager application in Chapter 3 on duration be covered earlier in the course.

This chapter is really one big application of concepts introduced earlier in the course. Not only does it help solidify students’ understanding of these concepts, but it also shows how these concepts are useful for solving managerial problems that business students are likely to encounter in the real world.



Answers to End-of-Chapter Questions

1.

Yes. By warning borrowers that they will not be able to get future loans if they engage in risky activities, borrowers will be less likely to engage in these activities in order to have access to loans in the future.

2.

Secured loans are an important method of lending for financial institutions because if the borrower defaults, the financial institution can take title to the collateral, sell it off, and use the proceeds to offset any losses on the loan. Thus, the financial institution can worry less about the adverse selection problem because it has some protection even if the borrower was a bad credit risk.

3.

This bank applied the principle of credit rationing in one of its forms: reducing the size of the loan granted to borrowers. This principle is basically an attempt to guard the bank against the moral hazard problem of encouraging an undesirable behavior of the borrower (i.e., one that will prevent Diego from using the loan to invest in his brewery, e.g., fly to Russia to watch the 2018 World Cup).

4.

To reduce adverse selection, a banker needs to screen out bad credit risks by learning as much as possible about potential borrowers. Similarly, to minimize moral hazard, the banker must continually monitor borrowers to see that they are complying with restrictive loan covenants. Hence it pays for the banker to be nosy.

5.

Since the FOMC decided not to alter the current level of the federal funds rate target, there will be no immediate effect on the bank income. However, if the increase materializes, then the bank will see a decrease in its profits of $5 million per each percentage point of the federal funds rate increased. Thus if the ¼% increase materializes, profits would fall by $1.25 million. Note that although the federal funds rate is not the only rate that the bank considers to price its assets and liabilities, it is usually considered a ―floor‖ interest rate, above from which all other interest rates are determined.

6.

False. Although diversification is a desirable strategy for a bank, it may still make sense for a bank to specialize in certain types of lending. For example, a bank may have developed expertise in screening and monitoring a particular kind of loan, thereby improving its ability to handle problems of adverse selection and moral hazard.

 Quantitative Problems 1.

A bank issues a $100,000 variable-rate, 30-year mortgage with a nominal annual rate of 4.5%. If the required rate drops to 4.0% after the first six months, what is the impact on the interest income for the first 12 months?

Solution: At 4.5%, the required payment is calculated as: PV = 100,000, I = 4.5/12, N = 360, FV = 0 Compute PMT. PMT = 506.685 If rate remain at 4.5%, the mortgage balance after 12 months is: PMT = 506.685, N = 348, I = 4.5/12, FV = 0 Compute PV. PV = 98,386.71, or $1,613.29 of the payments went toward principal.

The total payments = $506.685  12 = $6,080.22.

Interest income for the year is $6,080.22 ‒ $1,613.29 = $4,466.93 If rates drop to 4% for the last 6 months of the year: First, calculate the interest for the first six months: PMT = 506.685, N = 354, I = 4.5/12, FV = 0 Compute PV. PV  99,202.38, or $797.62 of the payments went toward principal.

The total payments  506.685  6  $3,040.11.

Interest income for the year is $3,040.11  $797.62  $2,242.49 of interest income.

Next, calculate the interest for the last six months: At 4.0%, the required payment is calculated as: PV  99,202.38, I  4.0/12, N  354, FV  0 Compute PMT. PMT  477.772 PMT  477.772, N  348, I  4.0/12, FV  0 Compute PV. PV  98,312.41, or $889.97 of the payments went toward principal.

The total payments  $477.772  6  $2,866.63.

Interest income for the year is $2,866.63  $889.97  $1,976.66 of interest income.

Total interest income  $2,242.49  $1,976.66  $4,219.15 Interest income has fallen by $247.78, or 5.5%, below what it would have been had the interest rate not fallen.

2. A bank issues a $100,000 fixed-rate, 30-year mortgage with a nominal annual rate of 4.5%.

If the required rate drops to 4.0% immediately after the mortgage is issued, what is the impact on the value of the mortgage?

Solution: At 4.5%, the required payment is calculated as: PV  100,000, I  4.5/12, N  360, FV  0 Compute PMT. PMT  506.685 In a 4.0% market, the value of the mortgage is: PMT  506.685, I  4.0/12, N  360, FV  0 Compute PV. PV  106,131.

The value of the mortgage has increased by $6,131, or 6.131%.

3. A bank makes a loan with the following characteristics: monthly payments for 20 years, with a nominal annual rate of 4.5%. The amount loaned is $350,000. What is the duration of the loan? Calculate the expected percentage change in value if the interest rate increases 1 percentage point immediately after approving the loan.

Solution: The monthly payment is computed using 12 × 20 = 240 periods, $350,000 as present value, and a monthly interest rate equal to 0.045/12. The monthly payment is: $2,214.27. The duration of the loan is calculated using an Excel spreadsheet: duration = 8.33. The expected percentage change in the value of the loan is calculated as:

P i P 0.01  Duration    8.33   7.97% P 1 i P 1.045

4. from

Calculate the new interest rate if a bank realizes that the value of a mortgage increases $450,000 to $471,428.57, if the duration of the mortgage is 10 and the interest rate used to price this asset was originally 5%.

Solution: The change in the interest rate solves the following equation: 21, 428.57 i  10   i  0.005 450,000 1  0.05

The new interest rate is therefore 0.05 – 0.005 = 4.5%.

5.

The duration of a bank is 9 years; the interest rate has recently decreased by 3/5 of a percentage point, increasing the value of the portfolio 4.5%. If the portfolio is now valued at $6.7 million, determine the value of the portfolio before the change in the interest rate.

Determine the interest rate at which the portfolio was originally priced (i.e., the level of the interest rate before its change).

Solution: The original valuation of the portfolio satisfies the following equation:

P P P P  P 6.7 6.7  0.045    1.045   1.045   1.045  P  P P P P P 1.045 P

6.7  6, 411, 483.25 1.045

The interest rate used to price the portfolio satisfies the following equation: 0.045  9 

6.

0.006 0.006  i  9  1  20% 1 i 0.045

A bank manager is worried because the income gap currently equals – $35 million and interest rates are expected to increase by 1.5%. Determine the amount of rate-sensitive assets if rate sensitive liabilities are $467 million. Calculate the change in bank income if interest rates do increase by 1.5%.

Solution: The amount of rate-sensitive liabilities solves the following equation: ‒35 = RSA ‒ 467 → RSA = 432 The change in bank income is calculated as: ∆I = ‒35,000,000 × 0.015 = ‒525,000

7.

A financial institution has rate-sensitive assets of $392 million. What is the maximum amount of rate-sensitive liabilities this institution will decide to keep in its balance sheet if interest rates are expected to increase by 1% and this institution wants to avoid losses in excess of $450,000?

Solution: The maximum amount of rate-sensitive liabilities solves the following inequality:

(392,000,000 ‒ RSL) × 0.01 ≤ 450,000 → RSL ≤

450,000  3,920,000 0.01

Therefore, rate-sensitive liabilities cannot exceed $347 million.

8.

Determine the income bank of an institution with the following assets: reserves ($6 million), short term securities ($8 million), commercial loans maturing in less than 1 year ($20 million), commercial loans maturing in more than 5 years ($30 million); and the following liabilities: federal funds ($9 million), short term borrowings ($10 million), long term borrowings ($7 million), and CDs maturing in more than 2 years ($4 million).

Solution: The income gap is calculated as: Rate-sensitive assets:

Short term securities ($8 million) Commercial loans maturing in less than 1 year ($20 million)

Rate-sensitive liabilities:

Federal funds ($9 million) Short term borrowings ($10 million)

GAP = (8+20) – (9+10) = $11 million.

