Financial Institutions, Markets, and Money, 11th Edition Kidwell, Blackwell, Whidbee, Sias Solution

Financial Institutions, Markets, and Money, 11th Edition By Kidwell, Blackwell, Whidbee, Sias

Email: Richard@qwconsultancy.com

CHAPTER 1 AN OVERVIEW OF FINANCIAL MARKETS AND INSTITUTIONS CHAPTER OBJECTIVES 1. This chapter introduces the basic elements of the financial system: financial claims, financial markets, and financial institutions. These elements integrate in a conceptual model of the financial system, shown in Exhibit 1-1. This chapter also develops basic vocabulary, which may not be prudently neglected.

2. The chapter compares and contrasts the two basic kinds of financing relationships—direct finance and financial intermediation—in the context of why financial needs exist, how financial claims arise, and what choices for financial activity emerge in different types of institutions and markets.

3. The chapter compares and contrasts major types of financial institutions and financial markets. These mechanisms—institutions and markets—afford participants more liquidity and diversification. Thus more funds flow to the most productive uses, competition among financial institutions lowers costs, and widespread market participation links prices more closely to information, all of which promote market efficiency. A vigorous financial system promotes economic growth and prosperity by maximizing rational opportunities for investment.

CHANGES FROM THE LAST EDITION 1. Chapter sections are numbered in this edition.

2. Chapter opener has been revised.

3. Tables, exhibits, and data have been updated. Exhibit 1.6 is new to this edition.

4. The set of learning objectives has been revised.

5. “Do You Understand?” questions: (1) in the first set, old Q.4 has been deleted and remaining questions revised, (2) two sets of DYU questions have been deleted and three added. There are now five sets of DYU questions in the chapter.

6. End-of-chapter questions: old Q.8 has been deleted and 11 new questions added (Qs. 8, 11-20).

7. Changes to Section 1.1, “The Financial System”: - The subsection “A Preview of the Financial System” has been added; - The subsection “Economic Units” has been eliminated; economic units are now discussed in the next subsection, “Budget Positions”, which has been shortened.

- The subsection “Financial Claims” has been shortened.

8. The sections “Moving Funds from SSUs to DSUs” and “Benefits of Financial Intermediation” have been eliminated. In their place are Section 1.2, “Financial Markets and Direct Financing”, and Section 1.6, “Financial Institutions and Indirect Financing”, that discuss the same material and more. E.g., Section 1.6 discusses asymmetric information, which gives rise to adverse selection and moral hazard issues.

9. The order of sections has been changed: Section 1.2, “Financial Markets and Direct Financing”, is now followed by the sections related to financial markets (“Types of Financial Markets”, “Money Markets”, and “Capital Markets”), and Section 1.6, “Financial Institutions and Indirect Financing”, is followed by the sections discussing types of intermediaries and risks they face.

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10. Section 1.3, “Types of Financial Markets”, has a new subsection on public and private markets.

11. Section 1.7, “Types of Financial Intermediaries”, has an expanded discussion of money market mutual funds (MMMFs).

12. The section “Financial Market Efficiency” has been deleted.

13. Section 1.9, “Regulation of the Financial System”, has been added. It covers regulation related to both consumer protection and stabilizing the financial system, as well as provides the highlights of the Restoring American Financial Stability Act of 2010.

14. The feature previously called “Chapter Take-aways” is now called “Summary of Learning Objectives”. The learning objectives from the beginning of each chapter are copied and followed by a short summary of the chapter material related to each objective. This has been done for every chapter.

CHAPTER KEY POINTS 1. The financial system brings savers and borrowers together. Stress these key concepts: SSUs and DSUs, financial claims, direct finance versus financial intermediation, financial institutions, transformation of claims, and types of financial markets. Remind students of financial intermediation in their own lives—checking accounts, insurance, student loans, etc.

2. Direct finance works if preferences of SSUs and DSUs match as to amount, maturity, and risk.

Financial intermediaries transform claims to reduce the recurring problem of unmatched preferences: Denomination Divisibility. DSUs prefer to borrow the full funding need all at once. SSUs tend to save small amounts periodically. Intermediaries pool small savings into large investments.

Currency Transformation. Intermediaries can buy claims denominated in one currency while issuing claims denominated in another. This would be difficult for most ordinary SSUs. Maturity Flexibility. DSUs generally prefer longer-term financing. SSUs generally prefer shorter-term investments. Intermediaries can offer different ranges of maturities to both.

Credit Risk Diversification. Intermediaries manage risk by evaluating and holding many different securities. SSUs on their own would have to leave “more eggs in one basket.”

Liquidity. Many claims issued by intermediaries are highly liquid because intermediaries substitute their own liquidity for that of DSUs. 3. Financial institutions are classifiable by their origins, purposes, and major characteristics: Depository Institutions Commercial banks Thrifts (savings and loan associations; mutual savings banks) Credit unions

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Contractual Institutions Insurance companies (life and casualty) Private pension funds State and local government pension funds Investment Funds Mutual Funds Money Market Mutual Funds Other Institutions Finance companies Federal agencies 4. Financial markets are classifiable in a number of concurrent ways: Primary or Secondary Public or Private Exchanges or OTC Spot, Futures, or Option Foreign Exchange International or Domestic Money or Capital The respective contributions of money markets and capital markets to the economy are important themes.

Representative lists of money and capital market instruments foreshadow chapters covered later in the text.

5. Financial intermediaries are major “information producers” in financial markets. The need for information arises because of asymmetric information – sellers or borrowers in financial transactions usually have more information than buyers or lenders. Asymmetric information is expressed in two ways: adverse selection, which occurs before a financial transaction takes place, and moral hazard, which occurs after the transaction.

6. Risks faced by financial institutions are: Credit risk Interest rate risk Liquidity risk Foreign exchange risk Political risk 7. Financial systems need to be regulated for two reasons: consumer protection and stabilization of financial systems.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

Does it make sense that the typical household is a surplus spending unit (SSU) while the typical business firm is a deficit spending unit (DSU)? Explain.

Households are ultimately SSUs, but have deficit periods when a home or other “big ticket” item is purchased. Businesses usually invest more in real assets than they receive in current operating cash flow.

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2.

Explain the economic role of brokers, dealers, and investment bankers. How does each make a profit?

Brokers, dealers, and investment bankers make markets at both primary and secondary stages.

Funds are raised and claims issued in primary markets with the help of investment bankers, who purchase securities from issuers at one price and sell them to the investing public at a higher price, earning the underwriter’s spread. In secondary markets brokers help bring buyers and sellers of financial claims together, charging commissions, and dealers trade claims in volume, providing liquidity and price discovery and earning the difference between ask and bid price (the bid-ask spread).

3.

Why are direct financing transactions more costly or inconvenient than intermediated transactions?

The parties to direct finance have to find each other and negotiate a more or less exact match of preferences as to amount, maturity, and risk. Intermediaries provide all parties choices about financial activity, and drive costs down through competition, diversification, and economies of scale.

4.

Explain how you believe economic activity would be affected if we did not have financial markets and institutions.

Financing relationships would arise only when preferences of SSUs and DSUs match. DSUs would not always obtain timely financing for attractive projects and SSUs would under-utilize their savings. The “production possibilities frontier” of the society would be smaller.

5.

Explain the concept of financial intermediation. How does the possibility of financial intermediation increase the efficiency of the financial system?

Financial intermediation is the process by which financial institutions mediate unmatched preferences of ultimate borrowers (DSUs) and ultimate lenders (SSUs). Financial intermediaries buy financial claims with one set of characteristics from DSUs, then issue their own liabilities with different characteristics to SSUs. Thus, financial intermediaries “transform” claims to make them more attractive to both DSUs and SSUs. This increases the amount and regularity of participation in the financial system, thus making financial markets more efficient.

6.

How do financial intermediaries generate profits?

Intermediaries pay SSUs less than they earn from DSUs. Operating costs absorb part of this margin. Risks taken by the intermediary are rewarded by any remaining profit. Intermediaries enjoy 3 sources of comparative advantage: Economies of scale —large volumes of similar transactions; transaction cost control—finding and negotiating direct investments less expensively; and risk management expertise—bridging the “information gap” about DSUs’ creditworthiness.

7.

Explain the differences between the money markets and the capital markets. Which market would General Motors use to finance a new vehicle assembly plant? Why? Money markets are markets for liquidity, whether borrowed to finance current operations or lent to avoid holding idle cash in the short term. Money markets tend to be wholesale OTC markets made by dealers. Capital markets are where real assets or “capital goods” are permanently financed, and involve a variety of wholesale and retail arrangements, both on organized exchanges and in OTC markets. GM would finance its new plant by issuing bonds or stock in the 4

capital market. Investors would purchase those securities to build wealth over the long term, not to store liquidity. GMAC, the finance company subsidiary of GM, would finance its loan receivables both in the money market (commercial paper) and in the capital market (notes and bonds). GM would use the money market to “store” cash in money market securities, which are generally, safe, liquid, and short-term.

8.

What steps should bank management take to manage credit risk in the bank’s loan portfolio?

Banks manage credit risk of their loan portfolios by (1) diversifying the portfolios across regions, industries, and types of loans, (2) conducting a careful credit analysis of potential borrowers, and (3) continually monitoring the borrowers over the life of the loan or investment. Banks develop and follow lending policies which set guidelines for lending officers.

9.

Metropolitan Nashville and Davidson County issues $25 million of municipal bonds to finance a new domed stadium for the Tennessee Titans. The bonds have a face value of $10,000 each, are somewhat risky, and mature in 20 years. Enterprise Bank of Nashville buys one of the bonds using funds deposited by Sarah Levien and Ted Hawkins, who each purchased a 6-month, $5,000 certificate of deposit. Explain the intermediation services provided by Enterprise Bank in this transaction. Illustrate with T-accounts.

Metropolitan Nashville and Davidson County ________________________________________ Cash $10,000 from EBN || Bond $10,000 to EBN

Levien _________________________________ CD $5,000 at EBN || Cash $5,000 to EBN Hawkins _________________________________ CD $5,000 at EBN || Cash $5,000 to EBN

Enterprise Bank of Nashville ___________________________________________________ Bond $10,000 from MNDC || CD Levien $5,000 Cash $5,000 from Levien || CD Hawkins $5,000 Cash $5,000 from Hawkins || Cash $10,000 to MNDC If Sarah or Ted had $10,000 and wanted to take the risks presented by the bonds, either of them could buy a bond in the direct market from a broker or dealer. Each likely prefers the government guarantee of the CD, the more easily affordable denomination of $5,000, and the ready liquidity (net of some known "penalty for early withdrawal"). Enterprise Bank now has a tax-free source of income from the municipal bond, has made its expert evaluation of credit risk, is diversified with other securities, and can buy the bonds with low transaction costs. Many banks are underwriters of municipal securities and carry inventories as dealers. The City of Nashville has financed a capital project (the stadium) by issuing financial claims (the bonds).

The bank bought a bond with deposit funds it raised by issuing Sarah and Ted CDs, which are assets to them and liabilities to the Bank. The bond and the CDs are separate claims varying in denomination, maturity, risk, and liquidity. The bank takes a position of risk, keeps part of the interest income from the bonds as a reward for that risk, and distributes part of it to Sarah and Ted to reward them for postponing current consumption. The city, the ultimate borrower or DSU, has no direct relationship with Sarah and Ted, the ultimate lenders or SSUs. 10.

Explain the statement, "A financial claim is someone's asset and someone else's liability."

There are always two sides to debt. To the issuer of the debt, it is a liability. To the holder of the debt, it is an asset. A financial asset always appears on two balance sheets; a real asset on just 5

one.

11.

Why are banks singled out for special attention in the financial system?

Banks are the dominant type of depository institutions. As such, they deal with consumers (depositors), and consumers’ trust in the banking system is extremely important for the flow of funds and ultimately the well-being of the economy. Also, banks, like other depositories, are highly leveraged (liabilities are often around 90% of total assets, with capital being the other 10%), which makes them much more vulnerable to credit and liquidity risks than other businesses.

12.

Explain why households are the principal SSUs in the economy.

Households in the U.S. are more likely to have their income exceed their expenditures than businesses, which either look to expand and thus are DSUs or pay out the extra cash to shareholders in the form of dividends or share repurchases, or governments, which are often plagued by political agendas and run deficits.

13.

Explain why direct financial markets are wholesale markets. How do consumers gain access to these important markets?

Direct financial markets are dominated by institutions that want to avoid the costs of registering securities with the SEC and transact large amounts of securities between each other. Only wealthy individuals, so called “accredited investors” (one must have high income and/or net worth to be considered an accredited investor) may participate in direct financial transactions such as private placements.

Small individual investors access financial markets indirectly through intermediaries such as commercial banks or mutual funds.

14.

What are money center banks and why were they not allowed to engage in investment banking activities following the Great Depression?

Money center banks are large commercial banks located in major financial centers. The GlassSteagall Act of 1933 separated commercial banking and investment banking because it was believed that excessive risk taking by commercial banks resulted in large number of bank failures after the 1929 stock crash followed by a depression. Commercial banks were again allowed in investment banking activities (and vice versa) in 1999.

15.

What is the difference between marketability and liquidity?

Marketability is the ease with which a security can be sold and converted into cash. Liquidity is the ability to convert an asset into cash quickly without a loss of value. While the two concepts are similar, marketability does not carry the implication that the security’s value is preserved.

16.

Municipal bonds are attractive to what type of investors?

Municipal bonds are long-term debt of state and local governments. Their coupon income is exempt from federal income tax. Therefore, they are attractive to individuals and businesses in high income tax brackets.

17.

Why do corporations issue commercial paper?

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Commercial paper is short-term corporate debt; it is issued to meet corporate short-term cash obligations.

18.

Explain what is meant by moral hazard. What problems does it present when a bank makes a loan?

When it comes to loans, moral hazard occurs if borrowers engage in activities that increase the probability of default. A firm that has taken a bank loan may take on very risky investment projects which, if successful, would result in large profits, but which have high probabilities of failure. The reason for such behavior is that lenders do not share the upside with shareholders of the firm. To reduce moral hazard, the bank may impose some restrictions on the borrower stipulated in the loan contract (e.g., to maintain certain financial ratios at a certain level or better, to not acquire certain assets, or to reduce expenses), and continually monitor the borrower.

19.

Explain the adverse selection problem. How can lenders reduce its effect?

Adverse selection arises from asymmetric information and, in the context of debt markets, refers to borrowers of poor credit quality applying for loans (perhaps because such borrowers need the loans the most in order to survive financially). The lender may reduce adverse selection by requiring loan applicants to supply detailed financial statements and other additional information, to use differential loan pricing for borrowers of different credit quality, or to reject loan applications if the risk appears too high. To process the information they collect, lenders often develop or acquire from third party credit scoring models that help determine borrowers’ creditworthiness.

20.

Why is the financial system so highly regulated?

The regulation is needed to protect consumers from abuses by unscrupulous financial firms and to ensure economic stability. People should have confidence in the financial system for it to function well, and a well-functioning financial system is critical for ensuring the flow of funds and, in turn, economic growth.

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CHAPTER 2 THE FEDERAL RESERVE AND ITS POWERS CHAPTER OBJECTIVES 1. This chapter describes the background and structure of the Federal Reserve System, perhaps the most powerful component of the financial system. The Fed has broad responsibilities for regulating the financial system, controlling the money supply, and influencing interest rates. Its design was influenced by inadequacies of the 19th-century banking system, which remain useful lessons about the consequences of neglecting or mismanaging financial systems.

2. The chapter explains the components of the Fed’s balance sheet and relates them to the money supply and financial system, thus introducing the concept of the “monetary base”. Understanding the main components of the monetary base is important before moving on to Chapter 3.

3. The chapter introduces the “tools of monetary policy”—open market operations, the discount rate, and reserve requirements. The tools differ concretely and significantly from each other, and have changed in relative importance as the financial system has evolved. The ability to compare and contrast them—and to understand why open market operations are the only fully viable tool of monetary policy— is also crucial before moving on to Chapter 3.

4. The chapter discusses what powers the Fed gained and how the Fed’s balance sheet changed during the financial crisis. Students should understand how the Fed was able to expand its balance sheet and change its structure and what it has accomplished by doing so.

CHANGES FROM THE LAST EDITION 1. Tables, exhibits, and data have been updated. Old Exhibit 2.4 has been deleted. The second “People and Events” insert has been revised.

2. “Learning by Doing” (LBD) inserts are the new feature for this edition. These inserts show in detail how to do certain numerical problems. In this chapter, there are two LBD inserts: one on p.62 and another on pp.69-70.

3. “Do You Understand?” questions: (1) two questions have been deleted and one added in the only question set in the chapter.

4. There are 11 new end-of-chapter questions (Qs. 11-21).

5. The chapter has a number of new subsections: “The Federal Reserve Bank of New York” (in Section 2.2, “The Current Structure of the Fed”) – to emphasize the importance of FRB of New York; “The Financial Crisis and Expanded Powers” and “New Regulatory Powers” (in Section 2.4, “The Fed’s Regulatory Powers”); the latter subsection discusses such issues as managing systemic risk and too big to fail.

“The Financial System Bailout” (in Section 2.6, “The Fed’s Balance Sheet”); “Paying Interest on Reserves” (in Section 2.8, “Federal Reserve Tools of Monetary Policy”).

CHAPTER KEY POINTS 1. The Fed has centralized as the U.S. has evolved from a confederation of regional economies to a truly national economy. The 12 Federal Reserve Banks, once largely autonomous in their respective regional 1

districts, remain operationally important but have lost their authority to set monetary policy. They are a minority (5 votes out of 12) on the FOMC, which sets U.S. monetary policy under ultimate control of the Board of Governors. The Federal Reserve Bank of New York, however, has a special status and a permanent spot on the FOMC. It is located in the heart of the Manhattan financial district and is charged with executing open market operations for the Fed. 2. The Fed's powers have expanded substantially since its creation. In addition to its original central bank functions, the Fed has gained many regulatory powers, summarized in Exhibit 2.4. Today the Fed directly influences the behavior of practically every U.S. financial institution. During the 2007-2009 financial crisis, the Fed gained even more regulatory powers. Throughout its existence, the Fed’s power and credibility have been based in large part on its considerable independence within the federal government. Students should understand how and why this independence endures, and grasp the ultimate limits on it.

3. The Fed’s balance sheet (Exhibit 2.6) is the mechanism through which the tools of monetary policy influence the money supply. A central bank is unique among financial institutions in that it can issue liabilities and acquire assets at will. The Fed’s most useful technique for doing so is open market operations—buying and selling securities on the open market. These transactions change the monetary base directly, immediately, and dollar-for-dollar as the Fed credits new reserves to pay for open market purchases and retires existing reserves to collect for open market sales. Historically, it has been U.S. government debt and more recently federal agency debt, but in response to the financial crisis and recession of 2007-2009 the Fed implemented several programs that acquired other assets such as mortgage-backed securities.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

Explain why the banking system was so unstable prior to establishment of the Fed in 1914.

After termination of the Second Bank of the United States in 1836, the U.S. was without a central bank until passage of the Federal Reserve Act in late 1913. Thus there was no overall control of the size or quality of the money supply. Until the National Banking and Currency Acts (186264), banks were largely unregulated and free not only to engage in unsound lending practices, but to issue banknotes—IOUs against themselves—without restraint. Over-issue of this “private currency” prompted hoarding of gold and silver, causing the money supply to be “inelastic”— unevenly distributed and not easily adjustable. Frequent bank failures exacerbated downturns in the normal business cycle. The National Banking apparatus was a step forward, but the need for a central bank became more evident as the post-Civil War economy cycled through boom, bust, and financial panic.

2.

What is a call loan? How did call loans contribute to economic recessions?

A call loan may be “called in”—declared due and payable—by the lender at any time. Call loans were once a common form of bank financing for agriculture and business. Until the Fed was created in 1913, there was no “lender of last resort” to keep banks liquid. After the federal government began taxing state banknotes in the 1860s, demand deposits—essentially “call loans” to banks from depositors—became highly popular. If too many depositors demanded their money back at once, banks would be forced to call in loans, usually causing borrowers to default, often causing their farms or businesses to fail, and not necessarily raising enough cash to pay off the depositors. The ensuing economic slowdown and financial uncertainty would provoke more depositors to try to withdraw funds from banks, forcing more banks to call in loans, triggering more defaults and business failures, dragging the economy into recession.

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3.

What were the four goals of the legislation that established the Federal Reserve System? Have they been met today?

The goals of the Federal Reserve Act of 1913 were to create: (1) a reliable mechanism for adjusting the money supply to the needs of the economy; (2) a lender of last resort that could furnish liquidity to banks in times of financial crisis; (3) an efficient payment system for clearing and collecting checks at face value throughout the country; and (4) a more vigorous bank supervision system to reduce the risk of bank failures.

Relatively low rates of inflation since the early 1980s are evidence of success with goal #1. The Fed was a true lender of last resort (goal #2) to financial institutions (including non-banks) and even some non-financial companies during the 2007-2009 financial crisis. The U.S. payment system—goal #3— operates so reliably as to be taken for granted. The financial services industry faced a major challenge during the 2007-2009 crisis, with numerous bank failures and near failures. The Fed worked hard to prevent failures of systemically important banks (goal #4) and other financial institutions and restore confidence in the financial markets..

4.

Explain why the Board of Governors of the Federal Reserve System is considered so powerful.

What are its major powers and which is the most important?

The 7 members of the Board make up a majority of the 12-member FOMC, which sets monetary policy (the Fed’s most important power). The Board also promulgates all the financial system regulations listed in Exhibit 2.4, enacts the policies and procedures by which the Federal Reserve System is internally governed, and appoints 3 of the 9 directors of each Federal Reserve Bank.

Governors, though appointed by the President and confirmed by the Senate, have a 14-year nonrenewable term of office and may thus discharge their duties with considerable political independence.

5.

Explain why the FOMC is the key policy group within the Fed. The Federal Open Market Committee, comprising the 7 Governors, the president of the New York Fed, and 4 of the remaining 11 presidents of Federal Reserve Banks, sets monetary policy for one of the world’s largest and most powerful countries, affecting interest rates, exchange rates, and economic growth. The Chairman of the Board of Governors sets the FOMC’s agenda, runs its meetings, and is the Fed’s face and voice to the outside world. Consequently, the Chairman is one of the world’s most powerful figures.

6.

Explain why Regulation Q caused difficulties for banks and other depository institutions, especially during periods of rising interest rates.

Reg Q, one of many “lettered” Fed regulations, originally prohibited banks from paying interest on demand deposits, prohibited thrifts from offering demand deposits, and imposed interest rate ceilings on interest-bearing deposits. These provisions served to limit price competition for deposits in a period when stability was the primary objective. When market rates rose above Reg Q ceilings, deposit withdrawal (disintermediation) would drain liquidity from depository institutions. Ultimately, Reg Q was phased out by the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) and the Depository Institutions Act of 1982. Today, the Fed depends on market forces to allocate flow of funds.