9.

The following financial statement is for the current year. From the past, you know that 10% of fixed-rate mortgages prepay each year. You also estimate that 10% of checkable deposits and 20% of savings accounts are rate sensitive.

Second National Bank Assets Reserves Securities  1 Year 1 to 2 Years  2 years Residential Mortgages Variables-rate Fixed-rate Commercial Loans  1 Year 1 to 2 Years  2 years Buildings, etc.

Total

Liabilities $ 1,500,000 $ 6,000,000 $ 8,000,000 $ 12,000,000 $ 7,000,000 $ 13,000,000 $ 1,500,000 $ 18,500,000 $ 30,000,000 $ 2,500,000

$100,000,000

Checkable Deposits Money Market Deposits Savings Accounts CDs Variables-rate  1 Year 1 to 2 Years  2 years Fed Funds Borrowings  1 Year 1 to 2 Years  2 years Bank Capital

$ 15,000,000 $ 5,500,000 $ 8,000,000

Total

$100,000,000

$ 15,000,000 $ 22,000,000 $ 5,000,000 $ 2,500,000 $ 5,000,000 $ 12,000,000 $ 3,000,000 $ 2,000,000 $ 5,000,000

What is the current Income GAP for Second National Bank? What will happen to the bank’s current net interest income if rates fall by 75 basis points?

Solution: RSA  6 M  7 M  (0.10  13 M)  1.5 M  $15.8 million RSL  (0.10  15 M)  5.5 M  (0.20  8 M)  15 M  22 M  5 M  12 M $62.6 million GAP  $15.8 million  $62.6 million GAP  $46.8 million I 46.8 million  (0.0075) $351,000 10. Orinoco Bank has the following rate sensitive assets: Treasury bills ($210 million), commercial loans ($540 million), and consumer loans ($200 million). The duration of each type of asset is 0.65, 1.87, and 6.9 years, respectively. Calculate Orinoco Bank’s average duration of the assets if physical capital equals $35 million and the bank holds $15 million in reserves.

Solution: The average duration of assets is a weighted average of durations, taking into account that total assets are 210 + 540 + 200 + 35 + 15 = 1,000 million.

Average duration of assets:  210   540   200  0.65    1.87    6.9       2.5263  1,000   1,000   1,000 

11. Determine the duration gap of a financial institution with an average duration of assets of 3.2 years, an average duration of liabilities of 4.5 years assuming the market value of assets is $405 million and the market value of liabilities equal $382 million.

Solution: The duration gap is calculated as:  382  DURgap  3.2    4.5   1.044 405  

12. Determine the minimum average duration of assets a bank needs if it wants to tolerate a duration gap not lower than – 1.5 years, assuming the average duration of liabilities is 3 years, assets are currently valued at $300 million, and liabilities are $280 million.

Solution: The minimum average duration of assets satisfies the following inequality:  280   280  1.5  DURAssets    3    3   1.5  DURAssets  300   300 

→ 1.3 ≤ DURAssets Therefore, the bank needs an average duration of assets of 1.3 years.

13. CNDF Bank has assets totaling $250 million with an average duration of 3.5 years, and liabilities totaling $225 million, with an average duration of 5 years. CNDF Bank is subject to Basel III requirements, and therefore has to maintain a capital/asset ratio of at least 8%.

Determine if CNDF Bank complies with the requirement if interest rates increase from 6% to 7%.

Solution: Capital/assets ratio before the change in interest rates = 25/250 = 10%. CNDF Bank is therefore complying with the capital asset ratio requirement.

The duration gap is calculated as:  225  DURgap  5    4   1.4  250  The change in the market value of the bank’s net worth:

0.01   NetWorth   1.4    250,000,000  3,301,886.8 1.06  

The change in assets is calculated as: 0.01   Assets   5    250,000,000  11,792, 452.83 1.06  

New capital/assets ratio: 25,000,000  3,301,886.8 21,698,113.2   9.1% 250,000,000  11,792, 452.83 238, 207,547.17

CNDF still complies with the minimum capital requirement.

14. The manager for Tyler Bank and Trust has the following assets to manage: Asset Bonds Consumer Loans Commercial Loans

Value

Duration (in years)

115,000,000 345,000,000

9.00 2.00

575,000,000

5.00

Liability Demand Deposits Saving Accounts

Value

Duration (in years)

690,000,000 ??

1.00 0.50

If the manager wants a duration gap of 3.00, what level of Saving Accounts should the bank raise? Assume that any difference between assets and liabilities is held as cash (duration  0).

Solution: DURa  (9.00  115/1035)  (2.00  345/1035)  (5.00  575/1035)  4.44 Assume that the Saving Account value  Y. DURl  [1.00  690/(690  Y)]  [0.50  Y/(690  Y)] L  DURgap  DURa    DURl  A  3.00  4.44  [(690  Y)/1035]  [1.00  690/(690  Y)  0.50  Y/(690  Y)] Y  $1,600,000,000

Solution: DURa  (9.00  75/1650)  (2.00  875/1650)  (5.00  700/1650)  3.59 Assume that the Saving Accounts value  Y. DURl  [1.00  300/(300  Y)]  [0.50  Y/(300  Y)] DURgap  DURa  (L/A  DURl) 3.00  3.59  [(300  Y)/1650]  [1.00  300/(300  Y)  0.50  Y/(300  Y)] Y  1347

15. The following financial statement is for the current year: Second National Bank Assets

Duration

Reserves Securities

5,000,000

0.00

 1 Year 1 to 2 Years  2 years Residential Mortgages Variables-rate Fixed-rate Commercial Loans  1 Year 1 to 2 Years  2 years Buildings, etc.

5,000,000 5,000,000 10,000,000

0.40 1.60 7.00

10,000,000 10,000,000

0.50 6.00

15,000,000 10,000,000 25,000,000 5,000,000

0.70 1.40 4.00 0.00

Total

$100,000,000

Liabilities

Duration

Checkable Deposits Money Market Deposits Savings Accounts CDs Variables-rate  1 Year 1 to 2 Years  2 years Interbank Loans Borrowings  1 Year 1 to 2 Years  2 years Bank Capital

15,000,000 5,000,000

2.00 0.10

15,000,000

1.00

10,000,000 15,000,000 5,000,000 5,000,000 5,000,000

0.50 0.20 1.20 2.70 0.00

10,000,000 5,000,000 5,000,000 5,000,000

0.30 1.30 3.10

Total

$100,000,000

Calculate the duration gap for the bank.

Solution: DURa  (0.40  0.05)  (1.60  0.05)  (7.00  0.10)  (0.50  0.10)  (6.00  0.10)  (0.70  0.15)  (1.40  0.10)  (4.00  0.25) DURa  2.695 By the same technique, using total liabilities of 95,000,000, DURl  1.03 L  DURgap  DURa    DURl   2.695  (95 /100  1.03)  1.7165 A   16. If the First National Bank sells $10 million of its securities with maturities greater than two years and replaces them with securities maturing in less than one year, what is the income gap for the bank? What will happen to profits next year if interest rates fall by 3 percentage points?

Solution: Rate sensitive assets increase by $10 million, so the GAP rises by $10 million to $7.5 million. If interest rates fall by 3 percentage points, profits rise next year by I  GAP  i  $7.5  (0.03)  $0.225 million  $225,000.

17. If the First National Bank decides to convert $5 million of its fixed-rate mortgages into variable-rate mortgages, what happens to its interest-rate risk? Explain with income gap and duration gap analyses.