7.

Explain the sense in which the Fed is independent of the federal government. How independent is the Fed in reality? What is your opinion about the importance of the Fed’s independence for the U.S. economy?

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There are no direct channels of bureaucratic, fiscal, or political pressure on the Fed. It is a creature of Congress, but not directly under its authority. The Board is appointed by but not answerable to the President. The Fed funds itself, thus Congress has no “power of the purse” over it. Ultimately, however, it may be more correct to say that the Fed is independent within, not of the government. What Congress creates, Congress can modify or destroy. Congress has from time to time established guidelines or objectives for the Fed (e.g., the Humphrey-Hawkins Act of 1978). The Fed remains independent because most politicians want it that way. They mostly agree that monetary policy is not a partisan issue. An independent Fed can also absorb blame if the economy falters, and take necessary but unpopular steps to combat various economic ills.

Critics argue that the Fed’s independence is elitist and undemocratic. Supporters argue that elected politicians cannot be fully trusted to handle the money supply. The underlying argument is as representative government itself: Should popular will decide public policy, or merely decide who decides? There is evidence (see Exhibit 2.5) that countries with more independent central banks have less inflation. However, there is no evidence that central bank independence correlates with employment or national income levels.

8.

A bank has $20,000 in reserves, $90,000 in bank loans, and $150,000 of deposits. If the reserve requirement is 10%, what is the bank’s reserve position? What is the maximum dollar amount of loans the bank could make? What would happen to the nation’s money supply if the Fed lowered the reserve requirement to 6 percent? Demonstrate your results with a numerical example.

Assuming reserve requirements apply to all the bank’s deposits, its $20,000 of reserves comprise required reserves of $15,000 (10% of total deposits of $150,000) and excess reserves of $5,000 (total reserves of $20,000 less required reserves of $15,000): Excess Reserves Loans Required Reserves Deposits

$ 5,000 || 90,000 || 15,000 || || $150,000

This reserve position supports up to $5,000 of new loans. In reality, reserve requirements do not apply to all deposits (see Exhibit 2.7).

Excess Reserves Loans Required Reserves Deposits

______________ $11,000 || 90,000 || 9,000 || || $150,000

If the reserve requirement were 6% instead of 10%, excess reserves would be immensely and immediately greater. The excess reserves shown here for illustration far exceed, as percentage of assets, what any bank would leave idle.

Excess Reserves

______________ $ 0 ||

Banks would “lend up” excess reserves quickly,

Loans Required Reserves Deposits

313,333|| 20,000 || || $333,333

expanding loans and deposits until any reserves were again absorbed as required reserves: DEP = RR/k

As this example suggests, reducing reserve requirements by 40%—something the Fed would never really do—would radically expand deposits and loans across the banking system. The Fed does not adjust reserve requirements very often, or by very much. Effects are too dramatic for the “fine tuning” it prefers.

9.

Why does the Fed not use the discount rate to conduct monetary policy? How does the Fed use the discount rate?

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In the early 20th century, long before modern money markets evolved, “discounting” was a common way to retrieve liquidity from financial instruments (e.g., factoring accounts receivable), and commercial banks did not have many “non-deposit” funding choices. When the Fed was formed, the discount rate was the primary tool of monetary policy because it was the cost of member banks’ main non-deposit source of funds—loans at the Discount Window. The Fed would discount (lend less than the face value of) loans and other financial instruments held by member banks, providing liquidity. Because the banking industry had few other funding choices but was the primary source of operating credit to farms and businesses, Fed discount policy was a reasonably effective direct control on the money supply. As money markets evolved, the Fed Funds market in particular developed, and the FOMC developed its processes, “discounting” in its foundational sense faded into history. Today changes in the discount rate merely signal policy intent; open market operations directly increase or reduce the money supply. Loans “at the Window” are still available, but depository institutions have many funding choices and are wary of “Window scrutiny”—questions regulators might have about early or regular trips to the Window. Discount Window loans outstanding are now just a tiny fraction of the Fed’s total assets.

10.

Explain how the Fed changes the money supply with an open-market purchase of Treasury securities.

Every Fed transaction with the private sector clears through the “bank reserve account”. When the Fed buys securities, it pays for them in a way no other financial system participant can: It unilaterally creates new money by crediting new reserves in the amount of the purchase to the reserve account of the depository bank of the securities dealer. Thus, open market purchases increase total reserves in the banking system directly, immediately, and dollar-for-dollar. During the financial crisis of 2007-2009, the Fed expanded open market operations from using only Treasury securities to buying large amounts of federal agency debt and mortgage-backed securities. The importance of open market operations is illustrated in Exhibit 2.6: The Fed’s portfolios of these securities are by far its largest asset categories.

11.

Northwest National Bank received new demand deposits (DD) of $1,650,000. The current reserve requirement is 6 percent. The bank has $80,000 in vault cash and $110,000 at the Federal Reserve that are not yet invested. How much in excess reserves does the bank have available to make new loans?

Total reserves = $80,000 + $110,000 = $190,000 Required reserves = $1,650,000*0.06 = $99,000 Excess reserves = $190,000 - $99,000 = $91,000

12.

Currently a community bank has $45,000 in reserves, demand deposits of $200,000, and loans of $145,000. It unexpectedly receives an inflow of deposits of $50,000 into checking accounts and another $25,000 into time deposits. Current reserve requirements on demand deposits and time deposits are 10 percent and 3 percent, respectively. What is the bank’s reserve position? What is the maximum dollar amount of loans the bank could make?

Total reserves are $45,000 plus the newly arrived cash of $75,000, or $120,000.

Required reserves = 0.1*(200,000 + 50,000) + 0.03*25,000 = $25,750 Excess reserves = $120,000 - $25,750 = $94,250.

The bank may immediately loan out the $94,250 of excess reserves and still meet the reserve requirement.

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13.

Suppose the current reserve requirements set by the Federal Reserve are as follows: Type of Liability Transaction deposits $0 to $10.7 million Transaction deposits more than $10.7 million to $55.2 million Transaction deposits more than $55.2 million Non-personal time deposits Eurocurrency liabilities

Requirement Percentage of liabilities 0 3 10 3 0

A bank has cash of $2 million, reserve deposits at the Federal Reserve of $25 million, transaction deposits of $275 million, non-personal time deposits of $100 million. Calculate the bank’s required reserves, excess reserves, and total reserves.

Total reserves = $2mln. + $25mln. = $27mln.

Required reserves = ($55.2mln. - $10.7mln.)*0.03 + ($275mln. - $55.2mln.)*0.1 + $100mln.*0.03 = $26.315mln.

Excess reserves = $27mln. - $26.315mln = $0.685mln.

14.

Refer to the table in Question 13. Now suppose the Federal Reserve raised the reserve requirement on transaction deposits between $10.7 million and $55.2 million to 5 percent and eliminated the reserve requirement on non-personal time deposits. Calculate the bank’s required reserves, excess reserves, and total reserves under these conditions.

Total reserves = $2mln. + $25mln. = $27mln.

Required reserves = ($55.2mln. - $10.7mln.)*0.05 + ($275mln. - $55.2mln.)*0.1 = $24.205mln.

Excess reserves = $27mln. - $24.205mln = $2.795mln.

15.

The Fed decides to buy $10,000 of government bonds from Goldman Sachs. Using T-accounts show the complete transaction. Did the money supply increase or decrease? Explain.

Goldman Sachs -$10,000 Gov. bonds +$10,000 Reserves at FRB

The Fed +$10,000 Gov. bonds +$10,000 Reserve deposit of Goldman Sachs

The money supply increased because the banking system as a whole now has $10,000 more in reserves.

16.

Why is the Federal Reserve Bank of New York granted special status? What is the special status?

The New York Fed’s special status is in its responsibility to conduct open market operations for the Fed on a daily basis. The New York Fed Trading Desk buys and sells securities on the open market to carry out the decisions of FOMC. The New York Fed also houses the foreign exchange desk which trades currencies on behalf of the Fed and the U.S. Treasury. The president of the NY Fed has a permanent spot on FOMC, while the remaining eleven FRBs have four of their presidents on the committee on a rotating basis.

The reason for the special status of the New York Fed is its location in the heart of the financial district in Manhattan – the home to some of the largest commercial banks and other financial firms in the world. The ability of the New York Fed officials to stay in close contact with these key market players is very important, especially in times of crises.

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17.

What were three important regulatory powers that the Fed gained from the passage of the Financial Regulatory Reform Act of 2010? Explain each briefly.

The three regulatory powers the Fed gained are: 1) The power to intervene in the business activities of large nonbank firms to better control systemic risk across the economy. In extraordinary circumstances, it has the power to break up firms or require them to divest of certain assets.

2) Increased focus on strengthening firms considered “too big to fail”, i.e., posing systemic risks to the economy. The Fed may impose tougher capital, leverage, risk-taking, and other standards for such firms.

3) Focus on regulating larger financial firms: The Fed no longer oversees small bank-holding companies and state-chartered banks and will only regulate large financial institutions, banks, and thrift holding companies with total assets in excess of $50 billion.

18.

With respect to the financial system, what is meant by “too big to fail”? Why is it an important issue?

Failure of a large financial firm may cause irreparable damage to the economy, resulting in a banking panic, recession, or even depression. To prevent the possible catastrophic consequences, the federal government may step in to bail out such firms, as it did in the fall of 2008. While a bailout may be the lesser evil than letting such firms fail, moral hazard may lead to wealth transfers from taxpayers to owners of these firms. That is, if a financial institution believes it is too big to fail, it may take excessive risks and, if these risks do not pay off, fail and end up being bailed out by the government (i.e., taxpayers). Minimizing the likelihood of having to bail out large financial institutions that are “too big to fail” calls for more stringent controls of capital positions, leverage, and risks taken by such firms.

19.

What are the arguments that support having a strong and independent Federal Reserve Bank?

The independence of the Fed relieves it from day-to-day political pressures and affords it to take unpopular measures beneficial for the economy in the long run. An example is contracting money supply to increase interest rates, which would likely dump inflation but cool of the economy in the short run.

20.

Why does the Fed want the ability to pay interest on reserve accounts?

Paying interest on reserves allows the Fed to influence not only the supply of reserves (which it does by buying or selling securities via open market operations) but also the demand for reserves.

Increasing the interest rate on reserves provides banks with an incentive to keep more excess reserves with the Fed rather than to lend to other banks or customers. Decreasing this rate or eliminating interest on reserves altogether would encourage banks to keep less excess reserves and lend more, all else equal.

21.

If the country went into a recession, would you expect banks to increase or decrease its holdings of excess reserves? Explain.

Recessions are characterized by declines in economic activity. Demand for loans falls during such times while deposits levels tend to remain fairly stable. As a result, banks tend to make less loans and hold more excess reserves.

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CHAPTER 3 THE FED AND INTEREST RATES CHAPTER OBJECTIVES 1. This chapter explains how the Fed measures the money supply, and introduces the monetary aggregates—M1 and M2. Having learned the components of the monetary base in Chapter 2, students must now grasp the difference between the “monetary base” and the “money supply”.

2. The chapter explains how the Fed influences interest rates, and introduces the Fed Funds Rate. Students must appreciate how the Fed Funds Rate is determined and why it is important.

3. The chapter explains why the Fed manipulates the money supply and interest rates by describing the linkages between these financial sector variables and economic activity in the real sector.

The chapter compares and contrasts two basic schools of thought about monetary policy—Monetarists and Keynesians, and discusses complications encountered by the Fed as it pursues its goals.

4. The chapter discusses the basics of fiscal policy and the recent financial crisis followed by a recession. Students should know the difference between monetary and fiscal policy and understand what can be done from the monetary and fiscal policy standpoints to combat financial crises and recessions.

CHANGES FROM THE LAST EDITION 1. Tables, exhibits, and data have been updated. Exhibit 3.5 from the 10th edition, “Changes in the Consumer Price Index”, has been dropped from the textbook. The second “People and Events” insert has been revised.

2. Learning Objective 5 has been added.

3.

“Do You Understand?” questions: (1) in the first set, old Q.2 has been deleted and new Q.4 added, (2) in the second set, Q.4 has been added.

4. There are nine new end-of-chapter questions (Qs.12-20).

5. MZM is no longer discussed as a money stock measure.

6. In Section 3.2, “The Fed’s Influence On Interest Rates”, the subsection “The Importance of the Fed Funds Rate” has been revised and the subsection “Managing Risk: the Fed’s Impact on Stock and Bond Markets” deleted.

7. Two new sections have been added: Section 3.3, “The Treasury Department and Fiscal Policy”, and Section 3.7, “Anatomy of a Financial Crisis”. The latter section discusses the factors contributing to the financial crisis and the housing bubble underlying it.

8. Section 3.4, “Goals of Monetary Policy” (formerly titled “Objectives of Monetary Policy”) now starts with a discussion of inflation targeting. Two of the six goals – price stability and full employment – are now discussed as being the primary goals. The subsection on price stability has been revised and put ahead of all other subsections in this section.

CHAPTER KEY POINTS 1. The “monetary base” and the “money supply” are not the same thing. The monetary base comprises Federal Reserve Notes in circulation and deposits of financial institutions with the Fed. The money supply reflects both monetary policy and private transactions: 1

M1 = currency, coin and travelers checks in circulation + demand checking deposits or checking accounts + “NOW” accounts and similar interest-on-checking accounts; M2 = M1 + savings deposits and money market deposit accounts + overnight repurchase agreements + Eurodollars + noninstitutional or “retail” MMMFs + small time deposits (under $100,000) 2. By controlling the monetary base, the Fed substantially influences the money supply. To meet reserve requirements, depository institutions deal in monetary base assets by depositing reserves with the Fed or holding adequate quantities of Federal Reserve Notes in their vaults. Excess reserves appear as the Fed buys securities on the open market, lends at the Discount Window, or cuts reserve requirements. As depository institutions lend or invest excess reserves, they increase M1 and finance spending in the real sector. By expanding or contracting the monetary base, the Fed increases or decreases excess reserves, raising or lowering incentive to lend or invest to encourage or discouraging expansion in the real sector.

3. To influence interest rates, the Fed targets but does not set the fed funds Rate. The fed funds market is a Fed-sponsored system in which depository institutions lend and borrow excess reserves among themselves. The interest rate on these transactions—the fed funds rate—is set by market forces. The FFR is a “benchmark” rate in the financial system—it normally represents the lowest possible cost of loanable funds. The Fed influences the FFR by controlling overall availability of reserves.

4. As the Fed adjusts the tools of monetary policy, reserve effects influence the Fed Funds Rate significantly in the short run: Open-Market Operations: Buying pressures the FFR downward by increasing excess reserves.

Selling pressures the FFR upward by decreasing excess reserves.

Discount Rate: Cutting the discount rate pulls the FFR downward: The Window becomes less costly relative to Fed Funds. Raising the discount rate pushes the FFR upward: Fed Funds become less costly, with institutions already reluctant to face “Window scrutiny”.

Reserve Requirements: Cutting reserve requirements pulls the FFR downward by increasing excess reserves. Raising reserve requirements pushes FFR upward by decreasing excess reserves.

Effects are direct, sustained, and too dramatic for “fine tuning”.

5. The Fed cannot set the fed funds rate in the long run because factors in the real sector ultimately determine credit demand. If the Fed tried to sustain an FFR too low, M1 could grow too rapidly and real investment decisions could be distorted (e.g., borrowing might just finance hoarding of assets). Too high, and M1 might not “keep up with” the real sector. The economy could falter as real investment declined. The best the Fed can ultimately do is try to promote stable price levels.

6. Monetary policy and the economy are linked. Monetary policy first impacts the financial sector. Then the real sector perceives changes in costs or benefits of borrowing, spending, saving, or investing. Two schools of thought contend as to these linkages. Monetarists believe the key financial variable for changing economic activity is the money supply. Keynesians believe it is interest rates.

7. The six goals of U.S. monetary policy, under the Employment Act of 1946 and the Full Employment and Balanced Growth Act of 1978 (also called the Humphrey-Hawkins Act), are Price Stability, Full Employment, Economic Growth, Interest Rate Stability, Stability of the Financial System, and 2

Stability of Foreign Exchange Markets.

The first two goals – promoting high employment consistent with a stable price level – are the primary goals of monetary policy.

8. As the Fed manipulates the money supply and interest rates to promote its goals, monetary policy “transmits” to the real sector via 3 channels: Business investment in real assets. Present values of future cash flows depend significantly on interest rates, as do costs of financing real assets. Monetary policy thus involves material incentives or disincentives for business investment.

Consumer spending for durable goods & housing. Much consumer spending is on credit, so it tends to vary directly with credit conditions. Falling interest rates tend to encourage spending; rising interest rates tend to discourage spending. Consumers, however, don’t necessarily make decisions the way businesses do. Thus, monetary policy should affect aggregate demand, but perhaps not as predictably as it affects business investment.

Net exports (gross exports minus gross imports). Interest rates affect exchange rates, which affect imports and exports. Monetary policy thus usually affects net exports. The Fed can weaken or strengthen the dollar, for reasons related or unrelated to export effects.

Monetary policy does not transmit without interference. The Fed must constantly adjust for technical factors—cash drains, the float, and U.S. Treasury payments. The Fed cannot predict the ultimate “velocity of money”—the level of real economic activity a unit of money will support.

9. Fiscal policy is the use of government expenditures and tax collections to affect economic output over the business cycle. According to Keynesian views, during recessions governments should be proactive and use expansionary fiscal policy, which means increasing government expenditures and/or decreasing taxes. In this line of thought, federal budget deficits are justified and even expected because they may help smooth out the business cycle.

10. The 2007-2010 financial crisis that originated in the U.S. subprime mortgage market before spreading out to other sectors of the economy, was a caused by a combination of factors: (1) deterioration of financial institutions’ balance sheets, (2) the housing bubble burst, (3) abnormally low interest rates for an extended period of time, (4) increase in uncertainty in the economy, and (5) a banking crisis. Asset bubbles form when asset prices over-inflate due to excess demand which is often caused by speculative motives. Asset bubbles are often driven by low interest rates and credit booms, as was the case in the U.S. housing bubble in the 2000s.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

What is the difference between M1 and M2? Why are there different measures of money?

M1 focuses on money as a medium of exchange—demand deposits and currency. M2 expands the meaning of money to include its use as a short-term store of value. To the elements of M1 it adds savings deposits, money market deposit accounts, overnight repurchase agreements, Eurodollars, noninstitutional money market mutual funds, and small time deposits. The Fed wants to know what definition of money has the greatest impact on interest rates, unemployment, and inflation.

2.

What would happen to the monetary base if the U.S. Treasury collected $4 billion in taxes, which 3

it deposited in its account at the Fed, and the Fed bought $2.5 billion in government securities?

Do you know now why the Fed and Treasury try to coordinate their operations in order to have minimal effects on the financial markets?

The first transaction would lower bank reserves and increase Treasury deposits at the Fed by $4 billion. The second transaction would restore $2.5 billion in bank reserves. The net reduction of $1.5 billion in reserves would put upward pressure on the Fed Funds rate. The Treasury will probably spend its deposits down quickly, increasing bank reserves by the total of the clearing checks. The Fed may then have to sell government securities to return reserves to their intended level.

3.

If the Fed bought $3.5 billion in government securities and the public withdrew $2.0 billion from their transactions deposits in the form of cash, by how much would the monetary base change?

By how much would financial institutions' reserves change? By how much would financial institutions' required reserves change if all proceeds from bond sales and all withdrawals from transactions accounts were deposited in or taken from accounts subject to a 10 percent reserve requirement? By how much would depository institutions' net excess reserves change?

The open-market purchase would increase the reserve component of the monetary base by $3.5 billion. The public’s withdrawals represent a $2 billion “cash drain”. The net effect on the monetary base ultimately depends on whether and to what extent the affected institutions replenish the cash. Assuming they replenish the $2 billion in cash by converting sufficient reserves into Federal Reserve Notes, the purchase of currency would be a “wash” and the monetary base would increase by $3.5 billion, the amount of the purchase of government securities. The affected institutions would initially allocate $350 million to required reserves, and immediately start trying to lend or invest $3.15 billion of excess reserves.

4.

If a country named Lower Slobovia decided to use U.S. dollars as a medium of exchange and therefore withdrew $10 billion in cash from its transaction deposits in the U.S., what would happen to the U.S. monetary base? What would happen to depository institutions' actual reserve holdings? What would happen to U.S. financial institutions' net excess reserves if the Lower Slobovians withdrew their money from bank deposits subject to a 10 percent reserve requirement? What would probably happen to the U.S. money supply?

Assuming the banks replenish their cash at the Fed, the monetary base will not change. FRN will increase by $10 billion and bank reserve deposit accounts will decrease by $10 billion. With the withdrawal of $10 billion in bank deposits, the banks' required reserves would decline by $1 billion (10% of $10 billion), but their actual reserve balances would decline by $10 billion, assuming replenishment of cash. Assuming no excess reserves, the destruction of bank reserves would reduce the money supply. The Fed is likely to replenish the reserves, assuming no policy changes.

5.

Assume a depository institution holds vault cash of $3 million and reserve deposits at the Fed of $25 million, and has borrowed $2 million from the Fed's discount window. If that institution holds $300 million in transactions deposits and is subject to a 3 percent reserve requirement on the first $50 million of those deposits and to a reserve requirement of 10 percent on all transactions deposits over $50 million, what are its required reserves? What are its excess reserves?

Reserves total $28 million: vault cash of $3 million and deposits at the Fed of $25 million.

Required reserves amount to $26.5 million (3% of the first $50 million of deposits plus 10% of the remaining $250 million), leaving $1.5 million in excess reserves. However, $2 million is due to the Fed at the Window, leaving the bank in a -$.5 million “net borrowed reserve” position.

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6.

What is the essential difference between the Keynesian and the Monetarist view of how money affects the economy?

Monetarists believe the key financial variable is the money supply. They assume the propensity to consume rises or drops as people perceive they have “more” or “less” money. Thus the money supply can be used to influence aggregate demand, and short-term interest rates merely indicate monetary policy’s effects. Keynesians believe the key financial variable is interest rates: Real sector economic growth is stimulated by falling rates as economic activity costs less to finance, or slowed by rising rates as economic activity costs more to finance. To Keynesians, money supply changes reflect reactions to interest rates

7.

What effects are decreases in reserve requirements likely to have on: a. b. c. d. e.

bank reserves federal funds rates bank lending Treasury bill rates the bank prime rate?

a. b. c. d. e.

none reduce them increase it reduce them reduce it

Explain your answers.

Reductions in reserve requirements will provide depository institutions with additional excess reserves. As they lend or invest these excess reserves to earn an interest return, Fed Funds rates and other short-term rates will fall, stimulating demand for loanable funds.

8.

Given your answers to Question 7, what, if anything, would you expect to happen to: a. b. c. d. e. f. g.

housing investment plant and equipment investment intended inventory investment government expenditures consumption exports imports

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

increase increase increase increase increase increase decrease

Why? As market interest rates decline, loans become readily available, money supplies expand, the public's liquid asset holdings increase, and the market value of financial assets rises. In addition, disintermediation pressures may diminish. As a result of the decline in interest rate, increase in liquidity, and increase in credit availability more expenditures will be undertaken in all segments of the economy.

9.

Explain the concepts of frictional unemployment, structural unemployment, and the natural rate of unemployment. How do these affect what is considered full employment?

Full employment implies that every person of working age who wants work is working. It is a desirable goal, but not necessarily a practicable one. A certain amount of unemployment in the economy is frictional unemployment—a portion of those that are unemployed are in transition between jobs. Another reason for people not working is structural unemployment, meaning that there is a mismatch between a person’s skill levels and available jobs or there are jobs in one region of the country but few in another region. Policy makers tolerate a certain level of unemployment—the natural rate of unemployment—a sort of “full employment unemployment 5

rate.” However, the politically acceptable rate of unemployment varies directly with the actual rate.

10.

What are some of the potential conflicts between goals of monetary policy? Explain.

Most of the goals are relatively consistent with one another. The goals often perceived in conflict are full employment and stable prices, at least in the short run. The conflict revolves around the perception that, as employment increases, so does inflation. This argument holds that high levels of unemployment mean substantial unused industrial capacity. As the economy begins to expand, unemployment starts to decline as workers are called back to work, and capacity utilization increases as more goods and services are produced. As the expansion continues, demand for labor and materials rises, putting upward pressure on price and wage levels.

11.

What are technical factors? How do they affect the implementation of monetary policy?

Cash drains are “leaks” between changes in the monetary base and changes in actual reserves.

These “leaks” occur as the public chooses to hold cash outside of banks, making it unavailable to use as actual reserves. Because cash drains reduce actual reserves, the Fed tries to anticipate when people are likely to withdraw cash. The Fed then tries to expand the money supply commensurately, to maintain the desired level of reserves. When people put cash back in, the Fed acts to decrease the monetary base back to the level consistent with monetary policy. Openmarket operations are ideal for this kind of “fine-tuning”. Similarly, the Fed must engage in openmarket operations to offset the effects of float, the difference between deferred availability cash items (DACI) and cash items in process of collection (CIPC). A third technical factor is changes in Treasury deposits at the Fed. Large payments into or out of Treasury balances at the Fed cause large shifts in depository institutions’ reserves as the checks are deposited and collected. Thus, the Treasury tries to coordinate any large fluctuations in its deposits with the Fed.

12.

Why do security traders pay so much attention to the fed funds rate? Why is the fed funds rate so important?

The fed funds rate is the interbank lending rate. It is of interest to many market participants for three reasons: (1) it measures the return on the most liquid financial asset – bank reserves, (2) it is closely related to monetary policy, and (3) it measures the available reserves in the banking system, which influences banks’ decisions on making loans.

13.

Why is the concept of a liquidity trap important in the conduct of monetary policy?

If money supply is expanded so much that any extra money would be hoarded (rather than lent or invested), further injections of money have no effect on interest rate and the economy overall.

This state is known as a liquidity trap. This is important when money supply is already high and interest rates low, such as after the 2007-2009 financial crisis in the U.S. and some other developed countries. It means that the economy should be stimulated by other means.

14.

What is fiscal policy? How does fiscal policy compare to monetary policy?

Fiscal policy is the control over government spending and taxes over the business cycle. Congress and President determine, and the Treasury Department carries out fiscal policy in the U.S. Monetary policy, on the other hand, boils down to the control of money supply; it is determined and carried out by central banks such as the Federal Reserve System in the U.S. or the European Central Bank in the Euro-zone.

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15.

Explain the fiscal policy stance that you would deploy if the economy were in a recession. How would you implement the policy?

The two basic fiscal policy stances are expansionary and contractionary. To combat a recession, a government can decrease taxes and/or increase expenditures to help create jobs and stimulate economic activity. It will cause the government budget deficit to increase or surplus to fall. This stance was first proposed by the British economist John Maynard Keynes.

16.

What is the government expenditure equation? Explain the three budget positions.

Government can finance its expenditures (G) with money raised by taxation (T) or incurring debt (B, for bonds): G = T + ΔB The three possible budget positions are: 1) Balanced budget (G = T); 2) Deficit (G > T): when expenditures exceed taxes collected, new debt is issued to finance the shortfall; 3) Surplus (G < T): when expenditures are less than tax revenues, debt can be retired.

17.

What are the six goals the Fed is required by government legislation to achieve? Which two goals are the most important? Why? The six goals of the Fed are: price stability, full employment, economic growth, interest rate stability, stability of the financial system, and stability of foreign exchange markets. The most important goals are high employment and stable prices. High inflation (unstable prices) is destructive because it causes unintended transfers of purchasing power between parties of financial contracts and discourages people from engaging in economic activity due to high uncertainty. Full employment is important because it is critical to the well-being of the economy and the society, as well as its individual members.

18.

Explain why stable prices are so important to an economy.

High rates of inflation present two problems. First, it is hard to adjust to price level changes. It means that those market participants who underestimate inflation lose purchasing power. The second problem is that high inflation rates increase uncertainty regarding long-term investment decisions. To avoid these risks, many potential investors may withdraw from the financial markets altogether, causing a decline in economic activity.

19.

Assume the Fed undertakes open-market operations and buys Treasury securities. Explain what should happen to interest rates. What is the expected change in nominal GDP?. How is nominal GDP then partitioned off between inflation and real GDP? When the Fed buys securities, money supply expands. In response, consumer and business spending increase, increasing nominal GDP. Nominal GDP changes occur due to changes in real GDP (that is, amount of goods and services produced) and due to changes in the price level.

When inflation is relatively high, most of a GDP increase is due to price changes rather than changes in the real output.

20.

In your opinion, what were the three most important factors that caused the 2008 financial crisis?

7

The first of the most important factors was the U.S. housing price bubble that burst. Asset price bubbles occur when demand is over-inflated. The U.S. housing price bubble became possible due to the combination of low mortgage interest rates and lax lending standards. When many mortgages made during the housing price run-up started defaulting, it caused deterioration in the balance sheets of financial institutions that held these mortgages or mortgage-backed securities. It was the second major factor contributing to the crisis. The third major factor was the bankruptcy of the investment bank Lehman Brothers in September 2008. It signaled that the government was willing to allow large financial institutions to fail and caused major concerns about the U.S. financial services industry, bringing the financial system to the brink of collapse.

8

CHAPTER 4 THE LEVEL OF INTEREST RATES CHAPTER OBJECTIVES 1. This chapter defines the concept of an interest rate and examines the forces that establish the level of interest rates in the economy.

2. The chapter distinguishes between the concepts of the real interest rate and a nominal interest rate, with particular attention to the effect of inflation.

3. The chapter surveys Loanable Funds Theory and its implications for forecasting interest rates.

CHANGES FROM THE LAST EDITION 1. Exhibits have been updated. Exhibit 4.4 is new to this edition. The second “People & Events” insert has been revised. The chapter opener and chapter preview have been revised.

2. There are ten new end-of-chapter questions (Qs.11-20).

3. The section “The Real Rate of Interest” has been revised.

4. Changes Section 4.4, “Price Expectations and Interest Rates”: (1) a revised beginning, (2) a new subsection “Price Level Changes”, (3) a revised subsection “The Realized Real Rate of Return”, (4) a new subsection “Negative Interest Rates”.

CHAPTER KEY POINTS 1. Interest is the “rent” on borrowed money. An interest rate is the price of “renting” or borrowing another’s purchasing power; thus credit or borrowed money is a priceable commodity. Interest penalizes the borrower for consuming before earning and rewards the lender for postponing consumption.

2. The fundamental long-run interest rate in the economy is the real rate of interest. It is called the “real” rate of interest because it is determined by the real output of the economy. It is determined at equilibrium between the demand for financing for productive real assets and the supply of savings. By definition it is the minimum rate of return necessary to offset the positive time preference for consumption in the absence of any transactional risk or expected change in purchasing power.

3. Loanable Funds Theory is a comprehensive theory of interest rate determination in financial activity.

The trade-off between productivity and thrift is the basic force in interest rates, but not the full explanation of short-run changes in interest rates observed in a complex financial system. Interest rates can be substantially influenced by demand for and supply of financial claims, trading in secondary markets that do not link directly to the real sector. Thus, interest rates in the near term depend on supply of and demand for loanable funds.

The supply of loanable funds comprises all sources of funds invested in financial claims: 1.

2.

3.

4.

Consumer savings.

Business savings (depreciation, amortization, and retained earnings).

Government budget surpluses.

Central bank action.

The demand for loanable funds comprises all uses of funds raised by issuing financial claims: 1.

2.

3.

Consumer credit purchases.

Business investment.

Government budget deficits.

If competitive forces operate in the financial sector, laws of supply and demand will bring interest rates in each market into equilibrium. The equilibrium, however, is temporary and dynamic. Any force that shifts supply or demand will tend to change interest rates.

4. Price expectations influence interest rates. Rational lenders who anticipate a decline in the purchasing power of money (inflation) will require compensation in the form of a premium over the real rate. The classic statement of this principle is Fisher’s equation: i = r + ΔPe, where i is the observed or nominal rate, r is the real rate, and ΔPe is the expected or ex ante inflation rate.

If expectations underestimate actual inflation, the realized real rate of return will not compensate the lender adequately for lost purchasing power and the borrower will receive an unintended transfer of wealth.

Higher rates of inflation can actually cause negative realized returns. There is no evidence that, as a group, borrowers or lenders are able to “outpredict” each other consistently. Historically, interest rates tend to change with changes in the rate of inflation, substantiating the Fisher equation. Short-term rates are more responsive to changes in inflation than long-term rates.

Nominal interest rates are almost always positive. They may become negative on rare occasions when investors are ready to pay a premium for safe storage of their money.

5. Forecasting interest rates, an inexact science at best, involves either of two methods: economic modeling and the flow of funds approach.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

What factors determine the real rate of interest?

The real rate of interest is determined by: (a) individual time preference for consumption, and (b) the return that firms expect to earn on their real capital investments. In equilibrium, the real rate of interest is determined when desired saving equals desired investment.

2.

If the money supply is increased, what happens to the level of interest rates?

An increase in the money supply shifts the supply of loanable funds to the right, lowering interest rates (at least in the short term).

3.

What is the Fisher effect? How does it affect the nominal rate of interest?

The Fisher effect is Irving Fisher’s hypothesis that expected inflation is embodied in current nominal interest rates. Assuming the ability to forecast expected inflation, nominal rates should vary directly with expected inflation.

4.

The 1-year real rate of interest is currently estimated to be 4 percent. The current annual rate of inflation is 6 percent, and market forecasts expect the annual rate of inflation to be 8 percent.

What is the current 1-year nominal rate of interest?

Assuming the Fisher effect, the current 1-year nominal rate should be 12 percent, the sum of the real rate (4%) plus the expected inflation rate (8%), an approximate but illustrative way of estimating the answer. The correct way to deal with compounding rates is to multiply (1+.04)(1+.08) - 1 = 12.32%.

5.

The following annual inflation rates have been forecast for the next 5 years: Year 1 Year 2 Year 3 Year 4 Year 5

3% 4% 5% 5% 4%

Use the average annual inflation rate and a 3% real rate to calculate the appropriate contract rate for a 1-year and a 5-year loan. How would your contract rates change if the Year 1 inflation forecast increases to 5%? Discuss the difference in the impact on the contract rates from the change in inflation.

A lender would require compensation for both opportunity cost and loss of purchasing power.

The sum of the real rate, 3%, plus the expected rate of inflation, 3%, would be roughly 6% and accurately, (1.03)(1.03) -1 = 6.09%. The 5-year rate would be the sum of the real rate plus the average inflation rate expected: (1.03)(1.04197) - 1 = 7.32%. If the 1-year expected inflation rate were 5%, the geometric average expected rate of inflation would be 4.6%, found as [(1.05)(1.04)(1.05)(1.05)(1.04)]1/5 – 1 = [(1.05)3(1.04)2]1/5 – 1 = 0.046, and the contract rate would likely be (1.03)(1.046) -1 = 7.74%. Nominal rates include the real rate plus the expected inflation rate.

6.

Under what conditions is the loss of purchasing power on interest in the Fisher effect an important consideration?

Retired individuals, church endowments, or foundations with fixed interest rate returns on longterm CD or bond investment portfolios are hurt with actual or anticipated inflation. With expected inflation, market interest rates increase, and the value of the investment declines. With inflation and fixed interest income, less can be purchased each period.

7.

What is the track record of professional interest rate forecasters? What do you think explains their performance?

Accurate forecasters will not likely publish their forecasts, but will use their ability to extract profits from the markets. The adjustment process, which incorporates all available information in an efficient market, will adjust the current rate structure to reflect the consensus forecast. Studies of public forecasts indicate a very poor forecasting ability.

8.

Explain how forecasters use the flow-of-funds approach to determine future interest rate movements.

Using the loanable funds theoretical constructs, forecasters predict fund flows through sectors looking for significant supply/demand or sources/uses variations, which may signal changes in

rates.

9.

An investor purchased a 1-year Treasury security with a promised yield of 10 percent. The investor expected the annual rate of inflation to be 6 percent; however, the actual rate turned out to be 10 percent. What were the expected and the realized real rate of interest for the investor?

The expected real rate is re = (1+i)/(1+ΔPe) – 1 = (1.1/1.06) – 1 = 3.77%; the realized real rate is (1.1/1.1) – 1 = 0.

10.

If the realized real rate of return turns out to be positive, would you rather have been a borrower or a lender? Explain in terms of the purchasing power of the money used to repay a loan.

The answer depends upon whether the lender (borrower) earns (pays) their expected real rate. If inflation were originally underestimated, borrowers would benefit at the cost of lenders—their real cost of borrowing would be less than anticipated. If inflation were overestimated, lenders would benefit at the cost of borrowers—real returns (borrowing costs) would be higher than originally anticipated.

11.

Explain what the nominal rate of interest is and how it is related to the real rate of interest.

Nominal rates are the quoted interest rates we observe in the marketplace. A nominal rate includes the real rate plus expected inflation over the investment period.

12.

Explain what is meant by the term positive time preference for consumption. How does it affect the rate of interest?

Most people prefer to consume goods sooner rather than later. This is known as a positive time preference for consumption. The higher this time preference is, the higher interest rate a person should be offered to forgo consumption and make an investment.

13.

Explain how the equilibrium real rate of interest is determined.

The equilibrium rate of interest is the point where the desired level of borrowing by deficit spending units (DSUs) equals the desired level of lending by surplus spending units (SSUs).

14.

Explain how the market rate of interest is determined applying the loanable fund interest rate model.

Interest rates depend on the supply of and demand for funds, which in turn depend on thrift and productivity. The sources of supply of loanable funds are consumer and business savings, government budget surpluses, and Federal Reserve increases in the money supply. The sources of demand are consumer credit purchases, business investments, and government budget deficits, and Federal Reserve decreases in money supply.

15.

What is the value of money? How does the value of money vary with aggregate price-level changes?

The value of money is its purchasing power, or goods and services that can be bought with it.

Price increases (decreases) decrease (increase) the value of money because a dollar can buy less (more).

16.

Explain why it is important to adjust financial contracts for inflation. What is the relevant inflation factor?

It is important because investors want to realize a positive real rate of returns, in other words, to beat inflation. The relevant inflation factor is the average annual inflation rate anticipated over the period of investment.

17.

Explain when the market rate of interest is equal to the real rate of interest.

Since market rates are nominal rates, the market rate is equal to the real rate when inflation is zero during a period.

18.

Explain what is meant by the realized rate of return. How does it differ from the real rate of interest?

The realized rate of return is the actual real rate to the lender at the conclusion of the loan contract. It depends on the actual inflation during the period. The real rate of interest is the base interest rate for the economy and is closely related to the productivity of capital investments and the people’s time preference for consumption.

19.

Explain what is meant by the term negative interest rate. Why can interest rate never be negative?

A negative interest rate on investment means that the investor (lender) pays the borrower rather than the other way around. Theoretically, interest rates cannot be negative because investors are better off not investing at all and earning zero percent interest than investing at negative interest rates.

20.

In financial markets, we occasionally observe negative interest rates. Reconcile the contradiction between the statement “The nominal rate of interest will never decline below zero” with the negative interest rate that occurred in the Japanese Treasury bill market in November 1998.

In some situations, investors seek safe storage for their money. In November 1998 in Japan many large investors did not want to keep money at banks, as they worried about the banking system’s health, and preferred to store the money in government bills; the overwhelming demand for the bills, coupled with an already very low interest rate environment, drove the T-bill yields below zero. The desire to preserve capital trumped the desire to grow it.

CHAPTER 5 BOND PRICES AND INTEREST RATE RISK CHAPTER OBJECTIVES 1. This chapter explains how interest rate changes affect bond prices. The student should come to understand the mechanics of bond pricing and the way bond markets simultaneously set prices and yields.

2. The chapter compares and contrasts the concepts of coupon rate, yield to maturity, expected yield, realized yield, and total return.

3. The chapter surveys the nature, measurement, and management of interest rate risk, with attention to volatility, price risk, reinvestment risk, and duration. Beyond learning the formula, the student should grasp the importance of duration as a measure of a) volatility and b) the holding period for which price risk and reinvestment risk just offset, assuring the investor the yield to maturity.

CHANGES FROM THE LAST EDITION 1. The chapter opener and both “People & Events” items have been revised.

2. “Learning by Doing”: There are three LBD inserts in the chapter, on pp.145-146, 147-148, and 156157.

3. “Do You Understand?” questions: in the second of three sets, old Qs.5 and 6 have been deleted.

4. End-of-chapter questions: old Qs. 5 and 6 have been deleted and eight new questions added (Qs. 1320).

CHAPTER KEY POINTS 1. Beyond the calculations, students should understand why money has time value. Inflation expectations may affect the discount rate, but the time value of money has more to do with an opportunity cost irrespective of expected changes in purchasing power. Use of financial calculators should be encouraged. Students can demonstrate to themselves the price and yield mechanisms on which fixed-income markets are based.

2. The value or price of a bond (or any fixed-income security) is the present value of the promised cash flows discounted at the market rate of return, i.e., the required return on this risk class in today’s market.

3. Certain risks affect prices and yields. A bond yield rewards at least 3 risks: default risk, price risk, and reinvestment risk. Price risk and reinvestment risk offset one another to some extent as interest rates vary.

Yields may be classified as expected or ex ante (yield to maturity and expected yield) or as realized or ex post, (realized yield and total return). Yield to maturity assumes coupon reinvestment at the same yield.

4. Price volatility is a proxy for price risk. Duration is also used as a price risk measure: the higher the duration, the greater the potential volatility. Bond volatility is directly related to term to maturity and inversely related to coupon rate.

5. Duration is the sum of the discounted, time weighted cash flows divided by the price of the security. A simple two- or three-year example is an efficient way to explain how varying contract terms and levels of interest rates affect duration. Durations change dynamically. Duration is directly related to term to maturity 1

and inversely related to coupon rate and yield.

6. Duration is a measure of interest rate risk in the following ways: a) as a measure of bond volatility; b) as a time point where price and reinvestment risk are offset; and, c) later when studying financial institutions, as a means of managing interest rate risk by matching the durations of sources and uses of funds. Matching maturities gives no recognition to the varied cash flows, and varied coupon reinvestment of sources and uses of funds.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

Julie Orzabal deposits $5,000 in a savings account offering 5.125% compounded daily. Assuming she makes no further deposits, what will be the balance in her account after 5 years?

The question requests the future value (FV) of a single present value (PV) of $5,000 growing at an annual percentage rate (APR) of 5.125%, compounded daily, for 5 years. Determine a daily rate and the number of compounding periods over the 5 years. Divide the rate by 365; multiply the annual periods by 365.

FV = PV(1 + i)n

FV = $5,000 (1 + .05125/365)1826

FV = $5,000 (1.0001404)1826 = $6,461.17

2.

Write the equation which expresses the present value (or price) of a bond that has a 10% coupon (annual payments), a 5-year maturity, and a principal of $1,000, if yields on similar securities are 8%.

Compute the price using a calculator.

Pb = Calculator: 3.

1000 FV

100 100 100 1,100 + + + = $1,079.85 2 1.08 1.08 1.083 1.084 5N

8I

100 PMT

PV = $1,079.85

Find the price of a corporate bond maturing in 5 years that has a 5% coupon (annual payments), a $1,000 face value, and an AA rating. A local newspaper's financial section reports that the yields on 5 year bonds are: AAA = 6%, AA = 7%, and A = 8%.

The price of the corporate bond (Pb) is:

Pb =

4.

50 50 50 50 1,050 + + + = $918.00 1 2 3 4 (1 + .07 ) (1 + .07 ) (1 + .07 ) (1 + .07 ) (1 + .07 )5

What is the yield-to-maturity of a corporate bond with a 3-year maturity, 5 percent coupon (semiannual payments), a $1,000 face value, if the bond sold for $978.30?

Payments comprise an ordinary annuity of $25 every 6 months for 3 years plus a lump sum of $1,000 at end of 3 years. What discount rate equates this payment stream to $978.30?

Pb =

25 25 25 25 25 1,025 + + + + + = $978.30 2 3 4 5 (1 + i / 2 ) (1 + i / 2 ) (1 + .i / 2 ) (1 + i / 2 ) (1 + 1 / 2) (1 + i / 2 )6

Calculator: 6N 25 PMT -978.30 PV 1,000 FV yield, or i/2 in the equation above); double to annualize: 5.80%.

2

I = 2.899% (semiannual

5.

Explain why yields and prices of debt-instruments are inversely related.

Coupon and principal amount are fixed at time of issue. The only way to adjust the yield on the bond to the prevailing market rate of interest is to bid the price upward or downward.

6.

What is the relationship between bond price volatility and term to maturity? Between bond price volatility and the coupon rate?

The longer the term to maturity and the lower the coupon rate, the greater the price swings for a given change in interest rates.

7.

Carol Chastain purchases a one-year discount bond with a face value of $1,000 for $862.07. What is the yield of the bond?

$862.07 =

$1000 (1 + i )1

Rearranging Equation (5.3), i = (1,000/862.07) – 1 = 16%.

8.