Solution: Rate-sensitive assets increase by $4 million, so GAP goes from $17.5 million to $13.5 million. (Of the $5 million of fixed-rate mortgages, $1 million is rate-sensitive because 20% are repaid within a year, so converting the $5 million of fixed-rate mortgages into variable-rate mortgages produces a net increase of rate-sensitive assets of $4 million.)

Because GAP falls in absolute value, the effect of changes in interest rates on its profits and hence on its interest-rate risk is smaller.

18. If the manager of the First National Bank revises the estimate of the percentage of fixed-rate mortgages that are repaid within a year from 20% to 10%, what will be the revised estimate of the interest-rate risk the bank faces? What will happen to profits next year if interest rates fall by 2 percentage points?

Solution: She reduces her estimate of rate-sensitive assets by $1 million (10% of $10 million) so the GAP goes from $17.5 million to $18.5 million. If interest rates fall by 2 percentage points, profits next year rise by I  GAP  i  $18.5  (0.02)   $0.37 million  $370,000.

19. If the manager of the First National Bank revises the estimate of the percentage of checkable deposits that are rate-sensitive from 10% to 25%, what will be the revised estimate of the interest-rate risk the bank faces? What will happen to profits next year if interest rates rise by 5 percentage points?

Solution: The manager raises the estimate of rate-sensitive liabilities by $2.25 million so that GAP goes from $17.5 million to $19.75 million. Because GAP rises in absolute value, the effect of changes in interest rates on its profits and hence its interest-rate risk is larger. If interest rates rise by 5 percentage points, profits next year change by I  GAP  i  $19.75 million  0.05 $0.9875 million.

20. Given the estimates of duration in Table 23.1, what will happen to the bank’s net worth if interest rates rise by 10 percentage points? Will the bank stay in business? Why or why not?

Solution: The percentage change in net worth as a percentage of assets is %NW  DURGAP  i/(1  i)  1.72  0.10/(1  0.10)  0.156  15.6%. With $100 million of assets, this means net worth declines by $15.6 million, from $5 million to $10.6 million.

Since the bank now has negative net worth, it is insolvent and will go out of business.

21. If the manager of the First National Bank revises the estimates of the duration of the bank’s assets to four years and liabilities to two years, what is the effect on net worth if interest rates rise by 2 percentage points?

Solution: The duration gap is now DURgap  DURA  (L/A  DURL)  4  (95/100  2)  2.1 years. The change in net worth as a percentage of assets is %NW  DURGAP  i/(1  i)  2.1  0.02/(1  0.10)  0.038  3.8%. With $100 million of assets, net worth declines by $3.8 million, from $5 million to $1.2 million.

22. Given the estimates of duration in Problem 21, how should the bank alter the duration of its assets to immunize its net worth from interest-rate risk?

Solution: It should solve the following equation: 0  DURA  [95/100  2]. This yields a duration of assets, DURA, of 1.9 years.

23. Given the estimates of duration in Problem 21, how should the bank alter the duration of its liabilities to immunize its net worth from interest-rate risk?

Solution: It should solve the following equation: 0  4  (95/100  DURL). This yields a duration of liabilities DURL of 4.2 years.

24. If the manager of the Friendly Finance Company decides to sell off $10 million of the company’s consumer loans, half maturing within one year and half maturing in greater than two years, and uses the resulting funds to buy $10 million of Treasury bills, what is the income gap for the company? What will happen to profits next year if interest rates fall by 5 percentage points? How could the Friendly Finance Company alter its balance sheet to immunize its income from this change in interest rates?

Solution: Rate-sensitive assets increase by $5 million so the GAP rises by $5 million to $17 million. If interest rates fall by 5 percentage points, profits next year change by Income  GAP  i  $17 million  (0.05)  $850,000. Friendly Finance could reduce its ratesensitive assets or increase its rate-sensitive liabilities.

25. If the Friendly Finance Company raises an additional $20 million with commercial paper and uses the funds to make $20 million of consumer loans that mature in less than one year, what happens to its interest-rate risk? In this situation, what additional changes could it make in its balance sheet to eliminate the income gap?

Solution: Interest-rate risk stays the same because rate-sensitive assets and rate-sensitive liabilities increase by an equal amount, leaving the income gap the same. The Friendly Finance Company still has an income gap of $12 million, and to eliminate it, it could either reduce its rate-sensitive assets to $43 million or increase its rate-sensitive liabilities to $55 million.

26. Given the estimates of duration in Table 23.2, what will happen to the Friendly Finance Company’s net worth if interest rates rise by 3 percentage points? Will the company stay in business? Why or why not?

Solution: The percentage change in net worth as a percentage of assets is %NW  DURGAP  i/(1  i)  (1.33)  0.03/(1  0.08)  0.037  3.7%. With $100 million of assets, this means net worth increases by $5.7 million, from $10 million to $15.7 million.

Since the bank has an even larger net worth, it is clearly solvent and will certainly stay in business.

27. If the manager of the Friendly Finance Company revises the estimates of the duration of the company’s assets to two years and liabilities to four years, what is the effect on net worth if interest rates rise by 3 percentage points?

Solution: The duration gap is now DURGAP  DURA  (L/A  DURL)  2  (90/100  4)  1.6 years.

The change in net worth as a percentage of assets is %NW  DURGAP  i/(1  i)    0.03/(1  0.08)  0.044  4.4%. With $100 million of assets, net worth increases by $4.4 million, from $10 million to $14.4 million.

28. Given the estimates of duration found in Problem 27, how should the Friendly Finance Company alter the duration of its assets to immunize its net worth from interest-rate risk?

Solution: It should solve the following equation: 0  DURA  [90/100  4]. This yields a duration of assets, DURA, of 3.6 years.

29. Given the estimates of duration in Problem 27, how should the Friendly Finance Company alter the duration of its liabilities to immunize its net worth from interest-rate risk?

Solution: It should solve the following equation: 0  2  (90/100  DURL). This yields a duration of liabilities DURL of 2.22 years.

Chapter 24 Hedging with Financial Derivatives Hedging Forward Markets Interest-Rate Forward Contracts The Practicing Manager: Hedging Interest-Rate Risk with Forward Contracts Pros and Cons of Forward Contracts Financial Futures Markets Financial Futures Contracts Following the Financial News: Financial Futures The Practicing Manager: Hedging with Financial Futures Organization of Trading in Financial Futures Markets Globalization of Financial Futures Markets Explaining the Success of Futures Markets Mini-Case Box: The Hunt Brothers and the Silver Crash The Practicing Manager: Hedging Foreign Exchange Risk with Forward and Futures Contracts Hedging Foreign Exchange Risk with Forward Contracts Hedging Foreign Exchange Risk with Futures Contracts Stock Index Futures Stock Index Futures Contracts Following the Financial News: Stock Index Futures The Practicing Manager: Hedging with Stock Index Futures Options Option Contracts Profits and Losses on Options and Futures Contracts Factors Affecting the Prices of Option Premiums Summary The Practicing Manager: Hedging with Futures Options Interest-Rate Swaps Interest-Rate Swap Contracts

The Practicing Manager: Hedging with Interest-Rate Swaps Advantages of Interest-Rate Swaps Disadvantages of Interest-Rate Swaps Financial Intermediaries in Interest-Rate Swaps Credit Derivatives Credit Options Credit Swaps Credit-Linked Notes Case: Lessons from the Subprime Financial Crisis: When Are Financial Derivatives Likely to be a Worldwide Time Bomb?