David Hoffman purchases a $1,000 20-year bond with an 8% coupon rate (annual payments). Yields on comparable bonds are 10%. David expects that, two years from now, yields on comparable bonds will have declined to 9%. Find his expected yield, assuming the bond is sold in two years.

Based on the YTM of 10% at the time of purchase, the purchasing price is $829.73:

$829.73=

$80 $80 $1,080 + + 1 2 (1.10 ) (1.10 ) (1.10 )20

Calculator: 1000 FV 20 N 10 I 80 PMT PV = $829.73.

In two years, based on 18 years remaining to maturity and the YTM of 9%, the bond price is expected to be $912.44:

$912.44 =

$80 $80 $1,080 + + 1 2 (1.09 ) (1.09 ) (1.09 )18

The expected yield is the rate that discounts the cash flows the investor expects to receive (in this case, two annual coupons of $80 and the selling price of $912.44) to the amount the investment was purchased for (in this case, $829.73):

$829.73 = Calculator: 9.

912.44 FV

2N

80 80 + 912.44 + (1 + i ) (1 + i )2

PV = -$829.73.

80 PMT

I = 14.29%

Calculate the duration of a $1,000 4-year bond with an 8% coupon (annual payments) that is currently selling at par.

2

The following table is useful for the duration calculation: ________________________________________________________________ Period (1) 1 2 3 4

Cash Flow (2) $80 $80 $80 $1,080 Sum

Duration=

PV at Mkt Rate of 8% (3) $74.07 $68.59 $63.81 $793.83 $1,000

(1)*(3) $74.07 $137.18 $190.53 $3,175.32 $3,577.10

Summationof timeWeighted PVs $3,577.10 = = 3.577 years Price $1,000

Early cash flows (high reinvestment risk) will be weighted at a low value, thus lowering duration. If the bond is held 3.577 years, the investor will earn the yield to maturity, 8%. If held to maturity, price risk is eliminated, but realized yield will be higher/lower than 8% depending on reinvestment rates.

10. Calculate the duration of a $1,000, 12-year zero coupon bond using annual compounding and a current market rate of 9%.

Duration = 12 years; the duration of a zero coupon bond is, by definition, its term to maturity.

Check: D = (1,000*12/1.09 12)/(1,000/1.0912) = 12 11.

Define interest rate risk. Explain the two types of interest rate risk. How can an investor with a given holding period use duration to reduce interest rate risk?

Interest rate risk is the potential deviations of realized yields from expected yields caused by changes in market interest rates. Interest rate risk comprises two subsidiary risks. Price risk is the potential variability in price (capital gains/losses) as price varies inversely with yields. Reinvestment risk is the potential variability in reinvestment rates, relative to the yield to maturity, caused by changing market interest rates. Selecting an investment with duration equal to the planned holding period locks in the yield to maturity.

12.

Calculate the duration for a $1000, 4-year bond with a 4.5% annual coupon, currently selling at par. Use duration to estimate the percentage change in the bond’s price for a decrease in the market rate to 3.5%. How different is your answer from the actual price change calculated using Equation 5.6?

Period (1) 1 2 3 4

Cash Flow (2) $45 $45 $45 $1,045 Sum

PV at 4.5% (3) $43.06 $41.21 $39.43 $876.30 $1,000

(1)*(3) $43.06 $82.42 $118.29 $3,505.20 $3,748.97

PV at 3.5% $43.47 $42.01 $40.59 $910.66 $1,036.73

Duration is the sum of the time-weighted cash flows divided by the price of the bond: $3748.97/ $1000 or 3.75 years. Per Equation 5.8, %ΔPB ≈ (-3.75)(-0.01/1.045)(100) ≈ 3.59%; compared to the actual price change of 3.67% (found by comparing the totals of Columns 3 and 5 above (the price 3

rises from $1,000 to $1,036.73) or by applying Equation 5.6).

13.

A bond with 3 years to maturity and a coupon of 6.25% is currently selling at $932.24. Assume annual coupon payments. a. What is its yield to maturity? b. Compute its duration using Equation 5.7 and the YTM calculated above at the discount rate. c. If interest rates are expected to decrease by 50 basis points, what is the expected dollar change in price? Percentage change in price? a. Calculator:

1,000 FV

3N

PV = -$932.24.

62.50 PMT

I = 8.92%

b. D = (62.5/1.0892 + 62.5*2/1.0892 2 +1,062.5*3/1.08923)/932.24 = 2,629.51/932.24 = 2.82. c. Per Equation 5.8, %ΔPB ≈ (-2.82)(-0.005/1.0892)(100) = 1.29%. Based on the initial will be price of $932.24, the dollar change in price is 1.29% of $932.24, or $12.03, and the new price is $944.27.

This is an approximation. The actual new price will be $944.50: Calculator: 1,000 FV 3N I = 8.42 62.50 PMT PV = 944.50.

This represents a $12.26, or a 1.31%, increase in the bond price.

14.

Consider a bond that has a coupon of 8% paid semiannually and has a maturity of 5 years. The bond is currently selling for $1,047.25. Use Excel to do the following analysis. a. What is its yield to maturity? b. Compute its duration. c. If interest rates are expected to increase by 75 basis points, what is the expected dollar change in price? Percentage change in price?

Excel spreadsheets with both the output and the formulas are below: Inputs Output Settlement 7/27/08 YTM 6.85% Maturity 7/27/13 Duration 4.41 Price, % of par 104.725 Coupon rate 8.00% %Δ Price using D -3.10% Frequency 1 $Δ Price using D -$3.24 Basis 1 Actual %Δ Price -2.98% Δyield 0.75% Actual $Δ Price -$3.12 Note: Settlement and Maturity dates are chosen such that there are 5 yrs. between them

2

Inputs Settlement 39656 Maturity 41482 Price, % of par 104.725 Coupon rate 0.08 Frequency 1 Basis 1 Δyield 0.0075

YTM Duration

Output =YIELD(B2,B3,B5,B4,100,1,1) =DURATION(B2,B3,0.0625,0.0892,1,1)

%Δ Price using D $Δ Price using D Actual %Δ Price Actual $Δ Price

=-E3*B8/(1+E2) =E5*B4 =PRICE(B2,B3,B5,E2+B8,100,B6,B7)/B4 - 1 =PRICE(B2,B3,B5,E2+B8,100,B6,B7)-B4

Note: Settlement and Maturity dates are chosen such that there are 5 yrs. between them

15.

Identify the price of a Morgan Stanley bond from the Wall Street Journal section titled “Corporate Bonds” or from Yahoo Finance. The bond should have a maturity of at least 4 years. Assume semiannual coupon payments. Using Excel, complete the following: a. b.

Compute its duration.

If interest rates are expected to increase by 45 basis points, what is the expected dollar change in price? Percentage change in price? c.

If interest rates are expected to decline by 35 basis points, what is the expected dollar change in price? Percentage change in price?

The price quote of 124.26 (in percent of par) was collected on July 27, 2011 at Yahoo Finance for a 7.25% semiannual coupon Morgan Stanley bond maturing on April 1, 2032. The actual/actual day count convention was assumed for computation purposes. The price changes in the Excel spreadsheets below are shown for part b (a 45 basis point increase in the yield). To compute the price changes for part c (a decline of 35 basis points), change the input in Cell C25 from 0.45% to -0.35%.

Settlement Maturity Price, % of par Coupon rate Frequency Basis Δyield

7/27/11 4/1/32 124.26 7.25% 2 1 0.45%

YTM Duration

5.29% 10.58

%Δ Price using D $Δ Price using D Actual %Δ Price Actual $Δ Price

-4.52% -$5.62 -4.92% -$6.12

YTM Duration

Output =YIELD(C19,C20,C22,C21,100,1,1) =DURATION(C19,C20,0.0625,0.0892,1,1)

%Δ Price using D $Δ Price using D Actual %Δ Price Actual $Δ Price

=-F20*C25/(1+F19) =F22*C21 =PRICE(C19,C20,C22,F19+C25,100,C23,C24)/C21 - 1 =PRICE(C19,C20,C22,F19+C25,100,C23,C24)-C21

Inputs Settlement Maturity Price, % of par Coupon rate Frequency Basis Δyield

40751 48305 124.26 0.0725 2 1 0.0045

3

16.

Explain what the convexity of a bond is. When pricing bonds, under what circumstances is convexity a problem?

Loosely speaking, convexity is a degree of curvature of the bond pricing function. Because the actual price-yield relationship is convex, and price changes computed using duration are linear approximations of this relationship, there is inevitably a pricing error when duration is used. More specifically, duration alone always underestimates the new bond price. That is, duration understates price increases when yields go down and overstates bond price declines when the yield goes up (see Exhibit 5.5). The pricing error is quite large for large changes in the yields.

17.

When reducing interest rate risk, why is duration matching superior to maturity matching?

Maturity matching only eliminates price risk (in the absence of bond defaults) but not reinvestment risk, while duration matching ensures the same outcome regardless of reinvestment rates by having price and reinvestment risks offset each other.

18.

If two bonds are identical in all respects, except one bond compounds annually and the other semiannually, which bond has the higher price? Why? The bond that compounds more frequently will be worth more because the coupons may be reinvested more frequently and earn more interest on interest.

19.

If the coupon rate on a bond is equal to the market rate of interest on similar bonds, what is the price of the bond? What are these bonds commonly called?

The bond will sell at its face value, or par. Such bonds are called par bonds.

20.

Which of the following bonds have the largest price risk and why? Note that the bonds are identical in all respects except for the size of the coupon. a. Zero-coupon bond b. Par bond c. Discount bond d. Premium bond The lower the coupon, the higher the bond’s duration and price risk. Thus, the zero-coupons bond will have the greatest price risk. Because all bonds have the same yield, the premium bond must be the one with the highest coupon. This bond will have the lowest price risk because bond price volatility increases as the coupon decreases.

4

CHAPTER 6 THE STRUCTURE OF INTEREST RATES CHAPTER OBJECTIVES 1. To introduce students to the structure of interest rates; that is, to explain why large numbers of different interest rates coexist in financial markets on any given day.

2. Discuss the relationship between term to maturity and interest rates; understand how different theories of the term structure explain the yield curve.

3. Explain how other factors – default risk, tax treatment, marketability, and options on debt securities – influence interest rates.

CHANGES FROM THE LAST EDITION 1. All time-sensitive tables and figures have been updated. Exhibit 6.9 is new to this edition. The information about bond default rates in the section titled “Default Risk” has been updated. The second “People & Events” item has been deleted.

2. Learning Objective 6 has been added.

3. “Learning by Doing”: The only LBD insert is on p.176.

4. There are four new end-of-chapter questions (Qs. 17-20).

5. In Section 6.1, “The Term Structure of Interest Rates”, the introduction and the subsection “Yield Curves and the Business Cycle” have been revised.

6. Section 6.6, “Behavior of Interest Rates over the Business Cycle”, has been added.

CHAPTER KEY POINTS 1. The term structure of interest rates is emphasized in this chapter; the concepts developed here will be used in later chapters that discuss the management of commercial banks and other financial institutions (especially savings and loan associations). An intuitive argument is made for the expectations theory that culminates in Equation 6.1.

If you wish, provide your students a more general version of Equation 6.2:

 (1 + t Rn )n  t + n−k f k =  n−k   (1 + t Rn−k ) 

1/ k

−1

Other theories that try to explain the shape of the yield curve, such as the Liquidity Premium theory, the Market Segmentation theory, and the Preferred Habitat theory are also discussed in this chapter.

These theories do not necessarily contradict each other. Rather, they add to each other. Using the expectations theory as a starting point, one can explain upward- and downward-sloping, as well as flat yield curves. The liquidity premium theory helps explain why the yield curve slopes upward most of the time. The segmentation theory explains kinks, spikes, and discontinuities in the curve, while the 1

preferred habitat theory supports a yield curve that is smooth (has no spikes or discontinuities but allows for kinks).

The impact of liquidity premiums and inflation on the term structure is discussed, and the yield curve over the business cycle is discussed.

2. The concept and theory of default risk is developed in detail. Emphasis is given to the discussion of how default risk premiums vary over the business cycle, bond rating as a measure of default risk, and some recent major corporate defaults.

3. The impact of different tax treatments on security yield is presented. It is important to emphasize Equation 6.4 because it helps explain why the tax status of a financial institution (or individual) affects investment decisions. For example, property/casualty insurance companies usually purchase municipal rather than corporate securities because municipals usually provide a higher after-tax yield to investors in high tax brackets.

4. The impact of marketability on security yields is discussed. A good point of discussion in class is the reason for the yield differential between Treasury and similar agency securities (i.e., default risk and marketability).

5. Security contract options provide the bond holder (put) or issuer (call) the ability to terminate the contract at a specified price. The conversion option on a bond gives the holder the right to convert the bond to common stock. Because put and conversion options give valuable rights to investors, yields on putable and convertible bonds are lower (and prices higher) than yields on similar bonds without options. Yields on callable bonds are higher than yields on similar noncallable bonds because the valuable right to call a bond belongs to the issuer and warrants a yield premium (a price discount) to induce investors to buy such bonds.

6. Cyclical behavior of interest rates depends on three economic forces: (1) changes in the money supply, (2) the demand for funds, and (3) inflationary expectations. The three forces put upward pressure on interest rates during periods of economic expansion and downward pressure during periods of contraction.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

Using the Federal Reserve Bulletin, the Federal Reserve Bank of St. Louis web site (FRED), or the Wall Street Journal, plot the yield curve for U.S. Treasury securities on a quarterly basis for this year. Given your knowledge of the term structure of interest rates, what would be your economic forecast for next year?

See the U.S. Treasury Bulletin, quarterly, for plots of the yield curve or The Wall Street Journal, daily in the "Credit Markets" section or on the "Markets Lineup," the second page in the Money & Investing section. The Federal Reserve Bulletin provides accessible, limited data for a plot.

The "U.S. Treasury Securities" section of The Wall Street Journal provides extensive, current maturity/yield data for plotting a yield curve in the section titled “Treasury Bonds, Notes & Bills”.

2.

Summarize the expectation theory and the preferred-habitat theory of the term structure of 2

interest rates. Are these theories in any way related or are they alternative explanations of the term structure?

The expectation theory states that the shape of the yield curve is related to investors' expectations of future interest rate levels. The preferred-habitat theory is a less restrictive variant of the market segmentation theory; it asserts that investors may hold debt securities outside of their preferred maturity ranges if offered a sufficient yield premium. The preferred-habitat theory explains the absence of discontinuities in the yield curve. The expectation theory is related to the liquidity premium theory, but is not related to the preferred-habitat theory.

3.

A commercial bank made a five-year term loan at 13 percent. The bank's economics department forecasts that one and three years in the future, the two-year interest rate will be 12 percent and 14 percent, respectively. The current one-year rate is 7 percent. Given that the bank's forecast is reliable, has the bank set the five-year rate correctly?

Given the bank's forecast, the five-year rate (tR5) should be equal to 10.64 percent using Equation (6.1):[(1.07)(1.12)2(1.14)2]1/5 -1 = 11.77%. The bank's loan rate is higher, likely to compensate the bank for the default risk of the loan.

4.

Define default risk. How does the default risk premium vary over the business cycle? Explain your answer.

Default risk is the variability of realized yields to an investor because of delays or failure to collect the contracted amount of interest and/or principal promised by the borrower. Default risk premium becomes larger during economic recessions, when more borrowers tend to default on their debt.

5.

What do bond ratings measure? Explain some of the important factors in determining a security's bond rating.

Bond ratings measure default risk. Among the important determinants of a firm’s bond rating are: (1) the firm’s expected cash flows; (2) the amount of the firm’s fixed contractual cash payments; (3) the length of time the firm has been profitable; and (4) the variability of the firm’s earnings.

6.

Why do most commercial banks hold portfolios of municipal bonds and relatively few corporate bonds?

Given that commercial banks are taxed at the full corporate tax rate (approximately 34 percent), the yield on municipal securities is higher than the after-tax yield on corporate bonds.

7.

Explain the importance of a call provision to investors. Do callable bonds have higher or lower yields than similar non-callable bonds? Why? A call provision allows an issuer to retire a bond prior to its stated maturity. Callable bonds have higher yields than similar non-callable bonds because of the possibility of not receiving the expected yield to maturity if a bond is retired before its maturity (e.g., calling for refunding purposes).

8.

Define marketability. Explain why marketability of a security is important to both investor and 3

issuer.

Marketability refers to the ease with which an investor can sell an asset. For investors, marketability means that the security can be sold easily in some secondary market; for issuers, marketable securities have lower borrowing costs.

9.

A new-issue municipal bond rated Aaa by Moody's Investor Service is priced to yield 8 percent.

If you are in the 33 percent tax bracket, what yield would you need to earn on a taxable bond to be indifferent?

Using Equation 6.4: 8% = ibt (1-.33); find ibt = 8%/(1 - .33) = 11.94%

10.

Historically, the yield curve typically has been upward sloping. Why would you expect this to be the case? (HINT: Historically, economic recessions typically last nine to twelve months; expansions typically last three to four years) The financial markets, for most of the post-WWII period, have anticipated increased levels of inflations and higher interest rates on average. Others would say the Federal Reserve Board has maintained an "easy money" posture, flooding the money market, keeping rates low. "Easy money" means inflation later, thus higher long-term rates. Compared to U.S. history, the upward sloping yield curve has been common only since the end of WWII, and historically, is not "normal"! Another explanation is that the liquidity premium that investors require to compensate them for holding longer-term securities has become more important after WWII.

11.

Under which scenario, rising interest rates or falling interest rates, would a bond investor be most likely to exercise a put option on a bond? Explain.

A put option would give the bondholder the option of selling the bond back to the issuer. This is likely only if current interest rates are above the coupon rate on the bond. Such bonds are not likely to trade at a discount relative to the put price, for they are redeemable by the issuer if rates increase.

12.

Suppose the 7-year spot interest rate is 9 percent and the 2-year spot rate is 6 percent. The forecasted 3-year rate two years from now is 7.25 percent. What is the implied forward rate on a 2-year bond originating 5 years from now? {HINT: Under the expectations hypothesis, in equilibrium an investor with a 7-year holding period will be indifferent between investing in a 7year bond or a combination of securities over the same period.} One must calculate the rate on a 2-year bond (t+5f2) acquired after investments for two years (1.06)2 and three more years (1.0725)3 that makes an investor indifferent to a 7-year bond at 9 percent (1.09)7.

1.097 = 1.062 1.07253(1 + t+5f2)2 (1+ t+5f2)2 = 1.097/(1.062 1.0725)3 or (1+t+5f2) = [1.8280/1.3861]1/2 1/2 - 1 = 14.84% t+5f2 = (1.3188) Proof: 1.062 1.07253 1.14842 = 1.097

13.

Suppose you hold a corporate bond that is convertible into the firm's stock. Stock prices are 4

falling and interest rates are also falling. Would it be a good idea to exercise your conversion option under these conditions? Why? Assuming that the firm's stock price has also been falling, the value of the conversion option is low. With interest rates falling, the bond is likely to be selling at a premium over the stock conversion value. In that situation, conversion would cost the investor money! It is not likely that one would convert to stock at this time.

14.

Suppose you expect interest rates to increase in the future. You are not indifferent toward interest rate risk and desire to maximize expected return. If you hold a portfolio consisting of 50 percent short-term bonds (< l year to maturity) and 50 percent long-term bonds, how might you adjust your portfolio to maximize your profit? Explain carefully.

This bond investor expecting interest rates to increase in the future has a few ways to protect his/her investment. Shifting from long-term to short-term is one option. Shifting from higher default risk to low default risk bonds is another, for the latter are less likely to decline in value as high risk bonds when rates rise. The investor could short T-bond futures or buy T-bond put options on futures to hedge his long-term bond exposure. The investor could enter a long-term swap related to the long-term portfolio, trading fixed income for variable in the future. All the hedges are conditions on the risk exposure of the rest of his/her portfolio of assets. To maximize profit and risk, sell the long bonds short and hang on!

15.

You are the holder of a variable-coupon bond that is convertible to a fixed-coupon bond. If you expect interest rates to rise, should you exercise your conversion option? Explain. What if you expect interest rates to fall?

The conversion option is the investors' to exercise or not. With rates expected to rise, conversion is not prudent. The income on the variable rate bond is likely to increase, and the value of the bond will stay near par. If rates are expected to fall, conversion is a possibility. Locking in today's rate on the fixed-rate bond, and riding the increased value of the bond up looks like a good option, depending on the fixed rate established upon conversion.

16.

Assume that the term structure of U.S. Treasury securities includes the following rates: Security 3-month bill 6-month bill 1-year bill 2-year note 3-year note

Annual Yield (%) 4.50 4.57 4.52 4.51 4.48

Using this information, calculate: (a) the six-month annualized yield expected in the second half of the current year, and (b) the one-year expected for year 3. [HINT: To answer (a), you will need to adjust the term structure formula for semiannual compounding.]

2

a.

 (1.0452)1  1.0452  −1 =  − 1 = 4.47% t + 0.5 f 0.5 =  0.5  1.0226   (1.0457)  2

5

b.

17.

t + 2 f1 =

(1.0448)3 − 1 = 4.42% (1.0451) 2

The observed yields on 1-year and 3-year securities are 8 percent and 11 percent, respectively.

What is the expected yield on a 2-year security 1 year from now?

 (1.11)3  f = t +1 2  (1.08)    18.

1/ 2

− 1 = 12.53%

An investor has an investment horizon of four years. The yield on a 2-year security today is 6 percent and the implied forward rate on a 2-year security two years from now is 6.75 percent.

What should be the yield on a 4-year security today such that the investor is indifferent between investing in a 4-year security versus a combination of two-year securities?

Since (1 + tR4) = [(1 + tR2)2(1 + t+2f2)2]1/4,

19.

2 2 1/4 – 1 = 6.37% tR4= (1.06 *1.0675 )

What is the preferred habitat theory? Explain how it differs from the market segmentation theory.

The preferred habitat theory is a less restrictive variant of the market segmentation theory; it asserts that investors may hold debt securities outside of their preferred maturity ranges if offered a sufficient yield premium. The market segmentation theory posits that market participants have strong maturity preferences and buy/sell securities consistent with these preferences; they do not venture outside of their preferred maturity ranges. As a result, the yield curve is determined by multiple supply and demand curves for securities of different maturities. The market segmentation theory allows for breaks and spikes in the yield curve. The preferred habitat theory explains the absence of discontinuities and spikes in the yield curve.

20.

If interest rates are expected to increase, identify what happens to the following factors using the expectations theory. (a) Demand for short-term securities by investors

Increase / Decrease

(b) Supply of short-term securities by borrowers

Increase / Decrease

(c) Price of short-term securities

Increase / Decrease

(d) Yield of short-term securities

Increase / Decrease

(e) Demand for long-term securities

Increase / Decrease

(f) Supply of long-term securities

Increase / Decrease

(g) Price of long-term securities

Increase / Decrease

(h) Yield of long-term securities

Increase / Decrease

(i) Shape of the yield curve

Normal / Inverted

6

CHAPTER 7 MONEY MARKETS CHAPTER OBJECTIVES 1. Discuss the economic role of money markets and general characteristics of money market instruments.

2. Introduce valuation methods of money market securities; enable students to compute money market yields and prices.

3. Make students familiar with the seven classes of instruments that comprise the money markets, as well as the characteristics of each of these markets.

4. Discuss the impact of the 2007-2009 financial crisis on the money markets.

CHANGES FROM THE LAST EDITION 1. All time-sensitive tables and figures have been updated. Four figures (Exhibits 7.2., 7.5., 7.9, and 7.10 in the 10th edition) have been deleted to make room for the coverage of the crisis. The chapter opener and “People & Events” inserts have been revised.

2. Learning Objective 12 has been added.

3. “Learning by Doing”: LBD inserts are on pp.211, 212 4. “Do You Understand?” questions: (1) in the first set, Qs.2 and 3 have been revised, (2) in the second set, Q.5 has been added.

5. One end-of-chapter question (Q.10) has been revised and one question added (Q. 11).

6. Coverage of the financial crisis and its impact on the money markets has been provided throughout the chapter. In addition, Section 7.9, “The Impact of the 2007-2009 Financial Crisis on the Money Markets”, has been added at the end of the chapter. The section briefly describes the origins of the crisis and discusses what happened in the markets for the most important money market instruments during the crisis; it also provides a summary of what the Federal Reserve did to stabilize the money markets.

7. The subsection “Auctioning new T-bills” in Section 7.4, “Treasury Bills”, has been revised to provide more details on the most up-to-date Treasury auction procedures.

8. Four sections that covered commercial paper, repos, NCDs, and BAs in the previous edition have been merged into Section 7.7, “Other Major Money Market Instruments”.

9. The subsection on commercial paper now introduces asset-backed commercial paper. Equation 7.6 from the 10th edition (commercial paper yield) has been deleted. The computations of commercial paper yields are now shown using Equations 7.1 and 7.2.

10. The concept of “haircut” has been introduced in the discussion of repurchase agreements.

11. Coverage of banker’s acceptances has been shortened as these instruments lost importance.

12. In Section 7.8, “Money Market Participants”, the subsection “The U.S. Treasury and Treasury Security Dealers” has been updated to reflect the latest developments; the subsection on money market mutual funds (MMMFs) has been added.

13. The section titled “The interrelation of money market rates” in the 10th edition has been revised; it is now titled “Relationships among Money Market Interest Rates” and is the last subsection of the Section 7.9, “The Impact of the 2007-2009 Financial Crisis on the Money Markets”.

CHAPTER KEY POINTS 1. This chapter examines the U.S. money markets, which serve as markets for liquidity. The money market is a collection of markets where short-term, marketable obligations with very little credit risk are bought and sold. The money markets are where businesses, government units, financial institutions, and world investors store liquidity, fund liquidity, and adjust liquidity. Also, the money markets are where the Federal Reserve conducts its monetary policy.

2. Emphasize the general characteristics of money market instruments. That is, money market instruments have: (a) low default risk, (b) short-term maturity, and (c) high marketability. Also emphasize the reasons why money market investors desire and require these characteristics.

3. The role of the key players in the money markets should be emphasized. These are: commercial banks, the Federal Reserve System, Treasury Department, dealers and brokers, money market mutual funds, and nonfinancial corporations. It would be especially useful to discuss the role of primary government security dealers as their role does not get coverage elsewhere in the text. Exhibit 7.8 may help better summarize the roles of different market participants in the money markets for you students.

4. Money market yields are computed differently from capital market yields. In particular, money market yields do not assume compound interest.

5. Discuss the characteristics of each of the money market instruments. They may differ by issuer, maturity, pricing methods (discount vs. add-on instruments), investor clienteles, default risk, and marketability. Make sure that your students understand how these differences are reflected in yields.

6. The close substitutability between money market instruments explains why interest rates on different money market instruments tend to move together over time. However, in a flight to quality yields on different instruments may change in opposite directions, as investors exit instruments they consider more risky and/or less liquid and invest in safest assets such as U.S. T-bills. Exhibit 7.9 may be used to make and “visualize” this point.

7. Reemphasize the importance of money markets to commercial banks for adjusting their liquidity position and as a source of funds. The U.S. money markets developed, to a great extent, as a regulatory avoidance movement of commercial banks.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

Calculate the bond equivalent yield for a 180-day T-bill that is purchased at a 6% asked yield. If the bill has a face value of $10,000, calculate its price.

First calculate the price of the T-bill using eq. 7.3 which is derived from eq. 7.1 in the text:

n   P0 = P f −  yd   Pf  360   180   = $10,000 − 0.06   $10,000 360   = $10,000 − 300 = $9,700 where Pf is the face value ($10,000), yd is the bank discount rate (6%) and n is the number of days (180).

The bond equivalent yield (ybe) uses the net amount of funds invested or price as the divisor and 365 days (See Eq. 7.2):

ybe =

P f − P0 P0



365  100% n

$10,000 − $9,700 365   100% $9,700 180 = 6.27%

=

2.

What are the characteristics of money market instruments? Why must a financial claim possess these characteristics to function as a money market instrument?

The three fundamental characteristics of money market instruments are: (a) low default risk, (b) short-term to maturity, and (c) high marketability. These characteristics give money market instruments their characteristic of being low risk. Money market investors demand low-risk securities because their cash excesses are only temporary.

3.

How are the Treasury and federal agency securities different? What difference primarily explains the yield differential between the two securities?

Agency securities have greater default risk and are less marketable than Treasury securities. As a result, Agency securities sell at lower prices (have higher yield) than similar Treasury securities.

4.

What types of firms issue commercial paper? What are the characteristics critical to being able to issue commercial paper?

Large businesses with high credit ratings issue commercial paper as an inexpensive source of short-term borrowing. Commercial paper is an alternative to borrowing from a commercial bank and, typically, the rates are lower than rates charged by banks. Because commercial paper is unsecured debt, most investors, in an attempt to protect their principal, only want paper with highest credit ratings. Rating agencies will quickly write down or remove their ratings for commercial paper if the financial conditions of a company deteriorate. The number of companies issuing commercial paper in the economic boom of the late 1990's shrunk considerably by 2001 as rating agencies pulled their commercial paper ratings. During the 2007-2009 financial crisis, issuers of asset-backed commercial paper (mostly financial institutions) had difficulty rolling over paper because investors had concerns about both the quality of assets backing the paper and the solvency of financial institutions issuing (and thus guaranteeing) the paper.

5.

Why is a bank line of credit necessary to back up an issue of commercial paper?

Back-up lines of credit would be used if the firm experiences financial difficulties or if credit market conditions become tight. Back-up lines of credit are often required by investors to assure protection of their principal and liquidity of the investment.

6.

Describe the steps in a typical banker's acceptance transaction. Why is the banker's acceptance form of financing ideal in foreign transactions?

See the discussion of Exhibit 7.7 for the steps in creating a banker's acceptance. Banker's acceptance provides two basic services: (a) financing, and (b) services and expertise specifically related to an international transaction. It is the latter that makes banker's acceptances an attractive means of financial international transactions.

7.

Explain how repurchase agreement transactions provide short-term investments to businesses. In what sense is a repo a collateralized loan?

The corporate treasurer purchases government securities for the amount of the investment from a bank for a specified time period. The business would have idle cash deposit balances that it would transfer out to invest. The bank retains the funds by providing a repurchase transaction whereby it sells securities owned (stored offsite in depository) to the business and agrees to buy them back at a higher price, thus paying the money market rate for the business' funds. The purchase price and sale price are agreed upon at the time the deal is made. The interest paid the corporation is the difference between the purchase and repurchase price of the collateralized securities. See the textbook section on repos for the T-account entries. A repo is a collateralized loan in the sense that the securities sold serve as collateral.

8.

Suppose Fargood Corporation engages in a repurchase agreement with The National Bank of Nebraska. In the agreement, Fargood sells $9,987,950 worth of Treasury securities to the bank and agrees to repurchase the securities in 30 days for $10,000,000. a. Is this transaction a loan, and if so, who is the borrower and who is the lender? Defend your answer.

The transaction is a repurchase agreement for Fargood and a reverse repurchase agreement for the bank. The bank is the lender because it is buying (investment of funds) the Treasuries owned by Fargood, the borrower of the funds for the period of the repo. Technically, it is not a loan but a purchase with agreement to resell, but the effect is the same as a loan to a customer. b. Is the loan collateralized? What is the collateral? Who holds the collateral during the term of the agreement?

The loan is collateralized because the securities sold serve as collateral. The bank or offsite depository would hold the securities during the contract period. c. What interest rate (or yield) is earned by the lender?

The annualized yield to the bank (cost to Fargood) would be:

y repo = =

Prepo − P0 P0



360 n

$10,000,000 − $9,987,950 360  = 1.45% $9,987,950 30

d. Draw T-accounts for this transaction, similar to the example earlier in the chapter. Show the assets and liabilities for each party before and after the transaction.

Fargood Corp

1) +Deposit in bank $9,987,950 -T Sec. $9,987,950 2) -Deposit $10,000,000 +T. Sec. $10,000,000

9.

National Bank

2)-Capital loss on repo $12,050

1) +T.Sec. $9,987,950

1)+Deposit (Fargood) $9,987,950

2) -T.Sec. $10,000,000

2)-Deposit (Fargood) $10,000,000 2)+Capital gain $12,050

Suppose 7-day fed funds trade at 1.65 percent annually. What is the yield on fed funds on a bond-equivalent basis?

To compare yields in the fed funds market with those of other money market instruments, the fed funds rate must be converted into a bond equivalent yield.

 365   365  ybe = y ff   = 1.65%  = 1.673%  360   360  10.

Why did many asset-backed and financial commercial paper issuers find it difficult to

raise funds from 2007 to 2009 but nonfinancial commercial paper issuers did not?

In 2007-2009, many of the assets backing ABCP issues performed poorly, making investors much less willing to purchase ABCP. The bankruptcy of Lehman Brothers in September 2008 raised questions about the viability of major U.S. financial institutions and the federal government’s willingness (or lack thereof) to rescue large institutions from failure. Some investors, including money market mutual funds, started avoiding commercial paper issued by financials.

11.

What did the Federal Reserve do to stabilize the money markets from 2007 to 2009?

The measures that directly impacted the money markets included expanding access to the discount window, auctioning short-term loans to depository institutions through the Term

Auction Facility (TAF), paying interest on required and excess reserves of depository institutions, and buying commercial paper directly from issuers through the Commercial Paper Funding Facility (CPFF). The CPFF represented a major departure from the Fed’s traditional ways because this facility, which was closed in February 2010, provided funds to firms that included nonfinancial corporations (central banks normally deal only with financial institutions). In December 2008, the Fed set the target federal funds rate as a range between 0 and 0.25% and started focusing on acquiring long-term assets.

CHAPTER 8 BOND MARKETS CHAPTER OBJECTIVES 1. This chapter continues our review of the fixed-income financial markets by analyzing the debt securities of the capital market. This chapter focuses on the debt capital market, its securities, its issuers, and investors.

2. The primary objective of this chapter is to describe the functions of, major participants in, and financial instruments traded in the U.S. and international bond markets.

3. Students should note that the secondary market for capital markets instruments allows households, businesses, and other participants to diversify risk and obtain portfolio flexibility. As a result, more funds flow into the capital markets, flow to the most productive uses, and as competition increases among financial market dealer/brokers and financial institutions, the savers' returns are higher and the borrowers' costs are lower than would otherwise be the case.

4. Students should be familiar with the broad spectrum of financial instruments that comprise the capital markets. The major instruments include Treasury, municipal, and corporate bonds, mortgages (covered in Chapter 9), and preferred and common stocks (covered in Chapter 10). The use of financial guarantees has become very important, as has securitization.

5. Each year money and capital markets move closer to a fully integrated 24-hour international market. Trading of U.S. Treasuries approaches that today.

CHANGES FROM THE LAST EDITION 1. All time-sensitive tables and figures have been updated. Exhibit 8.9 (credit spreads) is new to this edition. The chapter opener has been revised. One of the two “People & Events” inserts has been revised and the other deleted from the new edition.

2. Learning Objective 7 has been added.

3. “Do You Understand?” questions: a new question (Q.4) has been added to the first set and the second set (Q.3). In the third set, Q.2 has been revised.

4. There are two new end-of-chapter questions (Qs. 11 and 12).

5.

The subsection “U.S. Treasury Notes and Bonds” in Section 8.2, “U.S. Government and Agency Securities”, now explains how coupon rates are determined after the Treasury auctions.

6. In the section “State and local government bonds”, the subsection “The effect of the Tax Reform Act of 1986” has been eliminated, with some of its content moved to the subsection “The type and use of municipal bonds”.

7. In the section “Financial guarantees”, the discussion of the role of insurance companies has been expanded.

8. A paragraph on the relation of securitization to the crisis of 2007-2009 has been added in the end of the section “Securitized credit instruments”.

9. The section “Bond markets around the world” now provides the definition of Eurobonds.

1

10. The section on the financial crisis has been added at the end of the chapter.

CHAPTER KEY POINTS 1. Capital markets exist to facilitate the transfer of funds from surplus spending units to deficit spending units. Contrary to the short-term money markets, the capital markets are concerned with the transfer of funds that can be used to finance long-term capital investments.

2. The major capital market instruments covered in this and following chapters are as follows: Debt Securities

Equity Securities

corporate bonds state and municipal bonds government bonds federal agency bonds mortgages

common stock preferred stock convertible bonds and preferred stock

3. The secondary market for capital markets securities is important because it allows investors to alter the risk exposure of their portfolios before maturity. During the 1980s Drexel, Burnham and Lambert developed and maintained a secondary market for high-yield (junk) bonds. Thus a working secondary market enhances the primary market. Investors are encouraged to buy new securities if a secondary market is present to provide liquidity.

4. Corporations and government units are the major issuers of capital market claims (deficit spending units), and households are the major holders of capital market claims. (See Exhibit 8.1.) Financial intermediaries acquire capital market claims with funds obtained by issuing their own liabilities. The type of capital market claims that each intermediary acquires depends on its business objectives, its tax status, and the type of liabilities it has issued to obtain its funds.

5. A number of service institutions facilitate capital market transactions. These include: investment banks, brokers and dealers, security exchanges, credit rating services, financial institutions which extend financial guarantees, and regulatory authorities-particularly the Securities and Exchange Commission (SEC).

6. The U.S. federal government issues Treasury bonds to cover budget deficit. Among relatively new inventions are TIPS, whose principal is adjusted with inflation, and STRIPS, which are zero-coupon securities created by separating each cash flow of a coupon paying Treasury security. TIPS can be used to lock in a certain real return and to estimate expected inflation, while STRIPS are excellent in immunizing against interest rate risk. In particular, investors in zero-coupon securities do not have to worry about reinvestment risk.

7. Municipal bonds have their interest exempt from federal income tax and have some other features that distinguish them from Treasury and corporate bonds. Bond markets around the world are becoming increasingly linked: multinational corporations search for cheaper capital worldwide.

8. Credit spreads measure perceived differences in credit risk of bonds of different ratings. Widening credit spreads are indicative of the investors’ negative economic forecasts and flight to quality that accompanies the negative sentiment.

2

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

Calculate the gross profit that an underwriter would make if it sold $10 million worth of bonds at par (face value) and paid the firm that sold the bonds 99.25% of par.

The gross profit would be 0.75% of the $10 million raised in the market or: 0.0075 (10,000,000) = $75,000.

2.

If a bond dealer bought a $100,000 municipal bond at 90% of par and sold it at 93% of par, how much money did the dealer make on the bid-ask spread?

The spread of 3% of $100,000 is $3,000.

3.

If a corporate bond paid 9% interest, and you are in the 28% income tax bracket, what rate would you have to earn on a general obligation municipal bond of equivalent risk and maturity in order to be equally well off? Given that municipal bonds are often not easily marketable, would you want to earn a higher or lower rate than the rate you just calculated?

The after tax yield on the taxable corporate bond is 6.48% or [9%(1-0.28)] and is the comparable rate of a tax-free municipal bond. For any added risk on the muni bond (e.g., lower marketability), the investor would pay less or require a higher rate of return (i.e., above 6.48%).

4.

Suppose a trust is established to securitize $100 million in auto loans that paid 13% interest and the average rate paid on the tranches issued was 10%, whereas financial guarantees to protect against default on the loans cost 1.5%. How much money would the creator of the trust have available to pay for loan servicing and profits if the financial guarantee was purchased?

With a revenue rate of 13% and expenses of 11.5% (10% rate plus 1.5% guarantee cost), the annual cash flows available for loan servicing and profits is (0.13 – 0.115) x $100 million = $1.5 million.

5.

Why are private placements of securities often popular with both the buyer and the seller of the securities?

Private placements are direct sales between borrowers and the ultimate investors. The costly and time-consuming SEC registration is not required for private placements. In general, both issuers and investors believe they can negotiate a better deal than if they transacted in the public market.

6.

Give a concise definition for the following types of municipal bonds: (a) general obligation, (b) revenue, (c) industrial development, and (d) mortgage-backed.

The important characteristics of the above bonds are: (a) general obligation bonds are backed by the full taxing ability of the states or municipalities; (b)

revenue bonds default risk characteristics are determined by the expected revenue flow from the project the bonds are issued to finance;

3

7.

(c)

industrial development bonds are essentially loans at the tax-exempt interest rate to businesses; and

(d)

mortgage-backed bonds are collateralized by mortgages and provide mortgage loans to individuals at the tax-exempt rate.

What features make municipal bonds attractive to certain groups of investors? Why don’t other groups invest much in municipal securities?

Interest income from municipal bonds is tax-exempt at the federal level. All other factors being equal, investors select the security that provides the highest after-tax yield. In general, investors in high tax brackets find municipal bonds attractive investments - they have higher after-tax yields compared to similar taxable securities. Investors in low tax brackets may not find municipal bonds attractive compared to corporate bonds.

8.

Define the following terms: (a) private placement, (b) asset-backed security, (c) callable securities, (d) sinking fund provisions, and (e) convertible features of securities.

The above terms are explained as follows:

9.

(a)

private placement is the sale of bonds to a single investor or small group of sophisticated investors, that meet the guidelines for avoiding registration and disclosure requirements of the SEC and state laws. SEC requires that the issue be sold to no more than 35 investors to qualify as a private placement.

(b)

asset-backed securities are the financial claims issued when loans are securitized;

(c)

callable securities can be retired by the issuer's option prior to their stated maturity at a pre-specified price called the call price. Advantage is to issuers and investors have to be compensated with a call premium in the form of a higher yield.

(d)

sinking fund provisions require the issuer to retire a percentage of a bond issue on an annual basis. It reduces the risk of default to investors.

(e)

convertible features of securities are options of the investor to convert the security into another form of security, typically into an equity security

Explain how securities are brought to market under (a) a competitive offering and (b) a negotiated offering. How do the two methods of sale differ?

In a competitive sale, investment bankers bid on the securities as per a public notice. In a negotiated sale, a single investment banker and the issuer negotiate a deal; the investment banker often provides financial advice to the issuer and helps design the security issue.

10.

Describe the different forms of financial guarantees seen in the bond market.

Financial guarantees are credit enhancements offered by low credit risk businesses to those with high credit risk. Insurance companies write insurance policies to back bond issues in case of default; commercial banks back commercial paper with lines of credit (paying off the commercial 4

paper in case of credit deterioration) or swap transactions.

11.

Are Yankee bonds and Samurai bonds examples of Eurobonds? Why or why not?

Eurobonds are denominated in currencies other than the currency of the country in which they are sold. Yankees and samurais are sold in the U.S. and Japan and denominated in dollars and yen, respectively, which are the domestic currencies for the respective countries. Thus, they are not Eurobonds. An example of a Eurobond would be a dollardenominated bond sold in Japan or a yen-denominated bond sold in the US.

12.

What is a credit spread? What happened to credit spreads during the financial crisis of 2007-2009?

A credit spread is the difference between yields of otherwise similar debt securities with different credit risk. The credit spreads started to widen in the middle of 2007 and peaked in December 2008. The Baa-Treasury spread widened much more than the Aaa-Treasury spread. This is a manifestation of a flight to quality. The credit spreads narrowed in the second half of 2009 and 2010, when the bond markets returned to relative normalcy.

5

CHAPTER 9 MORTGAGE MARKETS CHAPTER OBJECTIVES 1. To describe the various types of mortgages and mortgage-backed securities available in the mortgage markets.

2. To describe the development of the secondary mortgage markets with the help of the federal government; to discuss how the mortgage markets have evolved over time.

3. To explain why many new forms of mortgages were developed and how they differ from conventional mortgages – both in contractual terms and in terms of who bears the risk for future price and interest rate fluctuations.

4. To explain the impact of the financial crisis on the mortgage markets.

CHANGES FROM THE LAST EDITION 1. Time-sensitive exhibits, data, and surrounding discussions have been updated. The first “People and Events” item has been deleted and the second revised.

2. Learning Objective 8 has been added.

3. “Learning by Doing”: There is one LBD insert on pp.281-282.

4. There are two new end-of-chapter questions (Qs. 6 and 7).

5. Section 9.2, “Types of Mortgages”, now has a discussion of prepayment penalties on ARMs; Section 9.3, “Mortgage Qualifying”, now has a discussion of subprime mortgages.

6.

Changes to Section 9.4, “Mortgage-backed Securities”: - The differences among GNMA, FNMA, and FHLMC are now discussed in the beginning of the section, as well as the current status of FNMA and FHLMC. - The subsections “Freddie Mac Participation Certificates” and “FNMA Pass-throughs” have been deleted. Instead, a short subsection titled “Freddie Mac and Fannie Mae Passthroughs” has been added.

7. The subsection “Mortgage Bankers” in Section 9.7, “Participants in the Mortgage Markets”, has been shortened.

8. Other sections have undergone minor revisions.

CHAPTER KEY POINTS 1. Mortgage markets are the largest debt markets in the U.S. Mortgages differ from other capital market instruments because (a) real estate is always pledged as collateral, (b) they are not standardized as to their amount, (c) their issuers typically are small, relatively unknown financial units, (d) their secondary markets are relatively limited, and (e) they are greatly affected by many legal restrictions pertaining to 1

their origination and contractual nature.

2. Commercial banks, mortgage pools, thrift institutions, and other financial institutions (including life insurance companies, pension funds, and finance companies), and various government agencies are the major holders of mortgage debt obligations. See Exhibit 9.8.