Overview and Teaching Tips

The treatment of financial derivatives markets (forwards, futures, options, and swaps) in this book differs markedly from that in other financial markets and institutions books. Financial derivatives are approached from the perspective of managers of financial institutions, and this is why this material is placed in the management of financial institutions part of the book. Rather than go into a lot of facts about these different markets, this chapter, which covers financial derivatives, focuses on how these markets work and how they can be used to hedge the risk faced by financial institutions. This approach makes more sense to students who now clearly see why studying these markets and their operation is relevant.

One problem that we have encountered in teaching students about financial derivatives is that many do not find the financial derivative contracts to be particularly intuitive. In order to get them to understand how these contracts work, we find that it helps to outline the basic principle of hedging: Hedging risk involves engaging in a financial transaction that offsets a long position with a short position, or offsets a short position with a long position. The chapter then uses this principle over and over again to demonstrate how different types of contracts can be used to hedge risk. In addition, to hammer home how these contracts work, this chapter contains several Practicing Manager applications that provide specific numerical examples of how hedges are conducted with financial futures and forward contracts. We know of no other financial markets and institutions textbook that takes as applied an approach to teaching students about financial futures and forward contracts as I do in this book. My experience is that only with applications of the type found in this chapter can students have any real understanding of what financial derivatives are all about.

The Practicing Manager applications in this chapter are all self-contained and can be skipped without loss of continuity. For example, if an instructor only wants to focus on hedging interest rate risk, then he or she can easily skip the applications dealing with hedging stock market risk or foreign exchange rate risk.

Other financial markets and institutions textbooks tend to give only a cursory treatment of what profits arise for a holder of an option contract given different market outcomes. They may have a figure illustrating the profits, but do not give a detailed explanation of how profits are generated. We think that this is a terrible mistake because students often do not find financial derivatives contracts to be particularly intuitive, and this is particularly true for the options contract. This chapter takes a different approach by containing an extensive explanation and discussion of Figure 24.1, which outlines the profits and losses that occur on financial options and futures contracts depending on what happens to the price of bonds. To get the students to understand these contracts and what their differences are, the instructor needs to carefully walk the students through the numerical

example of Figure 24.1. Our experience in class suggests that unless this is done, many students will just not understand what these financial derivatives and, particularly options, are all about.



Answers to End-of-Chapter Questions

1.

Financial managers should be prepared for an increase in interest rates somewhere in the near future. The fact that the FOMC announced a possible increase in interest rates as the economy recovers does not mean that interest rates will increase immediately, but they should be considering this scenario with higher probability. The instruments used by each financial manager will depend on the characteristics of their business and the portfolio they manage. In essence, they should be prepared for a price decrease in securities (as the discount factor increases), and will have to find the specific instrument that better helps them to hedge this risk (forwards contracts, financial futures contracts, options, etc.).

2.

It would swap interest on $5 million of variable-rate assets for the interest on $5 million of fixed-rate assets, thereby eliminating its income GAP.



Quantitative Problems

1.

Leticia has to hedge the interest rate risk of her holdings of $6,480,000 in Treasury bonds by buying or selling futures contracts. Determine the type of transaction and the price of each contract if Leticia buys/sells 48 contracts.

Solution: To offset the long position, Leticia has to take a short position by selling futures contracts for the amount to hedge. If Leticia sells 48 futures contracts, then each contract sells for $6,480,000/48 = $135,000.

2.

If the portfolio you manage is holding $25 million of 6s of 2043 Treasury bonds with a price of 110, what forward contract would you enter into to hedge the interest-rate risk on these bonds over the coming year?

Solution: You would enter into a contract that specifies that you will sell the $25 million of 6s of 2043 at a price of $110 one year from now.

3.

Calculate the amount of futures contracts you need to sell to hedge the interest rate risk on your holdings of $4 million of T-bonds. Assume each contract currently sells for $125,000.

Solution: The amount of contracts you need to buy solves the following equation: NC = $4,000,000/$125,000 = 32

4.

Refer to the previous exercise. Determine your profit if at the expiration date the settle price of the contract is 135 points. Calculate the gain or loss in each position.

Solution: If the settle price at the expiration date is quoted as 135 points, this means that the contract for $100,000 face value of bonds sells for $135,000.

Short Position: Amount paid to you at the expiration date: Cost of bonds delivered at the expiration date: Loss:

$125,000 × 32 = $4,000,000 $135,000 × 32 = $4,320,000 $320,000

Long position: Original value:

$125,000 × 32 = $4,000,000

Value at the expiration date: Gain:

$135,000 × 32 = $4,320,000 $320,000

5. Suppose that the pension you are managing is expecting an inflow of funds of $100 million next year and you want to make sure that you will earn the current interest rate of 8% when you invest the incoming funds in long-term bonds. How would you use the futures market to do this?

Solution: You would buy $100 million worth, i.e., 1000 contracts of long-term bond futures contracts with an expiration date of one year in the future. This means that you would be entitled to delivery of the long-term bonds at today’s price so that the current rate would be locked in.

6. How would you use the options market to accomplish the same thing as in Problem 5? What are the advantages and disadvantages of using an options contract rather than a futures contract?

Solution: You would buy $100 million worth (1000 contracts) of the call long-term bond option with a delivery date of one year in the future and with a strike price that corresponds to a yield of 8%. This means that you would have the option to buy the long bond with the 8% interest rate, thereby making sure that you can earn the 8%. The disadvantage of the options contract is that you have to pay a premium that you would not have to pay with a futures contract. The advantage of the options contract is that if the interest rate rises and the bond price falls during the next year, you do not have to exercise the option and so will be able to earn a higher rate than 8% when the funds come in next year, whereas with the futures contract, you have to take delivery of the bond and will only earn 8%.

7.

Suppose you buy a call option on a $100,000 Treasury bond futures contract with an exercise price of 105. If the price of the Treasury bond is 115 at expiration, is the option at the money, in the money, or out of the money? Determine the premium if the profit equals $8,000.

Solution: The call option is ―in the money‖ because you would want to exercise the right to buy the Treasury bonds at $105 and then sell them at $115, for a profit. If the profit equaled $8,000, this means that the premium was (115 – 105) × 100,000 – 8,000 = $2,000.

8.

Jason bought a put option on a $100,000 Treasury bond futures contract with an exercise price of 105 for a premium of $2,000. If on expiration the futures contract sells for 110, determine Jason´s profits and explain if he will exercise the right to sell the futures contract.

How would your answer change if the futures contract sells for 95 on expiration?

Solution: If price on expiration is 110: The option is ―out of the money‖ and Jason does not exercise his right to sell the futures contract. His profit is: – $2,000.

If price on expiration is 95: The option is ―in the money‖ and Jason exercises his right to sell the futures contract. His profit is: (105 – 95) × 100,000 – $2,000 = $8,000.

9.

Refer to the previous exercise. Determine Jason´s profits (for both prices on expiration date) if instead of buying a put option on a futures contract he sold a $100,000 Treasury bonds futures contract at par.

Solution: If price on expiration is 110: In this case Jason has to buy $100,000 face value of Treasury bonds, thereby spending $110,000, and he gets paid only $100,000, his profit is: – $10,000.

If price on expiration is 95:

In this case Jason has to buy $100,000 face value of Treasury bonds, thereby spending $95,000, and he gets paid $100,000, his profit is: $5,000.

10. If the savings and loan you manage has a gap of ‒$42 million, describe an interest-rate swap that would eliminate the S&L’s income risk from changes in interest rates.

Solution: It would swap interest on $42 million of fixed-rate assets for the interest on $42 million of variable-rate assets, thereby eliminating its income gap.