3. The federal government has played a major role in the evolution of the mortgage markets. (a)

First FHA and then VA insurance made it possible for mortgages to be traded in secondary markets, thereby allowing mortgage bankers to thrive and causing private mortgage insurance to be developed as well.

(b)

FNMA and FHLMC purchase insured mortgages in the secondary mortgage markets.

This has further spurred the development of secondary mortgage markets and related mortgage servicing firms (such as mortgage bankers).

(c)

FHLMC pools mortgages and sells securities that "pass through" all principal and interest payments to holders, while GNMA facilitates this process with its guarantees. In addition, FHLMC and FNMA issue mortgage-backed bonds. This allows standardized debt instruments to be issued that can compete effectively for funds in the capital markets. Thus, these developments, too, have sparked private sector duplication – which has generated a further increase in the ability of mortgage issuers to compete for funds with issuers of conventional capital market securities.

(d)

Recent developments like the collateralized mortgage obligation (CMO) and the REMIC have increased the attractiveness of the MBS relative to mortgage loans by reducing prepayment risk or default risk.

In addition to the insurance and secondary market functions, some government agencies (particularly state and local government housing authorities) make direct mortgage loans.

Further, government regulations affect the conditions of origination and nature of mortgage contracts.

The role of FNMA and FHLMC in the financial crisis and their takeover by the government raised questions about the government’s role in the mortgage markets. If government support for housing is reduced, mortgage credit may become more difficult to obtain and more expensive.

4. A wide variety of mortgage instruments exist outside of the traditional fixed-rate mortgages (FRM).

Many of the mortgage instruments (ARMs, ROMs, RAMs, and balloon payment mortgages) shorten the effective length of time in which the mortgage investor is "locked-in" to a specific interest rate. As a result, mortgage holders bear less interest rate risk and mortgage borrowers bear more. Rate discounts on ARMs relative to FRMs are set by market forces depending upon how much lenders are willing to sacrifice to transfer interest rate risk and their expectations of future interest rates. Other mortgage variants exist such as reverse annuity mortgages, graduated payment, and growing equity mortgages.

5. The basic classes of mortgage-backed securities (MBS) are as follows: (a) Pass-throughs simply pass through all principal and interest payments on a pool of 2

mortgages to investors; (b) CMOs are “layered” pass-throuhgs; different layers called tranches have different maturities, prepayment risk, and often different default risk; (c) Stripped MBS are pass-throughs split into IO and PO (interest-only and principalonly) classes, with IO shares passing through interest payments on the pool to investors, and the PO class passing through principal payments to investors.

6. The financial crisis of 2007-2009 that originated in the U.S. subprime mortgage market has slowed the growth of the mortgage markets, caused losses to many MBS investors and mortgage holders and insurers, including some of the largest financial institutions in the world, made mortgage lending standards more stringent (more typical for a pre-housing bubble period), and put Fannie Mae and Freddie Mac on the brink of extinction. .

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

If you had a 7 percent, $100,000 30-year fixed-rate mortgage, how long would it take before you had repaid half the loan balance due? If you paid an extra $100 per month to reduce the principal due on the mortgage, how long would it take to repay half the principal due? In the case where you paid an extra $100 per month, how long would it take to repay the entire loan?

Per Exhibit 9.1, loan B (bottom), the $50,000 balance is reached, per the table, between month 9 and 10 in year 21.

Calculator: 7/12 = 0.5833 I 360 N -100,000 PV 0 FV PMT = $665.30 Next, enter FV of 50,000 (don’t change the other inputs) and solve for N ≈ 261 months, or 21 years and 10 months.

If the homeowner had paid an extra $100 per month, or $765.30, the balance would drop to $50,000 in 13 years and 9 months. An extra $100 or a $765.30 payment would pay off the loan in n = 247 months, about 20 years and 7 months.

Calculator: 7/12 = 0.5833 I 765.30 PMT -100,000 PV 50,000 FV Next, enter FV of 0 (don’t change the other inputs) and solve for N ≈ 247.

2.

N = 164.46

If your bank held 1 percent of the units issued by a unit trust and the mortgages in the trust repaid $10,500,000 in interest and $1,500,000 in principal in its first year, how much principal and interest would your bank receive that year?

If one receives cash commensurate with ownership, one should receive 1 percent of the principal and interest received, or $120,000.

3.

If your mortgage balance was $60,000 and you had a floating-rate mortgage that called for you to pay interest at an annual rate of 2.75 percent over the one-year T-bill rate and the T-bill rate has been averaging 2.05 percent, how much interest would you owe on your mortgage next month?

3

With the rate now at 4.8 percent and the balance of $60,000, one would pay $60,000(0.048/12) or $240.00 in interest.

4.

Describe the factors that affect a borrower’s ability to qualify for a mortgage.

Several factors influence a home buyer’s ability to secure a mortgage loan. These include income level, amount available for a down payment, credit history, and other financial commitments. a. Borrower Income from all sources gives the lender an idea of the ability of the borrower to meet the monthly mortgage commitment. This commitment includes not only the monthly interest and principal paid, but also the amount needed to pay property tax, homeowners insurance and any mortgage insurance. c. Down Payment refers to the amount of cash the borrower can contribute towards the cost of the house as their equity. Traditionally this has been 20% of the cost of the house, allowing the buyer to seek a mortgage loan on the remaining 80 percent. d. Mortgage Insurance is necessary for borrowers who are unable to come up with a 20 percent down payment.  Some federal agencies like the Federal Housing Administration (FHA) and the Veterans Administration (VA) guarantee loans to qualified home buyers for a small fee that covers the cost of the insurance.  Those loans that do not qualify for a federal guarantee are called conventional loans. Lenders may require a borrower to secure private mortgage insurance (PMI) if they cannot come up with a 20 percent down payment. See Exhibit 9.5.

5.

Suppose your gross monthly income is $5,000. Assume that property taxes, homeowner’s insurance, and mortgage insurance payments total $200 a month. In addition, assume you have automobile and student loan payments that total $400 a month. If 30-year fixed rate mortgages have a current annual percentage rate of 6 percent, how much do you qualify to borrow based on the payment-to-income ratios described in the chapter?

Monthly mortgage payment (P&I) @ 25% of gross income: Additional payments for insurance & taxes = $200 Taking both payments into consideration, Monthly mortgage payment (P&I, T, HI, MI) @ 28% of gross income: Additional monthly debt obligations =

0.25*$5,000 = $1,250

0.28*$5,000 = $1,400

$400

Taking all payments into consideration Monthly mortgage payment (P&I, T, HI, MI) @ 33% of gross income:

0.33*$5,000 = $1,650

To figure out the amount you will be qualify to borrow based on the ratio of monthly payment to all debt obligations (33%), you would use the amount of $1,650 as the maximum amount you would pay towards P&I, tax and insurance and other debt obligations. Using the equation given below, you can compute the PV of the loan amount.

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1   360  1 − 1  1 + 0.06   1− n  (1 + i) 12   PVA = PMT * = $1,650 *    = $275,206.16 0.06 i   12       The maximum amount you will qualify for is $275,206.

6.

Suppose you are interested in buying a home valued at $500,000 and 30-year fixed-rate mortgages have an interest rate of 6%. What is your minimum down payment assuming you will borrow with a conventional mortgage? If property taxes and homeowner insurance total $500 per month and that you have other loan payments totaling $300 per month, how much do you need to earn on a monthly basis to qualify for a mortgage?

The minimum down payment for a conventional mortgage is 20% of the purchasing price, in this case $100,000. The P&I payment on a $400,000, 30-year, 6% mortgage is $2,398.20. Using the criterion of the P&I payment being no more than 25% of monthly income, your minimum income must be $2,398.20/0.25 = $9,593 a month to qualify.

The P&I, taxes and insurance total $2,898.20, and using the criterion of this amount not exceeding 28% of monthly income, your income must be at least $10,351 a month.

Your total financial obligations if this loan is made will be $3,198.20; if they are not to exceed 33% of monthly income, the income must be at least $9,692 a month.

Thus, monthly income must be at least $10,351 (the largest of the three amounts above) for you to qualify for this mortgage.

7.

Explain why mortgage investors demand a higher yield for investing in securities with call risk and extension risk. Why would a mortgage investor view mortgage prepayments negatively?

Prepayment (call) and extension risks are of concern to investors because of their impact on mortgage valuations. Unlike noncallable bonds, which increase in value at an increasing rate when yields fall and decrease in value at a decreasing rate when yields rise, mortgage portfolios increase in value at a decreasing rate when yields fall (because mortgage borrowers refinance more to take advantage of lower rates) and decrease in value at an increasing rate when yields rise (because very few mortgage borrowers refinance, and investors receive cash flows based on mortgage rates that are below the current rates).

8.

Assume you set up a REMIC that guaranteed that the class B tranche would bear all the credit risk, and the class A tranche would lose only if the class B tranche holders were not repaid.

What is the maximum interest rate you could offer the class B tranche holders and still make a profit from securitizing the loans if the class A tranche buyers were willing to accept a 7 percent return on their 90 percent interest in a pool of mortgages that generated an 8 percent interest return? (The class B holders would hold the other 10 percent interest in the pool.)

Assuming the agreement above referred to distribution of interest income, with 100 percent of the loans earning 8 percent and 90 percent of the REMICs paid 7 percent, the maximum rate on the 5

remaining 10 percent residual tranche would be: Let the Rate on Residual 10 percent be x.

9.

Then, 0.08 =0.9(0.07) + 0.1(x)

and x = 17%

Why was the development of mortgage insurance necessary before secondary mortgage markets could develop?

Potential buyers of mortgage debt could not afford to assess the credit-worthiness of every mortgaged homeowner, but many people could afford to assess the worth of governmental (or private) debt guarantees. Thus, more people are willing to buy mortgage debt instruments in the secondary market if these are insured.

10.

How has the development of secondary mortgage markets allowed mortgage issuers to attract additional funds from the capital markets?

Many mortgage-backed securities have characteristics similar to government bonds. Passthroughs, participation certificates, and collateralized mortgage obligations are sold in standard denominations. Also, because they are guaranteed, they can be resold easily if desired. Further, mortgage-backed bonds and CMOs not only are of standard denomination, these also provide guaranteed repayment schedules. Because thesoe securities gain more characteristics of bonds, they become more readily interchangeable with bonds in investors' portfolios. As a result, they can compete more effectively with bonds for investors' funds.

11.

Explain how mortgage-related securities have become more similar to capital market instruments over time.

They have become more standardized in terms of denomination – since GNMAs and PCs initially trade in evenly denominated units. In addition, most are well secured and/or guaranteed by wellknown financial entities. Some are even rated by rating services. Finally, CMOs, REMICs and mortgage-backed bonds promise to make fixed payments over their life span, just like conventional bonds.

12.

Why have mortgage market interest rates become more uniform across the country in recent years?

Because mortgage-backed securities have been able to compete for funds directly in the capital markets, lenders' costs of funds have become more uniform across the country as such securities have developed. Competition then ensures that equal costs of funds will be translated into roughly equal mortgage loan rates in each market area.

13.

How has the government encouraged the development of secondary mortgage markets?

Indirectly, the government has helped such markets through the development of FHA and VA mortgage insurance. Directly, the government has aided the development of second mortgage markets by supporting the development of FNMA and FHLMC, which buy large quantities of mortgages in the secondary markets and issue mortgage-backed bonds and pass-through securities. In addition, the government established GNMA, which initiated government guaranteed pass-through securities specifically so those securities could be sold in the secondary mortgage markets.

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14.

What is the difference between conventional mortgages and FHA and VA mortgages?

FHA and VA mortgages are insured by the federal government, conventional mortgages are not.

As a result of the guarantees, FHA and VA mortgages are often granted with lower down payment requirements than conventional mortgages. However, because of government restrictions, FHA mortgages may be written for smaller maximum amounts than conventional mortgages.

15.

If you expect prices and incomes to rise, would you rather have a conventional mortgage, FRM or ARM? What if you expected prices to fall? Explain your answer. Also explain how your answer would differ if you were a mortgage lender.

FRM. I would put little money down and my equity and income would build up rapidly due to inflation; thus, I would have little difficulty making future payments or recovering my principal if I sold my house. ARMs would be less desirable because their rates would rise as inflation forced up interest rates. Only if the reduction in rate were greater in present value terms than the expected sacrifice of price appreciation would I break even on a sale. From a lender’s perspective, an ARM would allow interest rate risk to be passed on to the borrower, while FRMs would force the lender to bear the risk of rising interest rates and inflation.

16.

Why have CMOs and REMICs made it easier for the mortgage markets to compete for funds with corporate bonds? What problems do their residuals pose?

CMOs and REMICs provide predictable cash flow patterns for investors that regular mortgages and pass-throughs did not. Residual claims represent the net after contracted interest and principal are paid. The more varied the residuals, the greater the required rate of return by residual investors.

17.

If mortgage bankers originate more mortgages than other types of financial institutions, why don't they also hold more mortgages in their asset accounts?

Mortgage bankers specialize in mortgage origination, packaging and selling mortgages to mortgage funds providers, like life insurance companies, pension funds, and banks, who have built their mortgage investment portfolio in the 1990's. Mortgage bankers often retain service rights, but economies of scale in loan servicing have led toward larger loan servicing organizations.

The fact that mortgage bankers do not hold mortgages they originate and thus face no credit or interest rate risk associated with the mortgages may have led some unscrupulous mortgage bankers during the credit boom of the early and mid-2000s to push some borrowers to buy properties they could not afford in the long run or to take on mortgage products that generated more fee income for the mortgage banker but did not serve the best interests of the borrower. This may have contributed to the ensuing housing market bubble burst and financial crisis.

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CHAPTER 10 EQUITY MARKETS CHAPTER OBJECTIVES 1. To describe the three types of equity securities – commons stock, preferred stock, and convertibles.

2. To explain the processes of and identify the key participants in placing new equity securities in the primary markets and trading existing equity securities in the secondary markets.

3. To discuss the risks related to equity investments and the process of valuing equities.

CHANGES FROM THE LAST EDITION 1. Exhibits and statistics have been updated. Exhibit 10.8 from the 10th edition, “The Relationship between Recessions and the Stock Market”, has been deleted. The first “People and Events” item has been deleted and the second revised.

2. Learning Objectives: LOs 2 and 3 have been revised, LO 5 has been added.

3. “Learning by Doing”: LBD insert is on pp. 320-321.

4. “Do You Understand?” questions: in the first set, two questions (Q.3 and Q.4) have been revised.

5. End-of-chapter questions: old Qs. 6-9 have been deleted and three new questions added (Qs. 6, 8, and 9). The internet exercise has been revised.

6. Changes to Section 10.2, “Equity Markets”: - It discusses a sample stock quote in greater detail now; for this purpose, Exhibit 10.2 has been revised to provide a detailed quote for one stock rather than less detailed quotes for several stocks; - Depth, breadth, and resilience of secondary markets are no longer discussed; - The subsection “Factors Affecting Bid-Ask Spreads” has been deleted.

7. Sections 10.3, “Equity Trading”, and 10.4., “Global Stock Markets” have been updated to reflect the latest developments, including the revised discussion of NASDAQ and a new subsection titled “Competition between the NYSE and NASDAQ”.

8. Shorts sales (new material for this edition) and type of orders are now discussed in the end of Section 10.4, “Global Stock Markets”; the discussion of stop orders has been added.

9. Section 10.6, “Equity Valuation Basics”, now starts with common stock valuation (rather than preferred, which is now at the end of the section) and shows more details of the derivation of the constant growth stock price formula.

10. Remaining sections have undergone minor revisions.

CHAPTER KEY POINTS 1. Equity securities, especially common stock, do not mature and investors must look to the market for a major portion of investors' required return, market appreciation.

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2. The initial sale of stock is made in the primary market. Whether underwritten by investment bankers or sold directly to investors by corporations, funds are raised in primary markets; subsequent trading is between investors in secondary markets. Since stock does not mature, secondary markets are critical; they provide the valuation for traded issues. Secondary markets take four possible forms: direct search, brokered, dealer, and auction markets. A thriving secondary market enhances the primary market: investors are encouraged to buy new securities if a secondary market is present to provide liquidity.

3. NYSE and NASDAQ are the two main US stock exchanges. Stock dealers and specialists process trades to ensure continuous markets, constantly analyzing securities based on new information or stock’s liquidity. Brokers route orders to dealers who offer the best quotes.

4. Globalization of equity markets is proceeding very quickly. Improved communications and computer technology have reduced costs and enabled information processing to occur at any time of day or night.

Listing on multiple exchanges is now very common and the stocks of large corporations trade twenty four hours a day.

5. Regulation of equity markets rests squarely with the Securities and Exchange Commission, which has broad powers to dictate how markets should operate. The SEC has yet not exercised full regulation within their authority, permitting the private sector to make decisions related to accounting practices, trading practices (NASD), etc.

6. The value of a stock is the present value of cash flows associated with the stock, discounted at the required rate of return. Stock valuation models discussed in this chapter allow to value no-growth stocks, constant-growth stocks, and nonconstant-growth stocks.

7. Because it is easy to eliminate unsystematic risk, equities are assumed to be held in diversified portfolios. The capital asset pricing model and the security market line are based on the notion that a stock has both specific (diversifiable, unsystematic) risk and market (non-diversifiable, systematic) risk.

Holding stocks in properly selected portfolios reduces the diversifiable risk, so that properly diversified investors only face the market risk of the portfolio. The relevant risk of a new security to the portfolio is the increment of variability to the portfolio.

8. Stock market indexes track changes in the value of a sample of stocks. A broad index, such as S&P 500 or Wilshire 5000, can serve as a proxy for market performance. Investors can essentially mimic the market’s performance by investing in an index mutual fund.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

Describe the major differences between common stock and preferred stock.

Usually there are considerable differences between a company's preferred and common in these areas: a) Considering maturity, equity does not mature, but preferred stock often has a written plan for retirement or an option to retire is retained by the issuing firm. b) Preferred stock usually has a "preferred" position in the claim on the income flow of the company. Preferred stock dividends, usually paying a fixed dividend rate relative to par value, are paid ahead of common in their entirety before common dividends are paid. If cumulative, prior preferred dividends must be paid before common shareholders receive a dividend. If participating, preferred and common may participate in earnings levels formally prescribed. In all cases, the 2

c) d) e)

2.

board of directors decides the payment of dividends to equity.

In liquidation, preferred has a prior claim on the liquidated assets of the firm ahead of common.

Preferred stockholders usually give up voting rights for their prior claim on the income stream and assets.

Preferred investors are mostly tax-paying financial corporations that havegenerous income tax exclusion on dividends received on equity shares and a high proportion of dividend income that is not taxed. Property and casualty insurance companies are major investors in preferred stock.

Why are convertible securities more attractive to investors than simply holding a firm's preferred stock or corporate bonds?

Convertibles provide a set, prior claim if the common equity does not perform. If the stock appreciates, the convertibles may participate in the good fortune of the company, created with their funds. The tradeoff is a lower yield on convertible securities.

3.

Valerie Apparel Lines (VAL) has 100 million shares of common stock outstanding and the company is electing seven directors by means of cumulative voting. If a group of minority shareholders controls 31 million shares, how many directors is the group certain of electing? If straight voting was used, how many directors would the group be certain of electing?

The number of directors they may elect under cumulative voting is determined by the following formula:

# of Directors Elected =

(Shares Owned - 1)(# of Directors Elected + 1)

Total Voting Shares (31,000,000 − 1)(7 + 1) = 2.48 = 100,000,000

The minority shareholders may elect 2 directors by cumulating their votes. With straight or majority voting, with only 31% of the shares, the minority shareholder group will not elect any directors.

4.

Weber Corporation has 10 million shares of a preferred stock issue outstanding that pays a cumulative $6 annual dividend on a quarterly basis. As a result of poor profitability, however, the company has not paid the preferred stock dividend for the previous five quarters. The company also has 20 million shares of common stock outstanding. Weber Corporations’ profitability has improved recently and the board of directors believes that the company can pay $100 million in dividends next quarter. How much of a dividend can the company pay on its common stock?

Of the $100 Million available for total dividends, the preferred stock is cumulative so that dividend arrearages must be paid before any dividend may be paid to common.

Preferred Dividends to be paid: Quarterly preferred dividend = $6.00/4 = $1.50 Accumulated preferred dividend to be paid first = $1.50*5 = $7.50/share Total Preferred Dividends to be paid = $7.50 x 10 million shares = $75 million

3

Before paying a common dividend, the current quarter’s preferred dividend must be paid.

Amount due to preferred stockholders = ($1.50 x 10 Mil) = $15 Million, Common Dividends to be paid: Amount available for common stockholders = $10 Million Common dividends per share = $10 Mil/20 Mil. Shares = $0.50 per share 5.

Arbuckle Corporation is selling two million shares of common stock in its initial public offering (IPO). The company’s investment banker, Jones Securities, will offer the stock to the public at $15 per share and charge Arbuckle Corporation an underwriting spread of 7 percent. What are the gross proceeds from the IPO? What are Arbuckle Corporation’s net proceeds from the offering? How much does Jones Securities earn for conducting the offering?

Gross proceeds from the IPO = $15 x 2 Million = $30 Million.

Underwriting spread earned by Jones Securities = 7%* 30,000,000 = $2.1 Million Net proceeds to Arbuckle Corporation = $27.9 Million

6.

Explain why investors look at a stock’s P/E ratio rather than its price to determine if the stock is cheap or expensive.

Because a stock price depends on the number of shares outstanding, comparing stock prices does not make sense. Investors want to compare apples to apples, and comparing earnings provide the desired “common denominator”. The P/E ratio is how much investors are willing to pay for each $1 of a company’s earnings per share. High P/E ratios indicate either that the stock is “expensive” (overvalued) or that investors expect high earnings growth in the future. Note that the P/E ratio is a standardized measure of a stock’s price, and is not sensitive to changes in the number of shares outstanding.

7.

Briefly describe the role of the NYSE specialists. How does this role differ from that of a dealer?

Like a dealer, a stock specialist makes a continuous market at the stock trading post for his/her own account and maintains the limit price order book, executing trades for others at varied prices.

Unlike dealers, specialists have an affirmative obligation to maintain bid and ask quotations for particular stocks at all times. NYSE specialists also maintain the book of limit orders, in which case they act like order clerks, not dealers.

8.

Explain how an American Depository Receipt (ADR) works.

ADR is a dollar-denominated claim representing a certain number of shares of a foreign company held in custody by a U.S. financial institution. For examples, Siemens AG, a large German electronics company, has had an ADR listed on the NYSE since March 2001. This particular ADR represents one share of Siemens stock (but the number of foreign shares in an ADR is often different from one). JP Morgan holds the Siemens ADR shares in custody. When Siemens pays dividends in euros, ADR holders receive dollar cash flows. ADRs allow U.S. investors diversify internationally more easily and help foreign firms tap the U.S. equity markets.