11. If your company has a payment of 200 million euros due one year from now, how would you hedge the foreign exchange risk in this payment with 125,000 euros futures contracts?

Solution: You would buy 200 million euros of March futures contracts. With a contract size of 125,000 euros, you would buy 200 million/125,000 = 1600 contracts.

12. If your company has to make a 10 million euros payment to a German company in June, three months from now, how would you hedge the foreign exchange risk in this payment with a 125,000 euros futures contract?

Solution: You would hedge the risk by buying 80 euro futures contracts that mature 3 months from now.

13. Suppose that your company will be receiving 30 million euros six months from now and the euro is currently selling for 1 euro per dollar. If you want to hedge the foreign exchange risk in this payment, what kind of forward contract would you want to enter into?

Solution: You would want to enter into a contract in which you deliver 30 million euros six months from now in exchange for U.S. $30 million.

14. A hedger takes a short position in five T-bill futures contracts at the price of 98 5/32 . Each contract is for $100,000 principal. When the position is unraveled, the price is 95 12/32 . What is the gain/loss on this transaction?

Solution: Gain/contract  (98 5/32  95 12/32)  1,000  $2,781.25 Total gain  $2,781.25  5  $13,906.25 15. A bank issues a $100,000 variable-rate, 30-year mortgage with a nominal annual rate of 4.5%. If the required rate drops to 4.0% after the first six months, what is the impact on the interest income for the first 12 months? Assume the bank hedged this risk with a short position in a 181-day Tbill future. The original price was 97 26/32 and the final price was 98 1/32 on a $100,000 face value contract.

Did this work?

Solution: At 4.5%, the required payment is calculated as: PV  100,000, I  4.5/12, N  360, FV  0 Compute PMT. PMT  506.685 If rate remain at 4.5%, the mortgage balance after 12 months is: PMT  506.685, N  348, I  4.5/12, FV  0 Compute PV. PV  $98,386.71, or $1,613.29 of the payments went toward principal.

The total payments  $506.685  12  $6,080.22.

Interest income for the year is $6,080.22  $1,613.29  $4,466.93 If rates drop to 4% for the last 6 months of the year: First, calculate the interest for the first six months: PMT  506.685, N  354, I  4.5/12, FV  0 Compute PV. PV = $99,202.38, or $797.62 of the payments went toward principal.

The total payments = $506.685 × 6 = $3,040.11.

Interest income for the year is $3,040.11  $797.62  $2,242.49 Next, calculate the interest for the last six months: At 4.0%, the required payment is calculated as: PV  99,202.38, I  4.0/12, N  354, FV  0 Compute PMT. PMT  477.772 PMT  477.772, N  348, I  4.0/12, N  354, FV  0 Compute PV. PV  $98,312.41, or $889.97 of the payments went toward principal.

The total payments  $477.772  6  $2,866.63.

Interest income for the year is $2866.63  $889.97  $1,976.66 Total interest income  $2,242.49  $1,976.66  $4,219.15 Interest income has fallen by $247.78, or 5.5%.

The gain on the T-bill future  (98 1/32  97 26/32)  1,000  218.75. This reduced the loss in interest income to just $29!

16. Laura, a bond portfolio manager, administers a $10 million portfolio. The portfolio currently has a duration of 8.5 years. Laura wants to shorten the duration to 6 years using T-bill futures. Tbill futures have a duration of 0.25 years and are trading at $975 (face value  $1,000). How is this accomplished?

Solution: The average portfolio duration needs to be 6 years.





10,000,000  6  (10,000,000  8.5)  (Y  0.25) 60,000,000  85,000,000  (Y  0.25) 25,000,000  Y  0.25 Y  $100,000,000

Laura must take a short position in $100,000,000 worth of T-bill futures. At the current price, this requires 100,000,000/975  102,564 contracts.

17.

Suppose you buy a futures contract at a price of 107 and that the margin requirement is 2 points. Determine the settlement price at which you will receive a margin call if the maintenance margin requirement is 1 point.

Solution: Since each point equals $1,000 of the contract, the settlement price at which you will receive a margin call satisfies the following equation: 1,000 = 2,000 ‒ (107 ‒ SP) × 1,000 → SP = 106 Therefore, if the price drops to 106, your balance at the brokerage firm drops to $1,000, your maintenance margin requirement.

18. Chicago Bank and Trust has $100 million in assets and $83 million in liabilities. The duration of the assets is 5.9 years, and the duration of the liabilities is 1.8 years. How many futures contracts does this bank need to fully hedge itself against interest rate risk? The available Treasury bond futures contracts have a duration of 10 years, a face value of $1,000,000, and are selling for $979,000.

Solution: This requires creating a DURgap = 0. Clearly, the duration of the assets exceeds the duration of the liabilities, so the bank will take a short position, effectively increasing its liabilities. Assume that the dollar amount of the position is Y. 83  Y  83 Y    1.8   10   0 100 83  Y 83  Y   500 = 149.40 + 10Y

DURgap  5 

Y = 35.06, or a position in $35,060,000 futures.

At the current price, this requires $35,060,000/979,000 = 35.812 contracts, or 36.

19. A bank issues a $3 million commercial mortgage with a nominal APR of 8%. The loan is fully amortized over 10 years, requiring monthly payments. The bank plans on selling the loan after 2 months. If the required nominal APR increases by 45 basis points when the loan is sold, what loss does the bank incur?

Solution: The mortgage requires monthly payments as follows: PV = 3000000, I = 8/12, N = 120, FV = 0 Compute PMT. PMT = $36,398.28 After 2 months, the remaining balance is: PMT = 36398.28, I = 8/12, N = 118, FV = 0 Compute PV. PV = $2,967,094.27 However, at the prevailing rate, the mortgage is sold for: PMT = 36398.28, I = 8.45/12, N = 118, FV = 0 Compute PV. PV = $2,910,552.12, or at a loss of $56,542.15 20. Assume the bank in the previous question partially hedges the mortgage by selling three 10year T-note futures contracts at a price of 100 20/32. Each contract is for $1,000,000. After 2 months, the futures contract has fallen in price to 98 24 /32 . What was the gain or loss on the futures transaction?

Solution: On each contract, the gain is (100 20/32  98 24/32)  10,000  18,750

Total gain = $18,750  3 = $56,250 21. Springer Country Bank has assets totaling $180 million with a duration of 5 years, and liabilities totaling $160 million with a duration of 2 years. Bank management expects interest rates to fall from 9% to 8.25% shortly. A T-bond futures contract is available for hedging. Its duration is 6.5 years and is currently priced at 99 5/32 . How many contracts does Springer need to hedge against the expected rate change? Assume each contract has a face value of $1,000,000.

Solution: $180 million  5 = ($160 million  2) + (TB  6.5) TB = 89,230,769 Since the current price is $991,562.50, this requires 90 contracts. They should take a short position.

22. From the previous question, rates do indeed fall as expected, and the T-bond contract is priced at 103 5/32 . If Springer closes its futures position, what is the gain or loss? How well does this offset the approximate change in equity value?

Solution:

L  DURgap  DURa    DURl   5  (160 /180)  2  3.22 A  

Change in equity = –3.22  (‒0.0075/1.09)  180,000,000 = $3,990,826 Each T-bill contract is worth $1,031,562.50, or $92,840,625 for the 90 contracts.

This represents a loss of $3,609,856, which roughly offsets the gain in equity value.

Although it appears that the bank would have been better off doing nothing, there was no guarantee that rates would not rise!

23.

A bank issues a $100,000 fixed-rate, 30-year mortgage with a nominal annual rate of 4.5%. If the required rate drops to 4.0% immediately after the mortgage is issued, what is the impact on the value of the mortgage? Assume the bank hedged the position with a short position in two 10-year T-bond futures. The original price was 64 12 /32 and expired at 67 16 /32 on a $100,000 face value contract. What was the gain on the futures? What is the total impact on the bank?

Solution: At 4.5%, the required payment is calculated as: PV = 100,000, I = 4.5/12, N = 360, FV = 0 Compute PMT. PMT = $506.685 In a 4.0% market, the value of the mortgage is: PMT = 506.685, I = 4.0/12, N = 360, FV = 0 Compute PV. PV = $106,131.

The value of the mortgage has increased by $6,131, or 6.131%.

The gain on each futures contract is (67 16/32 ‒ 64 12/32 )  1,000 = $3,125. The total gain is $6,250. However, depending on how this is handled, the loss in mortgage value will not show on the balance sheet or income statement.

However, the gain in futures will. This could potentially create a tax liability, perhaps as high as several thousand dollars. The exact treatment of the gain under current tax rules can be quite complicated and may diminish the ability of the bank to properly hedge.

24.

A bank customer will be going to London in June to purchase £100,000 in new inventory. The current spot and futures exchange rates are: Exchange Rates (Dollars/Pound) Period

Rate

Spot March June September December

1.5342 1.6212 1.6901 1.7549 1.8416

The customer enters into a position in June futures to fully hedge her position.

When June arrives, the actual exchange rate is $1.725 per pound. How much did she save?

Solution: She paid an actual rate of $1.6901 per pound, or $169,010. Had she simply taken the spot rate at the time, the cost would have been $172,500. She saved $3,490.

Of course, the actual rate could have been below $1.6901.

25. Suppose a bank has an income gap of – $15 million. How can this bank use interest rate swaps to hedge against interest rate increases? Determine the amount of the notional principal and propose an interest rate swap.

Solution: If the bank has a negative income gap, this is because it has more rate-sensitive liabilities than rate-sensitive assets. To protect itself against interest rate increases, it should convert fixed rate assets into rate-sensitive assets, for example by engaging in an interest rate swap with notional principal of $15 million, which involves paying over a given period of time a fixed rate on the $15 million in exchange for a variable rate applied to the same $15 million for the same period.

26. Liverpool Bank has an income gap of – $10 million, Alur Finance Co has an income gap of $25 million, and TLBR Bank has an income gap of – $15 million. Propose an interest rate swap that will benefit all three institutions. Determine the amount of notional principal for each interest rate swap.

Solution: Alur Finance Company can swap the interest generated by the excess of ratesensitive assets for fixed income, thus effectively converting the $25 million of rate-sensitive assets into fixed-rate income. This can be done by engaging in an interest rate swap with Liverpool Bank, where Liverpool Bank sends the income generated by a fixed rate applied to the notional principal of $10 million in exchange for the income generated by a variable rate applied to the notional principal (this favors Liverpool Bank, which can effectively reduce its income gap, by converting fixed income assets into rate-sensitive assets). The same procedure is conducted with TLBR bank, in this case for a notional principal of $15 million.

27. A banker commits to a two-year $5,000,000 commercial loan and expects to fulfill the agreement in 30 days. The interest rate will be determined at that time. Currently, rates are 7.5% for such loans. To hedge against rates falling, the banker buys a 30-day interest-rate floor with a floor rate of 7.5% on a notional amount of $10,000,000. After 30 days, actual rates fall to 7.2%. What is the expected interest income from the loan each year? How much did the option pay?

Solution: Assuming a simple interest commercial loan, the interest received each year will be 7.2%  $5,000,000 = $360,000.

If rates had remained at 7.5%, the interest income would have been 7.5%  5,000,000 = $375,000.

Since rates fell, the floor pays $10,000,000  (0.075 ‒ 0.075) = $30,000. This makes up from the lower interest ($15,000) in both years. Unfortunately, the entire gain will probably have to be recognized this year.

28. A trust manger for a $100,000,000 stock portfolio wants to minimize short-term downside risk using Dow put options. The options expire in 60 days, have a strike price of 9,700, and a premium of $50. The Dow is currently at 10,100. How many options should she use? Long or short? How much will this cost? If the portfolio is perfectly correlated with the Dow, what is the portfolio value when the option expires, including the premium paid?

Solution: The trust manager needs $100,000,000/10,100 = 9,901 contracts. This will cost

$495,050.

The value of the portfolio as a function of the Dow will look like:

29.

Dickey Bank anticipates an increase in interest rates in 2016 and has therefore decided to engage in an interest rate swap in which it pays 3% over a notional principal of $4 million annually. Fuller Finance Company pays Dickey Bank the interest income generated by applying the T-bill rate plus 2%. Can you determine if the income gap of Dickey Bank is negative or positive? Determine the amount paid by each institution if the T-bill rate is 0.5% or 1.5%.

Solution: Since Dickey Bank is expecting an increase in interest rates and wants to protect itself against this risk, it must be that its income gap is negative (i.e., an increase in interest rates will increase more the cost of funds than the interest payments it receives on its assets).

If the T-bill rate is 0.5%: Dickey Bank pays: 0.03 × $4,000,000 = $120,000 Fuller Finance Company pays: (0.005 + 0.02) × $4,000,000 = $100,000 If the T-bill rate is 1.5%: Dickey Bank pays: 0.03 × $4,000,000 = $120,000 Fuller Finance Company pays: (0.015 + 0.02) × $4,000,000 = $140,000

30.

North-Northwest Bank has a differential advantage in issuing variable-rate mortgages, but does not want the interest income risk associated with such loans. The bank currently has a portfolio of $25,000,000 mortgages with an APR of prime + 150 basis points, reset monthly. Prime is currently 4%. An investment bank has arranged for NNWB to swap into a fixed interest payment of 6.5% on a notional amount of $25,000,000 in return for its variable interest income. If NNWB agrees to this, what interest is received and given in the first month? What if prime suddenly increased 200 basis points?

Solution: NNWB earns $25,000,000  (0.055/12) = $114,583.33. This is turned over to the investment bank under the terms of the swap. In return, NNWB receives $25,000,000  (0.065/12) = $135,416.67.

If prime jumps 200 basis points, NNWB earns $25,000,000  (0.075/12) = $156,250.

This is turned over to the investment bank under the terms of the swap. In return, NNWB receives $25,000,000  (0.065/12) = $135,416.67.

Chapter 25 On the Web: Financial Crises in Emerging Market Economies Dynamics of Financial Crises in Emerging Market Economies Stage One: Initial Phase Stage Two: Currency Crisis Stage Three: Full-Fledged Financial Crisis Case: Crisis in South Korea, 1997-1998 Financial Liberalization/Globalization Mismanaged Perversion of the Financial Liberalization/Globalization Process: Chaebols and the South Korean Crisis Stock Market Decline and Failure of Firms Increase Uncertainty Adverse Selection and Moral Hazard Problems Worsen and the Economy Contracts Currency Crisis Ensues Final Stage: Currency Crisis Triggers Full-Fledged Financial Crisis Recovery Commences Case: The Argentine Financial Crisis, 2001-2002 Severe Fiscal Imbalances Adverse Selection and Moral Hazard Problems Worsen Bank Panic Begins Currency Crisis Ensues Currency Crisis Triggers Full-Fledged Financial Crisis Recovery Begins Global Box: When an Advanced Economy is Like an Emerging Economy: The Icelandic Financial Crisis of 2008 Preventing Emerging Market Financial Crises

Beef Up Prudential Regulation and Supervision of Banks Encourage Disclosure and Market-Based Discipline Limit Currency Mismatch Sequence Financial Liberalization

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Overview and Teaching Tips

This web chapter is for instructors who want to have a more international orientation of their courses. It extends the analysis in Chapter 8 on financial crises to economies that are just entering the world marketplace. The analysis is parallel to that in Chapter 8, with Figure 25.1, which is similar to Figure 8.1, outlining the dynamics of financial crises in emerging market economies.