9.

Explain the differences between a market order, limit order, stop loss order, and stop buy order.

A market order is an order to buy or sell at the best price available at the time. A limit order is an

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order to buy or sell at a designated price or better price. A stop order is similar to a limit order. A sell (buy) stop order is an order to sell (buy) only if the price falls (increases) to the stop price. A stop loss order is a stop sell order that helps lock in profits or limit losses to a holder of securities.

A stop buy order does the same for short sellers.

10.

Rachel and Mary have both decided to buy 100 shares of WWW.COM, a hot Internet stock. The market price is $240 per share when Rachel places a market order and Mary places a limit order at $230 per share. One week later, the price of WWW.com is $305 per share after having increased steadily since Lance and Jennifer placed their orders. How much profit has Rachel made? How much profit has Mary made?

Rachel has done very well and Mary is out of luck. Rachel made ($305 - $240) x 100 = $6,500 while Mary’s limit order is still in the specialist’s order book, not yet executed. If the stock had dipped to $230, the limit order price, the specialist would have bought it at $230, producing a profit of ($305 - $230) x 100 = $7,500!

11.

Val believes the price of ABC is too high at $35/share. She shorts 100 shares. A week later, the price is $32/share when she covers a short position. How much money did Val make?

The selling price is $35 and the buying price is $32. Thus, Val made $3/share, or $300 overall.

Shorts sellers, like all investors, try to buy low and sell high. The only difference is that they sell first and buy later.

12.

Winters Hi-Hook Inc., a golf club manufacturer, is currently paying dividends of $.50 per share.

These dividends are expected to grow at a 20 percent rate for the next two years and at a 3 percent rate thereafter (forever!). What is the value of the stock if the appropriate discount rate is 14 percent?

This is an example of a variable dividend growth rate, Equation 10-11. One must find the PV of the first stage growth dividends and add it to the PV of the constant growth perpetuity assumed after the first stage growth, the beginning in the third year.

Dividends

PV at 14%

D1 = $0.50 (1.20) = $0.60/1.14 =

$0.526

D2 = $0.60 (1.20) = $0.72/1.142 = PV of first stage growth

$0.554 $1.080

D3 = $0.554(1.03) = $0.571 P2 = D3/(r - g) = $0.72/(0.14 - 0.03) = $6.545 The price of the stock is the sum of the PV of the stock two years from now estimated to be $6.545/(1.14)2 = $5.04 plus the PV of the first stage growth of $1.08, or $6.12.

13.

Dolezilek Power Company promises to maintain dividends of $5.00 per share on its preferred stock, indefinitely. The stock currently sells at $37.50 per share. What is the required return on the stock?

The market has priced the stock at $37.50 based on its $5 annual perpetual dividend. The market now requires a $5/$37.50, or 13.3% return.

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14.

Patty’s Gardening Supplies is a young start-up company. It plans to pay no dividends over the next five years because it must reinvest all earnings in the firm to finance planned growth. The firm then plans to begin dividends of $3 per share, which are anticipated to grow at 10 per cent per year for three years, and six percent per year in perpetuity beyond that. If the required return on Patty’s Gardening Supplies stock is 15 percent, what should be today's stock price?

The stock is expected to pay a $3.00 dividend in the sixth year; $3.00(1.10) = $3.30 in the seventh year, and $3.30(1.10) = $3.63 at the end of the eighth year. The PV of the first stage three-year dividend stream at the end of the fifth year is: PV0 = $3.00/(1.15)6 + $3.30/(1.15)7 + $3.63/(1.15)8 + [3.63(1.06)/(0.15 – 0.06)]/1.158 = $3.724 + $13.976 = $17.70.

15.

You purchase 100 shares of Adams Trading Company stock today for $22.50 per share. At the end of one year, you collect a dividend of $2.75 and then sell the stock at $24.50 per share. What is your total return on the stock? What is the dividend yield? What is the capital gains yield?

The total return is the sum of the dividend yield ($2.75/$22.50 = 12.22%) plus the capital gain ($2/$22.50 = 8.89%) or 21.11%. Another way, $2.75 dividend plus $2 capital gain or $4.75 earned on $22.50 invested is 21.11%. This yield assumes that dividends are paid at the end of the year.

16.

Farrell Motors stock has a beta of 1.3. If the market has an expected return of 9 percent and the risk-free rate is 1 percent, what is the expected return of the stock according to the security market line?

The expected rate of return is the sum of the risk-free rate plus the market risk premium times beta, or 1% + (9% - 1%)(1.3) = 11.4%. The expected market return is 9%; Farrell Motors' beta is 30% higher than the market, so their required rate of return is higher.

17.

The market's required return on Paul Bunyan Oil Company stock is currently 13.8 percent. If the expected return on the market portfolio is 12.6 percent and the risk-free rate is 3.5 percent, what is the beta of Paul Bunyan stock?

The required return of Paul Bunyan Oil exceeds the return on the market portfolio, indicating a beta above one. The market risk premium, 12.6% - 3.5%, or 9.1% times a beta plus the risk-free rate of 3.5% is Paul Bunyan's RRR of 13.8. Solving for beta, 13.8% = 3.5% + (9.1%)β

18.

and

β = (13.8% – 3.5%)/9.1% = 1.13

Explain the difference between systematic and unsystematic risk. Explain how beta captures systematic risk.

Unsystematic risk is the diversifiable risk portion of the total risk of a stock. Properly diversified, the portfolio formation eliminates the unsystematic (company-specific, diversifiable) risk, leaving the investor facing the systematic risk of the portfolio. Beta is a measure of the relative variability of the stock relative to the market portfolio. By definition, the market portfolio only has systematic risk.

19.

You have decided to create stock market indexes using three representative stocks. At the end of

6

day one, stock X has a price of $20 per share and 20 million shares outstanding, stock Y has a price of $25 per share and 50 million shares outstanding, and stock Z has a price of $35 per share and 40 million shares outstanding. You calculate a price-weighted index and a market capitalization-weighted index. You have decided that the beginning value of each index at the end of day one will be 100. What is the value of each index at the end of day two if stock X’s price is $23 per share, stock Y’s price is $22 per share, and stock Z’s price is $36 per share?

Price-Weighted Index:

Stock X Stock Y Stock Z TOTAL

Shares Outstanding 20,000,000 50,000,000 40,000,000

Price $20 $25 $35 $80

Day 1 Market Value ($ Millions) $400 $1,250 1,400 $3,050

Price $23 $22 $36 $81

Day 2 Market Value ($ Millions) $460 $1,100 $1,440 $3,000

With a desired base of 100 the divisor will be 80/100 or 0.8. On day 2 the index moves to $81/0.8 = 101.25, up 101.25/100 = 1.25% for the day.

Market Value Weighted Index: With a desired base of 100 = $3050 Million, then the second day the index would be ($3000/3050)*100 = 0.9836 x 100 = 98.36, a decline of 1.64 %.

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CHAPTER 11 DERIVATIVES MARKETS CHAPTER OBJECTIVES 1. The primary purpose of this chapter is to develop student understanding of futures, options, and swaps: how they work and are regulated, what is traded, and what are potential gains/losses and risks.

2. To develop student understanding of financial hedging techniques by providing numerous illustrations of how lenders and borrowers can reduce risk, guarantee the cost of funds, immunize portfolios, or guarantee investment returns by trading in the futures markets.

3. To compare and contrast futures, options, and swaps, their potential gains and losses, and their uses for hedgers and speculators.

CHANGES FROM THE LAST EDITION 1. Time-sensitive data have been updated. Both People & Events insert have been deleted, and a new one, Swap Market Regulation, added.

2.

Learning goals: LO 6 has been revised and LO 7 added.

3. “Learning by Doing”: LBD insert is on pp.348-349.

4. “Do You Understand?” questions: in the first set, Q2 has been revised.

5. End-of-chapter questions: Old Qs.10 and 14 have been deleted and new Q.14 added; Q.10 is old Q.11; Qs. 11, 12, and 13 are revised old Qs. 12, 13, and 15. The internet exercise has been revised.

6. Two of the end-of-chapter questions ( Qs. 10 and 14 in the previous edition) have been deleted and one new question added (Q. 14). Some questions have been revised.

7. In Section 11.3, “Futures Markets”, the subsection “Futures Market Instruments” has been revised.

8. In Section 11.4, “Uses of the Financial Futures Markets”, the subsections “Hedging a Balance Sheet”, “Price Sensitivity Rule of Hedging”, and “Income versus Net Worth Hedging” have been deleted.

9. Section 11.8, “Swaps Markets”, has been revised. A subsection on credit default swaps has been added; the subsection “Swap Markets Regulation” has been deleted; swap regulation (including the changes after the financial crisis) is now discussed in a People & Events insert.

10. Other sections have undergone minor revisions.

CHAPTER KEY POINTS 1. Derivative securities derive their values from values of some other assets, real or financial. Derivatives can be used for both hedging and speculating. It is important that your students distinguish between these two activities. Hedgers strive to reduce or eliminate risk, while speculators consciously take on risk.

2. Both futures and forward markets allow traders to reduce future price risk by entering into contracts to buy or sell currency, security, or commodity at a set price at a specified time in the future.

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3. Futures markets are more structured than forward markets in that uniform contracts are traded and buyers and sellers trade with the futures exchange rather than directly with each other. Thus, it is easier for people to liquidate their contracts prior to delivery, and very few deliveries are actually made on futures contracts.

4. Margin requirements are stipulated by futures exchanges to ensure that all parties will honor their futures contracts. Positions of traders are marked to market every day, reflecting daily value changes. If price movements are adverse, the contract holder may be required to deposit additional money in order to meet the margin requirements. If a trader does not add funds to answer the margin call, his position is liquidated. This eliminates default risk from the futures markets. Forward transactions have no such provisions and therefore are not free from default risk. The advantage of forwards is that they are not standardized and thus can be tailored perfectly to the needs of the counterparties in terms of amount, asset classes, and maturity.

5. The futures markets, and options on futures contracts, are regulated by the Commodity Futures Trading Commission - which certifies contracts and guards against manipulation. The SEC regulates the trading of options on common equities. The futures exchanges practice self-regulation.

6. Financial futures markets can be used to (a) guarantee costs of funds, (b) guarantee investment returns, (c) hedge portfolios against interest rate risk, (d) reduce risks associated with foreign transactions, and (e) guarantee rates of return on temporary foreign investments.

7. Risks associated with trading in the futures markets include (a) basis risk, (b) related-contract risk, (c) manipulation risk, and (d) margin risk.

8. Options allow investors to limit the risk of downside losses without sacrificing an upside potential of their investment. Options are rights to buy or sell assets, while futures and forwards are obligations. For a fee – the "premium" – an investor can accrue all gains from favorable price movements and lose only the "premium" if prices move adversely. Thus, options can provide insurance against potentially damaging price swings.

9. The two components of an option’s value are intrinsic value and time value. Options are more valuable with greater time to expiration and greater volatility in the price of an underlying asset.

10. In a traditional swap, fixed or variable rate future interest flows are swapped for the opposite flow.

Such a swap can be viewed as a series of forwards. Credit default swaps (CDS) essentially provide credit insurance to investors in various debt obligations. Swaps historically traded over the counter, largely unregulated, similar to forwards. However, under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, many standardized swaps will become subject to the futures regulatory model: these swaps will be required to take place on regulated trading platforms and be cleared by regulated clearinghouses.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

What is the difference between the forward and the futures markets? What are the pros and cons associated with using each one?

FORWARDS:

FUTURES:

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The forward market is unstructured Forward contracts trade over the counter.

Unstandardized, tailored to the needs of the counterparties.

Numerous dealers match individual buyers and sellers and/or trade for their own accounts.

No margin is required.

Futures transactions are conducted on an organized exchange.

Contracts are made between buyers or sellers and the exchange.

Margin requirements are imposed to ensure no one will default when prices move adversely.

Very few contracts are settled by delivery.

The futures market is useful when it is necessary to hedge price risk over a period of time.

Marked to market daily.

All elements of the contract are standardized (Only price is variable).

Trade on exchanges, and are very liquid.

Clearing house guarantees delivery and payment.

Low default risk.

May not be tailored to counterparties’ needs.

Most forward contracts are settled by delivery.

The forward market is useful when a set amount of currency is needed on a specific date.

No marking to market All elements of the contract are negotiated.

Highly illiquid because of customized features.

Default potential may be quite high.

2.

What role does the exchange play in futures transactions?

The exchange sells to buyers and buys from sellers. It also requires that margin requirements be maintained, sets the terms of futures contracts, and makes sure that exchange trading rules are not broken. This eliminates default risk from futures contracts.

3.

How can a thrift institution guarantee its costs of funds for a period of time by using the futures market?

By selling CD, Eurodollar, or T-bill futures short for up to several years in the future, it can guarantee that its net costs of funds will approximately equal the rates at which it sold short plus the usual risk premium it pays on its CDs.

4.

Why do you think some futures contracts are more widely traded than others?

Because price volatility is wider for some markets than others and some contracts involve financial instruments or commodities in which a great number of people have an interest in reducing price risk. Also, some contracts are more popular because of exchange encouragement and others have greater appeal to speculators.

5.

What agency is the chief regulator of futures markets? Why is federal regulation necessary?

The Commodity Futures Trading Commission is the chief regulator. Federal regulation is necessary because the futures markets in the past have attracted manipulators. Because people with power, influence, or a vested interest can influence decisions of their peers, or may actually vote in their own interests, regulation by federal agencies is necessary.

6.

Explain the difference between a put and a call. Draw a diagram showing the payoffs of puts and calls at expiration. Draw it from the prospective of both the option buyer and the option seller.

A call is a right to buy an underlying asset at the strike price, while a put is a right to sell an underlying asset at the strike price. Parts (a) and (b) of Exhibit 11.7 show the payoffs of option

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buyers and sellers.

7.

Why do you think exchanges are more concerned with writers of naked options than with writers of covered options?

Covered option writers already own the security (or hold a short position) necessary to make good on the option they sold should it be exercised. Naked option writers don't have a hedged position; they therefore are required to post cash as earnest money to guarantee their promise if price movements are adverse, and the option is exercised.

8.

Explain the difference in the gain and loss potential of a call option and a long futures position.

Under what circumstances do you think someone would prefer the option to the futures or vice versa?

In both cases, the buyer gains if the price of the underlying instrument rises. However, the option buyer must pay a premium to obtain the position, whereas the future buyer does not. In return, the option buyer loses no more than the premium if the underlying instrument falls in value. The buyer of the future loses a potentially large (almost unlimited) amount if the price of the underlying instrument falls.

Someone would prefer an option to a futures if the premium were sufficiently low that one deemed one-sided price protection to be worthwhile. For instance, an S&L manager might want to hedge against a rise in interest rates by buying T-bond puts. If interest rates rose, the manager would gain enough to offset losses on the S&L's mortgage portfolio. If interest rates fell, the mortgage portfolio would rise in value (and be offset only by the cost of the call premiums and not by an equally large loss on futures transactions).

9.

Futures contracts on stock indices are very popular. Why do you think that is so? How do you think they might be used?

By buying index futures an individual can ride the trend of the market without buying individual stocks. These also allow individuals to neutralize their portfolios if they expect temporary stock price declines without incurring the transaction costs associated with selling stocks.

10.

Assume that in March a farmer and a baker enter into a forward contract on 1,000 bushels of wheat at a price of $3.00 per bushel for delivery in September. In September the spot price of wheat is $2.50 per bushel. Who has profited from entering into the forward contract and who has lost? How much is the gain and how much is the loss?

The farmer has locked in a price for his/her wheat at $3 when the spot price is $2.50. The farmer is ahead by $.50 x 1000 = $500, whereas the baker’s hedge, locking in a source of wheat at $3, has produced a $500 loss. Still, by entering into the forward contract, the baker eliminated or significantly reduced the uncertainty regarding his/her profit margin through locking in a specific price for wheat.

11.

Assume the initial margin on a Eurodollar futures contract is $878 and the maintenance margin is $650 (the contract size is $1mln). If the contract price declines by 25 basis points, by how much do the long and short positions’ margin balances change? Which position, if any, gets a margin call?

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For each change in a basis point, the contract value changes by $25, so a decrease in price (increase in interest rates) of 25 basis points will cause a loss (25 x $25 = $625) for the long position (buying price is 25 basis points higher) and a $625 gain for the short position (selling Eurodollar for a price 25 basis point higher). The $625 hit will effect a margin call for the long position for the margin account will only have $878 - $625 = $253,which is below the maintenance margin of $500. The trader will have to add $625 to satisfy the initial margin of $878.

12.

Refer to Exhibit 11.6. What is the time value and what is the intrinsic value of a call option on Wells Fargo with a strike price of $23.00 and October expiration? What is the time value and what is the intrinsic value of a put option on Wells Fargo with a strike price of $23.00 and October expiration?

Option value is the sum of its intrinsic value and time value. The Wells Fargo $23 October 2010 call has an intrinsic value, the difference between the market price of the stock and the strike or exercise price of $25.59 - $23 = $2.59. Since the option trades a current price of $2.60, its time value is $2.60 - $2.59 = $0.01.

The Wells Fargo $23 October 2010 put has an intrinsic value of zero because the difference between the strike and the underlying stock price is negative, $23 - $25.59 = -$2.59. The time value is $0.16, the option’s entire market price. A holder has a right to sell the stock at $23 per share when it trades at $25.59. If the option were expiring, it would be worthless. However, because some time remains in the put’s life, there is a chance that the stock will move below $23 before the option expires. This is why the put’s value is above zero.

13.

A bank has entered into an interest rate swap. The swap has a notional principal amount of $100 million and calls for the bank to make annual fixed interest rate payments of 5 percent and to receive an annual floating interest rate payment of LIBOR plus 2 percent. If LIBOR is 1 percent, what payment will the bank make or receive?

The amount of annual fixed “payments” made by the bank is $5 million ($100 million x 5%).

LIBOR is 1 percent, so the bank will “receive” 3 percent of the $100 million, or $3 million.

Because only the net amounts are exchanged in swaps, the bank will end up making a payment of $2 million.

14.

Do you think swap contracts will have more or less counterparty default risk after the rules in the Dodd-Frank Wall Street Reform Protection Act are implemented? Why? Swap markets will be more similar to futures and options markets, with features such as exchange trading, margin requirements, and centralized clearing. This will reduce default risk of swaps.

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CHAPTER 12 INTERNATIONAL MARKETS CHAPTER OBJECTIVES 1. To introduce several basic concepts including exchange rate risk, determination of interest rates, balance of payments accounting, purchasing power parity.

2. To describe the continuing internationalization of financial markets. The student should understand how international payment flows are generated, the role banks play in mediating international transactions, and why exchange rates fluctuate.

3. To describe the process of financing international trade; explain how foreign exchange risk can be managed through forward and options transaction.

4. An additional objective of the chapter is to explain the linkages that exist between spot exchange rates, forward exchange rates, domestic interest rates, and domestic inflation in different countries.

CHANGES FROM THE LAST EDITION 1. Time-sensitive data and figures have been updated. Exhibit 12.2 from the 10th edition (The Equilibrium Exchange Rate”) has been deleted. The second “People & Events” has been deleted.

2. Learning Objective 3 has been revised.

3. “Learning by Doing”: There are two LBD inserts, on pp.380-381 and 389-390.

4. There are ten new end-of-chapter questions (Qs. 16-25).

5. The subsection “The equilibrium exchange rates” has been deleted.

6. The section “International Trade and Exchange Rates” has been deleted. The purchasing power parity (PPP), which was covered in that section, is now part of Section 12.5, “Spot and Forward Transactions”.

7. The sections “Foreign Exchange Markets” and “Spot and Forward Transactions” have been moved ahead of the section “Capital Flows and Exchange Rates”.All sections have undergone minor revisions.

CHAPTER KEY POINTS 1. The supply of and demand for currencies in foreign exchange markets set exchange rates. The three major force influencing exchange rates are international trade flows, capital flows, and political flows.

The concept of purchasing power parity may help explain changes in commodity prices across the world.

2. The balance of payments can explain changes in exchange rates. If a deficit in the current account (imports exceeding exports) is offset by the surplus in the capital account (foreign investors buying domestic securities), then a country’s currency may not depreciate against those of major trading partners.

3. Governments may intercede in the exchange markets or attempt to regulate private investment and currency flows to alter domestic exchange rates.

4. Foreign exchange markets facilitate international trade. These markets represent a network of large

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commercial banks trading currency around the clock. The Eurodollar market developed, in part, because the U.S. dollar is a major trading currency that is sometimes subjected to governmental controls.

Eurodollars (and other Euro-currencies) have grown in popularity in that they provide one way that governmental controls on domestic currencies can be avoided. Eurodollar markets now play a major role in world financial transactions. A combination of historical, economic, and technological factors has contributed to the rapid internationalization of financial markets.

5. Domestic interest rates, inflation rates, and exchange rates are linked to interest rates, inflation rates, and exchange rates of other countries through the spot and forward exchange markets. The higher the rate of inflation in a country, the higher its short-term interest rates are likely to be relative to foreign interest rates. However, high inflation relative to other countries will also cause that country's forward exchange rates to fall below spot exchange rates sufficiently to eliminate profits from interest rate arbitrage.

Similarly, the exchange value of the most inflationary country's currency will fall over time. The forward exchange rates between currencies maintain interest rate parity between countries.

6. Because inflation, interest rates, and spot and forward exchange rates are linked, the actions of other countries can have an effect on our domestic financial markets and policies. As a result, domestic financial institutions can be affected by international financial policies and developments. The introduction of the euro eliminated exchange rate uncertainties and made financial planning easier among the countries that have adopted it.

7. Exchange rate risk is the risk that changes in exchange rates will lead to losses for traders. It can be managed through currency forward and option contracts.

8. Commercial banks greatly facilitate international trade by providing letters of credit, drafts, and bills of lading, among other means. They also trade currency forward contracts, which helps manage exchange rate risk.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

If a bushel of corn costs ₤3.00, and a British pound is worth $1.50, how many dollars would a person receive for 100,000 bushels of corn sold in Britain in the spot market? If the delivery were to occur in three months and the U.S. interest rate exceeded the British rate by 2 percent per year, what would likely be received in the forward exchange market for a conversion arranged now if the current spot rate is $1.50 per British pound? Explain.