Then the chapter takes students through two detailed applications, South Korea in 1997-1998 and Argentina in 2001-2002, to illustrate how useful the analysis in the chapter is.

We have found that my students particularly enjoy the discussion of the crazy government policies that promote financial crises in emerging market countries, and we spend a lot of time on this in the case on South Korea because of the perverse policies to help out the chaebols, who had enormous influence on South Korean politics. Similarly, we spend a lot of time in the case on Argentina discussing how severe fiscal imbalances led to policies that encouraged banks to take on government debt, which eventually was to be their downfall.

Once the case discussions are finished, students can use the material at the end of the chapter to debate differing policies to prevent future emerging market financial crises. They also enjoy the global box on the Icelandic financial crisis, because it illustrates how advanced economies can find themselves in similar circumstances to emerging market economies and be subjected to the enormous costs of financial crises.

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Answers to End-of-Chapter Questions

1. Mismanagement of financial liberalization or financial globalization that leads to excessive risk taking by financial institutions that eventually blows up and leads to a financial crisis.

The second cause is severe fiscal imbalances which lead to a sovereign debt crisis that ends up destroying the balance sheets of financial institutions, which then leads to a financial crisis.

2.

The quality of domestic institutional arrangements is a key factor in the process of financial liberalization for emerging market economies. The proper enforcement of both existing and new regulations contributes to create and maintain a sound system of prudential regulation, restricting, for example, excessive risk taking by financial intermediaries. Additionally, the prevalence of corruption and/or excessive control of the process of financial liberalization by powerful business interests increases the probability of financial crises, since it weakens the effectiveness of the regulatory framework.

3. Severe fiscal imbalances can result in governments encouraging financial institutions to buy the government debt. Then when the government is unable to repay the debt, financial institutions suffer substantial losses. The resulting destruction of their balance sheets hinders the ability of financial institutions to do financial intermediation, which increases moral hazard and adverse selection problems, so financial markets seize up. In addition, the destruction of financial institutions’ balance sheets makes it difficult for a country’s central bank to raise interest rates and this can lead to a currency crisis, which then precipitates a financial crisis.

4. A rise in interest rates as a result of rising interest rates abroad increases moral hazard and adverse selection problems, while a collapse in the stock market decreases the net worth of firms, which also increases moral hazard and adverse selection problems. Failures of prominent financial firms also increase uncertainty and make asymmetric information

5.

worse, again increasing adverse selection and moral hazard problems. All of these contribute to financial markets seizing up and thus help promote financial crises.

Deterioration in bank balance sheets makes it difficult for central banks to raise interest rates to defend the currency, because if they do so, it will make banks worse off. Once speculators recognize this, they have a one-way bet and will start selling off the currency, which can result in a collapse of the currency and a currency crisis. Severe fiscal balances, besides leading to a deterioration of bank balance sheets if a sovereign debt crisis occurs, can also contribute directly to a currency crisis, because once investors in the government debt suspect they will not be paid back, they will sell off the currency, which can trigger a currency crisis.

6. The policy put forward by Uruguay tried to solve the problem of currency mismatch. This problem hinders the ability of emerging market economies to successfully conduct the process of financial liberalization, since it increases the risk of financial crises. In the event of a devaluation of the domestic currency, agents that have their debt denominated in a foreign currency realize that their debt (in units of the domestic currency) increases. After more than 10 years of the application of these measures, the Uruguayan economy has a much smaller exposure to the risk of currency mismatch.

7.

The chaebols needed to acquire funds to expand their operations because they were unprofitable. They thus got the South Korean government to allow them to accelerate the opening of their capital market to short-term capital flows and also were allowed to convert finance companies that they owned into merchant banks, which were virtually unregulated and which could borrow abroad. The result was that the financial system was more vulnerable because of this short-term borrowing from abroad, while the merchant banks went under when their loans to the chaebols went sour. The resulting damage to the financial system was a key factor that led to South Korea’s financial crisis.

8.

They can put in place regulations to increase the amount of bank capital so banks have a greater cushion if they suffer loan losses and also have greater incentives to pursue safer investments because they have more to lose. Prudential supervision can also encourage banks to have better risk management, which will make excessive risk-taking less likely.

Emerging market countries can also devote more resources to bank supervisors so they are able to effectively monitor banks to keep them from taking on too much risk. All of these steps would make banks more able to withstand negative shocks and would reduce risk taking, thereby making the likelihood of a banking and a financial crisis much lower.

9. The recommendation of the IMF to increase the domestic interest rate contributed to reducing economic activity in South Korea during the financial crisis. Even after many years, it is very difficult, if not impossible, to ascertain the true effect of such a policy recommendation. Critics of the IMF recommendation state that this only made things worse for South Koreans, by increasing unemployment and poverty, and actually making the recovery slower. IMF staff argues that the increase in the domestic interest rate was necessary to fight inflation and to send the message that policymakers were committed to do everything that was necessary to fight the crisis.

10. Emerging market countries might want to implement financial liberalization and globalization gradually because this would give them time to set up better prudential regulation and supervision to limit risk taking by financial institutions.

Chapter 26 On the Web: Savings Associations and Credit Unions Mutual Savings Banks Savings and Loan Associations Mutual Savings Banks and Savings and Loans Compared Savings and Loans in Trouble: The Thrift Crisis Later Stages of the Crisis: Regulatory Forbearance Competitive Equality in Banking Act of 1987 Political Economy of the Savings and Loan Crisis Principal–Agent Problem for Regulators and Politicians Case: Principal–Agent Problem in Action: Charles Keating and the Lincoln Savings and Loan Scandal Savings and Loan Bailout: Financial Institutions Reform, Recovery, and Enforcement Act of 1989 The Savings and Loan Industry Today Number of Institutions S&L Size S&L Assets S&L Liabilities and Net Worth Capital Profitability and Health The Future of the Savings and Loan Industry Credit Unions History and Organization Sources of Funds Uses of Funds Advantages and Disadvantages of Credit Unions The Future of Credit Unions

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Overview and Teaching Tips

This chapter explores thrift institutions, which provide financial services to individuals and households.

A brief history of mutual savings banks and savings and loan associations is given in the first two sections of this chapter. Students get a clear background of the history that shaped the foundation of these institutions. One main difference between the two is the ownership structure. The chapter concentrates more on savings and loans. It discusses the early crises of the S&Ls, which caused

turmoil for millions of people with money in these institutions. For an excellent example of the nature of the S&L crisis, refer students to the case dealing with Charles Keating and the Lincoln Savings and Loan Scandal.

In 1989, the Bush Administration bailed out the failing Savings and Loans. New restrictions were imposed on thrift institutions so this problem would not occur again. The S&L industry today has a smaller number of institutions since many merged or failed. Many of the loans are now secured by real estate to ensure repayment. What lies ahead for S&Ls are gradual changes in the industry to overlap their services with commercial banks.

Another type of thrift institution is the credit union, which lends and provides services to its members who are consumers, not businesses. A description of the history of credit unions and its membership is in this section. Credit unions won over employers by offering their employees banking facilities closer to their place of work. Common bond membership is a major feature that distinguishes credit unions from other financial institutions. The idea means that only members of a particular occupation, organization, or association are permitted to join the credit union. This type of membership does limit credit unions from diversifying their risks. Since credit unions are nonprofit and tax exempt, they can offer lower fees for services than banks usually would offer customers. Most of the money in credit unions comes directly from customer savings and share draft accounts. The advantages of credit unions outweigh the disadvantages, as demonstrated by their growth and popularity.

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Answers to End-of-Chapter Questions

1. All of the depositors at a mutual bank are owners of the firm. Instead of receiving interest payments, they receive dividend income.

2. Because most shareholders do not own a very large percentage of the firm, it is not costeffective for them to provide management oversight.

3. The presence of deposit insurance diminishes the importance of the mutual form of ownership having a risk-averse appeal to risk-averse investors.

4. Deregulation, regulatory forbearance, and a lack of examiners led to the thrift crisis.

5. Because depositors were insured by the government against losses, they had no incentive to monitor bank management.

6. The inclusion of goodwill on S&Ls’ balance sheets allowed them to capitalize things like their good name and reputation as an intangible asset at a high level. This made many S&Ls’ net-worth-to-asset ratio more favorable and gave them the ability to hide the fact that they were insolvent.

7. The net worth ratio is the most common measure of capital adequacy.

8. Currently the main threat to the survival of the S&L industry seems to be the fact that financial institutions specialized in mortgage lending are not needed anymore. The financial system has evolved in ways that there are many more options available for prospective homeowners to get the necessary funds to buy a house. Therefore, one can expect at least that the industry will not thrive in the future, and will most probably slowly disappear.

9. Credit unions are mandated to provide financial services to consumers rather than corporate customers.

10. CUNA encourages the formation of credit unions. It provides support for existing credit unions in the form of technical aid. It also sponsors a number of affiliations that are useful to credit unions.

11. Under the common bond membership rule, credit unions are not allowed to diversify their risk. If the only productive activity in the region experiences an extraordinary event (e.g., a flood) the credit union will have a high default rate on loans.

12. The tax-exempt status of credit unions lowers their costs so they are able to offer higher interest rates on deposits, lower rates on loans, and less expensive fees on bank services than commercial banks can.

13. The common bond membership rule restricts membership in any particular credit union so that the average size of credit unions is substantially lower than for commercial banks.

14. In many least developed countries, there exist financial intermediaries very similar in structure to credit unions. Many credit union-type institutions have emerged in least developed countries precisely to provide financial services to large segments of the population that are not reached by traditional commercial banks. A few least developed countries have tried to encourage and promote these institutions, for example by regulating the industry, to make financial services available to more people.

15. The main advantages of credit unions are employer support, tax-exempt status, and strong trade associations.

16. Regulatory forbearance is a dangerous strategy because once a bank is insolvent, it has even stronger incentives to commit moral hazard and take on excessive risk. It has little to lose if its risky activities go sour, but has a lot to gain if the risky activities pay off. The resulting excessive risk taking makes it more likely that the deposit insurance agency will suffer large losses.

17. There are many lessons to draw from the scandal associated with Charles H. Keating Jr. and the Lincoln Savings and Loan Association. One important aspect of this scandal involves the ability of a powerful individual to be able to avoid regulations by contributing to political campaigns. Additionally, one can think that the credibility of the political system as a whole was undermined, since the senators that were part of this scandal were allowed to pursue their political careers.

18. The FIRREA legislation provided funds for the S&L bailout, created the Resolution Trust Corporation to manage the resolution of insolvent thrifts, eliminated the Federal Home Loan Bank Board and gave its regulatory role to the Office of Thrift Supervision, eliminated the FSLIC and turned its insurance role and regulatory responsibility over to the FDIC, imposed restrictions on thrift activities similar to those in effect before 1982, increased the capital requirements to those adhered to by commercial banks, and increased the enforcement powers of thrift regulators.

19. If political candidates receive campaign funds from the government and are restricted in the amount they spend, they will have less need to satisfy lobbyists to win elections. As a result, they may have greater incentives to act in the interest of taxpayers (the principals), and so the political process might improve.

20. The spirit of the increase in capital-asset ratio for S&Ls included in the FIRREA mimics the idea behind the minimum capital requirements set forth by the Basel accords for commercial banks. In both cases the idea is to limit risk taking by managers of these financial institutions. Regulators propose that if banks and S&Ls have more to lose if they fail, then they will not pursue risky lending practices. That is why they require both banks and S&Ls to hold more capital per assets.

Chapter 27 On the Web: Finance Companies History of Finance Companies Purpose of Finance Companies Risk in Finance Companies Types of Finance Companies Business (Commercial) Finance Companies Consumer Finance Companies Sales Finance Companies Regulation of Finance Companies Finance Company Balance Sheet Assets Liabilities Income Finance Company Growth

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Overview and Teaching Tips

Finance companies are discussed as an important element in the growing economy. Finance companies allow individuals with smaller pocketbooks to borrow money to purchase items they would not otherwise be able to buy. They are usually called a financial intermediary because they borrow large amounts, but lend small amounts to individuals and businesses. High-risk customers are often more accepted at finance companies for loans offered at higher interest rates.

Finance companies are divided into three types: business, sales, and consumer. Factoring is a type of provision of credit where the factors buy accounts receivables. Also, they provide leases and floor plan loans. Consumer finance companies usually finance customers with bad or no credit to purchase such items as furniture or home appliances. Point out to students that customers who go to consumer finance companies will pay a higher interest rate because they are at higher risk of default. In-house credit and credit card companies including Ford Motor Credit are excellent examples of sales finance companies.

Since finance companies do not have depositors, they are not regulated heavily by the government. However, they must disclose the costs of the loan and limit the rate of the interest.

When collecting delinquent and defaulted loans, finance companies must follow state and federal government regulation.

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Answers to End-of-Chapter Questions

1. A balloon loan requires that a single large payment be made when the loan matures, whereas on an installment loan, the borrower makes a series of small, equal payments.

2. Automobiles began to be mass-marketed and consumers needed loans to purchase them.

3. Finance companies need to be extra worried about rumors of a recession because their borrowers are usually individuals with not great credit. This means that default rates are above average for this segment of the market. If a recession hits the economy, many borrowers will not be able to pay their loans.

4. Consumer finance companies often charge far higher interest rates than banks.

5. Yes, because there is no well-established secondary market for their loans.

6. If interest rates decrease, the change in net worth will be negative. A decrease in interest rates means a negative sign in the second term of the equation that describes the change in net worth as a percentage of assets studied in Chapter 23 (since duration was assumed to be negative, the first term is positive): NW i   DURgap  A 1 i This shows that finance companies also face interest rate risk.

7. Finance companies offer specialized ways for companies to obtain a line of credit. A finance company can either (1) make a loan and purchase Marc’s accounts receivable at a discount, providing Marc with immediate cash to purchase the asset, or (2) a finance company can purchase the equipment themselves and lease the equipment out to Marc for a set number of years.

8. The finance company faces the risk of loss from a bad harvest.

9. Under a floor plan, the finance company holds the inventory as security and releases its lien on the inventory only when the items are sold and the loan is paid.

10. They are sales finance companies.

11. The tax code allows the interest paid on loans secured by homes to be deducted from taxes.

This lowers the effective cost of the debt.

12. Finance company customers frequently file bankruptcy because they often have few assets to lose. The bankruptcy can make collection on the loan impossible and often delays retrieval of collateral.

13. Regulation Z requires that the company disclose the annual percentage rate charged on loans in a prominent and understandable fashion.

14. Usury statutes limit interest rates.

15. There are no depositors to protect and no government deposit insurance is involved.

Regulation that does affect finance companies are focused on protecting unsophisticated customers.