If a U.S. dollar cost of a British pound is $1.50 and corn is selling for $3.00 in the U.S., the pound cost of 100,000 bushels of corn in Britain's spot market is:

Cost of corn =

$3.00 = £2.00 $1.50/pound

The price of 100,000 bushels = £2 x 100,000 = £200,000 Assuming the forward/spot differential is reflected by interest rate differentials, if U.S. interest rates exceed British rates by 2 percent per year, we can assume that U.S. inflation rate exceeds British inflation rate by 2 percent per year and that the U.S. dollar is expected to depreciate by 2 percent per year, or (1.02).25 or 1.00496 per quarter. The 90 day forward rate should be $1.50(1.00496) = $1.5074/£.

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2.

If a dollar can buy 98 Japanese yen and a British pound costs $1.50, how many yen would it take to buy £1? If a pound of copper costs £1 in Britain, ¥160 in Tokyo, and $1.45 in the United States, where is a pound of copper most expensive and where is it least expensive?

The yen/British cross-rate is found by the product of the yen/$ times the cost of a pound per dollar or 98(1.50) = 147 yen. The dollar unit is used as a basis for estimating the yen/pound rate, assuming that trading has kept the three currencies at parity. Using the dollar as the base currency, a pound of copper in Japan costs an equivalent of $1.63 (¥160/¥98), and in Britain 1*($1.50) or $1.50. The copper is most expensive in Japan and least expensive in the U.S.

3.

Assume that the spot and one-year forward rates for the British pound are $1.60 and $1.55, respectively and are $0.90 and $0.92 per euro, respectively. If interest rates are 4 percent in the United States, 6 percent in Britain, and 3 percent in Germany, where can you get the best return on a covered one-year investment?

• • •

Assuming a $100,000 investment, one will have $100,000 (1.04) or $104,000 at the end of one year.

The $100,000 converts to £62,500 at the spot rate of $1.6/£, becomes £66,250 after earning 6 percent, and converts at the forward rate of $1.55/£ to $102,688.

The $100,000 converts to €111,111 at the spot rate of $0.90/€, becomes €114,444 after earning 3 percent, and converts at the forward rate of $0.92/€ to $105,289. ➢

4.

Under the current forward/spot differentials, one can earn the best return by converting U.S. dollars to Euros and investing in Germany.

If the United States runs a deficit in its current account of $100 billion and receives a net inflow of $60 billion on long-term investments in a year, by how much will its short-term capital flows have to change in order to accommodate all these flows?

Assuming that the capital flows will offset the trade flows, keeping exchange rates stable, and the short-term capital flow should be $40 billion dollars. A net $100 billion in $ would be placed in the forex market and picked up by the capital flow conversion to dollar-denominated investments.

5.

Why are international banks able to earn large fees from providing letters of credit and forward currency transactions?

By writing letters of credit and helping execute forward currency transactions, banks help traders and investors in international markets reduce default risk and exchange rate risks, respectively.

Demand for letters of credit and currency forwards is such that some banks are able to generate a significant portion of their income from the fees charged for these services.

6.

If purchasing power parity applied to Big Macs, and a Big Mac cost $2.50 in the United States while the British pound cost $1.50 and €0.90 euros could be obtained for $1.00, how much would the Big Mac cost in Britain and Germany, respectively? Why might it actually have a different price?

Assuming purchasing power parity or that the cost of a Big Mac is the same in the local currency around the world, • The cost of a British Big Mac = $2.50 /$1.50 = £1.667 pounds.

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•

In Germany the cost = $2.50 * €0.90/$ = €2.25.

The big Mac price is driven by local food and labor costs and is not as likely to reflect PPP. 7.

If the Japanese yen were to change from ¥100/$ to ¥90/$, would the U.S. balance of payments improve (become more positive) or not? Consider what effect the exchange rate change would have on both U.S. exports and imports to and from Japan and on purchase decisions made by manufacturers or importers located in other countries.

A drop from 100 to 90 yen would mean that the yen had risen relative to the dollar. Thus, U.S. goods would be cheaper relative to Japanese goods, so the United States would import fewer Japanese goods and the Japanese would import more U.S. goods. Also, purchasers in other countries would be more likely to buy U.S. goods than Japanese goods. Consequently, the U.S. balance of payments would most likely improve.

8.

Assume that the United States and Canada are both initially in an economic recession and that the United States begins to recover before Canada. What would you expect to happen to the U.S. dollar – Canadian dollar ($/C$) exchange rate? Why? If the U.S. economy grew faster than Canada 's, U.S. imports would increase causing a trade deficit and a later decline in the U.S. dollar as U.S. imports increased relative to exports.

9.

The newly industrializing countries (NIC) of the Far East such as Korea, Taiwan, and Hong Kong have dramatically increased their merchandise exports during the 1980s. Based on what you know about the determinants of international trade flows, state why this export success may have occurred and predict what this will mean for the exchange value of the NIC's currencies.

Lower relative costs of production, governmental exchange controls, trade barriers, and policies to maintain a low currency value relative to the United States dollar, combined with the tremendous demand from the United States for foreign high-quality goods, has given these countries a long-standing export surplus with the U.S. With U.S. real interest rates relatively high over the 1980s and because of the boom in U.S. financial markets, the financial investors in these countries have absorbed the glut of U.S. dollars, generated with trade surpluses, and recycled the dollars into U.S. financial investment.

10.

Explain the role that letters of credit and banker’s acceptances play in international transactions.

Is a banker's acceptance a sight draft? Why or why not?

Letters of credit and banker’s acceptances allow a merchant to obtain payment for his goods in the domestic currency as soon as he can provide the documentation that he has complied with his part of the transaction. A banker's acceptance is a time draft(not a sight draft) originating in a foreign exchange transaction that has been accepted by the exporter's bank.

11.

Why do domestic governments often try to limit domestic flows of funds abroad for investment in foreign countries? How did such limitations in the United States contribute to the development of the Eurodollar markets?

Governments try to limit the outflow of investment funds so there will be less domestic currency being exchanged for foreign currency – thereby driving down the exchange rate of domestic currency. U.S. investors kept money they received abroad in Eurodollars in foreign banks, so they could later invest those funds as they wished, without fear that the United States might

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impose investment restrictions on new outflows of U.S. dollars.

12.

Will the domestic capital account be helped or hurt if foreign investment flows into the country increase?

The balance of payments is merely a recording of the specific types of international transactions.

An inflow of investment capital now supports the foreign exchange rate, but future income flows back to the investing country will serve as an outflow on the current accounts balance.

13.

How can central bank intervention affect the exchange value of a currency? Will the currency generally rise or fall if a central bank sells its home currency?

A central bank can use its stocks of foreign currencies to buy its own currency in the foreign exchange markets. It also can buy foreign currencies for domestic currency. Buying the domestic currency will increase its exchange value due to an increased demand for it, while selling it will decrease the exchange rate due to an increased supply.

14.

How does inflation affect a country's spot and forward exchange rates? Why? Is it absolute inflation or inflation relative to other countries that is important?

It is relative inflation that is important. Inflation causes forward exchange rates to fall relative to spot exchange rates only if other countries' prices are expected to be stable or increase less. If other countries' prices were expected to inflate at the same rate, forward rates would still equal spot rates – assuming all countries' interest rates were the same.

15.

Describe several of the factors which have promoted the internationalization of financial markets during the previous 15 years. Are any of these factors reversible?

The following factors have, in a variety of ways, contributed to the internationalization of financial markets: 1) 2) 3) 4)

The demise of fixed exchange rates in Eastern Europe and Asia.

The revitalization of Eastern Europe.

The extraordinary budget and trade deficits of the United States since 2001.

The slowdown of Japan’s growth being offset by the developing economies in Asia, Eastern Europe and Latin America.

5) The development toward a unified European Economic Community, a common central bank, and the currency that has begun to congregate a powerful economic force, especially since 2003.

6) The continuing integration of international product and service markets.

7) Improved telecommunications and computer technology leading to round the clock trading.

Despite the events of September 11, 2001 in the U. S., continuing growth of terrorism in the Middle East and Europe, the ongoing conflict in Iraq and in the Palestine region, the increasing economic dependence upon other countries, growing environmental problems requiring cooperation, and continued improvements in telecommunications and computer technology are moving world trade and financial markets to higher levels of integration.

16.

Suppose the spot exchange rate today is $1.5/£. The inflation rate is expected to be 3% in the United States and 5% in the United Kingdom over the next year. The annual real interest rate will

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be 2% in both economies. Calculate the nominal rates in both countries next year. i = (1 + r)(1 + ΔPe) – 1: iUS = 1.02*1.03 – 1 = 5.06%; iUK = 1.02*1.05 – 1 = 7.10%.

17.

Suppose the spot exchange rate today is $1.5/£. The annual inflation rate is expected to be 3% in the United States and 5% in the United Kingdom over the next three years. The annual real interest rate will be 2% in both economies. Calculate the nominal rates in both countries next year. i = (1 + r)(1 + ΔPe) – 1: iUS = 1.02*1.03 – 1 = 5.06%; iUK = 1.02*1.05 – 1 = 7.10%.

18.

Suppose the nominal interest rates are 5% in the United States and 2% in the United Kingdom this year. The inflation rate is 1.5% in the U.S. and 2% in the U.K. next year.

Calculate the real interest rates in both countries. Which country is likely to attract more investment from abroad, holding everything else constant? r = (1 + i)/(1 + ΔPe) – 1: rUS = 1.05/1.015 – 1 = 3.45%; rUK = 1.02/1.02 – 1 = 0%.

The US should attract more foreign investments due to the higher expected real rate of return.

19.

Suppose the spot exchange rate today is $1.5/£. The inflation rate is expected to be 3% in the United States and 5% in the United Kingdom over the next year. What is the expected exchange rate in one year? Is pound expected to appreciate or depreciate against the U.S. dollar one year from now, based on PPP? $1.5*1.03 = £1*1.05 $1.545 = £1.05 £1 = $1.545/1.05 = $1.4714.

The UK pound is expected to depreciate against the dollar, from $1.5 to $1.4714.

20.

Suppose the spot exchange rate today is $1.5/£. The inflation rate is expected to be 3% in the United States and 5% in the United Kingdom each year over the next two years. What is the expected exchange rate at the end of year two? Is pound expected to appreciate or depreciate against the U.S. dollar by the end of year two, based on PPP? $1.5*1.03*1.03 = £1*1.05*1.05 $1.5914 = £1.1025 £1 = $1.5914/1.1025 = $1.4434.

The UK pound is expected to depreciate against the dollar, from $1.5 to $1.4434.

21.

An American importer needs to pay £100,000 in 30 days and would like to sign a forward contract to hedge the exchange rate risk. Should the importer buy or sell pounds through a forward contract? Suppose the 30-day forward rate is $1.60/£ and after signing the contract the spot rate in 30 days turns out to be $1.55/£. How many dollars does the firm have to pay in 30 days? Should the firm have not hedged?

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The importer should buy pounds forward. It would pay $1.60*100,000 = $160,000 in 30 days to acquire the pounds needed to pay the foreign supplier. If the exchange rate in 30 days is $1.55/£, the firm would be better off not hedging, since it would buy pounds at this rate. However, the goal of hedging is to eliminate risk, not maximize profits on every transaction. Since there is no way of knowing future exchange rates, hedging with futures locks in the exchange rate, which eliminates exchange rate risk.

22.

An American exporter is expected to receive ¥10,000,000 in 180 days and would like to sign a forward contract to hedge the exchange rate risk. Should the importer buy or sell yen through a forward contract? Suppose the 180-day forward rate is $0.01/¥ and the spot rate in 180 days turns out to be $0.0105/¥. How many dollars does the firm expect to receive in this case? Should the firm have not hedged?

The exporter should sell yen forward to dispose of the yen it will receive. With the forward, the firm would receive $0.01*10,000,000 = $100,000; without it, the firm would receive $105,000.

Even though the firm seems better off without the forward, this is a result of the hindsight bias. It hedged to eliminate uncertainty and achieved the goal.

23.

An American importer needs to pay £250,000 in 90 days and would like to use currency options to hedge the risk of appreciation of the pound. Should the importer buy a call or a put option on pound? Suppose an option on £250,000 maturing in 90 days has a strike price of $1.60/£, and the spot rate in 90 days turns out to be $1.55/£. Should the importer exercise the option if it has bought the option contract? How many dollars does the firm have to pay in 90 days?

Because the firm needs to pay in foreign currency, it should buy a call option (the right to buy pounds that will be used to pay the supplier). The importer should let the option expire because it is better off buying pounds at the spot rate of $1.55 than at the strike of $1.60. The firm will pay $1.55*250,000 = $387,500 in 90 days. The up-front cost is the option premium.

24.

An American exporter is expected to receive ¥10,000,000 in 180 days and would like to currency options to hedge the exchange rate risk. Should the importer buy a call or a put option on Japanese? Suppose an option on ¥10,000,000 maturing in 180 days has a strike price of $0.01/¥ and the spot rate in 180 days turns out to be $0.0085/¥. Should the exporter exercise the option if it bought the option contract? How many dollars does the firm expect to receive in this case?

The firm should buy a put option that will allow to sell the yen received at the strike price. The exporter should exercise the put, receiving $0.01*10,000,000, or $100,000. Selling the yen at the spot rate instead would result in the total dollar amount of only $85,000.

25.

You noticed the current spot exchange rate is $1.50/£ and the one-year forward exchange rate is $1.60/£. The one-year interest rate is 5.4% in dollars and 5.2% in pounds. Assuming you can borrow at most $1,000,000 or the equivalent pound amount (i.e., £666,667, at the current spot exchange rate), can you make a guaranteed profit? If so, how would you carry out the transaction? If not, why not?

Guaranteed profit can be made in the following manner: At the outset, (1) borrow $1,000,000 for one year at 5.4%, (2) convert to pounds at $1.50/£ for the total of $£666,667, (3) invest pounds for one year at 5.2% to receive £666,667*1.052 = £701,333 in one year, and (4) enter into a one-year forward contract to sell £701,333 in one year at $1.60/£.

In one year, (1) collect your pound investment with interest, £701,333, (2) convert to dollars at

7

the rate of $1.60/£ locked in the forward contract for the total of 701,333*1.60 = $1,122,133, and (3) repay the dollar loan with interest, $1,054,000.

The profit is $1,122,133 - $1,054,000 = $68,133.

This analysis assumes the investments are risk-free, i.e., the return of £701,333 in one year is guaranteed.

8

CHAPTER 13 COMMERCIAL BANK OPERATIONS CHAPTER OBJECTIVES 1. This is the first of two chapters on commercial banking. Commercial banks, the largest category of financial institutions and the one most present in daily life, are widely diversified in their business activities, are the main transmitter of monetary policy, and are the center of the payments system.

2. The chapter examines commercial banks as profit-maximizing firms. Their principal business activities are evident in their balance sheets and income statements. Deposits are the major source of funds; loans and investments are the major uses of funds.

3. The chapter surveys management and pricing of loans, fee-based bank services, as well as off-balance-sheet activities.

4. The chapter discusses in some detail banks’ balance sheet (sources and uses of funds) and income statement (sources of income and expenses, as well as earnings and performance), including recent trends.

5. The chapter explains the importance of bank holding companies and financial holding companies. Bank holding companies have been used to circumvent geographic limitations on branching and functional limitations on services. The Financial Services Modernization Act of 1999 provided for financial holding companies, which can acquire insurance and investment banking subsidiaries.

CHANGES FROM THE LAST EDITION 1. All time-sensitive data have been updated. The first “People & Events” insert has been deleted.

Exhibit 13.9, “Off-balance-Sheet Activities of Commercial Banks” has been replaced with the new Exhibit 13.9, “Commercial Banks’ Unused Commitments”. Exhibit 13.10, “Commercial Banks’ Interest Rate Derivative Contracts” is new to this edition. Exhibits 13.11-13.15 are updated Exhibits 14.1-14.5 from Ch.14, “Bank Management and Profitability”, in the previous edition. That chapter is no longer in the text.

2. The set of learning objectives has been revised.

3. “Do You Understand?” questions: (1) in the third set, old Q.1 has been deleted, (2) a new set of three DYU questions has been added after the new section “Bank Performance”. There are now four DYU sets of questions in the chapter.

4. End-of-chapter Questions: Q.2 has been revised, old Qs.16 and 17 deleted, and Qs.17 and 18 added; Qs. 16 and 19 were Qs. 18 and 16, respectively, in the previous edition. The internet exercise has been expanded.

5. Sections 13.10 and 13.11, “Bank Earnings” and “Bank Performance”, were in Ch.14, “Bank Management and Profitability”, in the previous edition. That chapter is no longer in the text.

6. Revisions have been made throughout the chapter to reflect the latest developments in the banking industry.

7. In section 13.4, “Bank Uses of Funds: Bank Investments and Cash Assets”, the subsection “Investments” has been shortened. In Section 13.5, “Bank Uses of Funds: Loans and Leases”, the subsection “Loans to Depository Institutions” has been deleted.

1

8. The section “Pricing Bank Deposits” has been deleted.

9. Section 13.8, “Fee-based Services”, has been significantly shortened.

10. Sections 13.10 and 13.11, “Bank Earnings” and “Bank Performance”, are revised sections with the same titles that have been moved from former Ch.14, “Bank Management and Profitability”, which is no longer in the text.

CHAPTER KEY POINTS 1. The trends in the industry reflect both consolidation and deregulation. There are fewer banks as the industry consolidates, but more branches as limits on geographical expansion relax. Small banks outnumber large banks about, but large banks control the vast majority of industry assets.

2. Banks are profit maximizers. They earn most of their income from loans and investments financed by both deposit and nondeposit liabilities. Fee-based services and off-balance-sheet activities have become increasingly important, providing revenue without additional capital or regulatory burden.

3. The main source of bank funds is various types of transaction and time deposits. Other borrowings to support lending and investment include Fed funds, Eurodollars, repurchase agreements, Discount Window loans, and Bankers' acceptances. Capital notes, bonds, and equity capital are sources of funds related less to operations and more to permanent structure. Compare sources of funds for large and small banks, discuss the reasons for the differences.

4. The main use of bank funds is lending (with leasing considered an extension of lending). Point out the wide variety of loans banks make compared to other lenders. Bank investment portfolios exist chiefly to provide liquidity and some income, representing less risk than loans. Compare and contrast the limited number of low-risk investment choices available to banks with the variety of loans they can make.

5. The “evolution” of the prime rate convention is a useful starting point to explain loan pricing, which applies the now-familiar idea of a nominal rate comprising some base rate adjusted for risk. Matchedfunding and fixed-rate loan pricing represent practical applications of term structure. Loan pricing is driven by market conditions and risk, with risk assessed according to the “Five Cs of Credit”.

6. Other services not readily evident on the balance sheet include correspondent banking, trust, investments, insurance, and off-balance-sheet services. Over the past three decades there has been a significant increase in off-balance-sheet activity by large U.S. banks. These activities have the common feature of separating or unbundling traditional services associated with lending, such as credit risk evaluation and funding. By separating the funding of loans from these activities, banks earn fee income without the risk of purchasing an asset, the cost of funding it, or the regulatory burden of carrying it.

Major types of off-balance-sheet activities include loan commitments, letters of credit, loan brokerage, securitization, and derivatives. Banks may desire not to own assets: They have a comparative advantage in originating loans and other asset transactions, but are at a disadvantage in carrying these assets because of regulation. Banks pay a “regulatory tax” in the form of federal deposit insurance premiums, foregone interest holding required reserves, and mandatory capital requirements exceeding what would be otherwise maintained. Firms less regulated have a comparative advantage owning loans or other assets.

7. The primary source of income for banks is interest earned on loans and investments, he primary expenses are interest paid on deposits and borrowed funds, as well as salaries and employee benefits.

Noninterest (i.e., fee) income has been a growing source of income over the last three decades. Discuss the differences between large and small banks and recent trends in bank earnings and performance.

8. Most banks are organized as bank holding companies (BHCs) to achieve geographic expansion, to engage in some nonbanking activities, and to minimize taxes. Many BHCs gain a financial holding 2

company (FHC) status to offer additional nonbanking services through affiliated companies.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

What is the primary goal of a commercial bank? Why may this goal be translated into maximizing the firm's stock share price?

The primary goal of a bank is profit maximization. Stock prices provide continual monitoring of how well management is doing on behalf of stockholders, and reflect shareholder’s expectations about the firm’s future performance. For firms not widely traded, this type of continuous review is not available.

2.

Why are deposits a more important source of funds for small banks than for large banks? Why are deposits considered a more stable source of funds for small banks than for large banks?

Small banks are usually retail oriented and have a greater proportion of individual accounts.

Large banks have proportionally more business accounts, whose balances fluctuate more.

3.

What are borrowed funds? Give some specific examples. Have borrowed funds become more or less important as a source of funds for banks?

Borrowed funds are non-deposit borrowings which support lending or investing. Examples include fed funds, Eurodollars, repurchase agreements, Discount Window loans, and bankers' acceptances. Borrowed funds have become more important as other financial institutions have competed successfully to attract the short-term transactional and savings balances of the depositing public.

4.

Why are negotiable CDs and federal funds primarily sources of funds for very large banks?

Large banks can more easily enter these parts of the money market. Transactions are very large (usually $1 million or more), and banks must be well known and of the highest credit standing.

5.

Define “bank capital”. What is the economic importance of capital to a firm?

Bank capital comprises capital stock, undivided profits, and special reserve accounts (not to be confused with reserve balances at the Fed). Capital is the “cushion” against which losses— particularly loan losses—are written off. Capital is also the residual claim of owners against the firm. For regulatory purposes, subordinated capital notes (debt) may count as part of a bank's capital.

6.

What are the major uses of funds for a bank? What are the differences between large and small banks? Explain.

A bank’s major uses of funds are lending and investing. Investment securities are more important to the portfolios of smaller banks than to those of larger banks. Larger banks have access to many more sources of liquid funds than do smaller banks, and therefore they do not need to rely as heavily on investment securities for liquidity. Smaller rural banks are more likely to carry significant portfolios of agricultural loans. Smaller banks are less likely to supplement their lending activities with leasing. Smaller and medium-sized banks tend to have more loans and a negligible proportion of assets tied in trading account assets compared to large banks.

7.

What are the important differences between investments and loans in a bank portfolio of assets?

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The investment securities permitted to banks are highly liquid, highly marketable, and relatively low-risk. Loans are personalized contracts, lower in marketability unless participated or securitized, and higher in risk unless exceptionally well-secured.

8.

What are the advantages and disadvantages of using credit scoring to evaluate a loan application?

While conventional credit analysis could take days, credit scoring takes only seconds. Thus lenders can provide instant credit for many loan products. Another advantage is that a person’s credit score is based on objective criteria, which minimizes potential discrimination. The disadvantage of scoring is that it is impersonal and does not allow for special circumstances.

Critics of credit scoring also argue that the secretiveness behind scoring models makes it difficult for potential borrowers to improve their score. For example, consumers who consolidate debt may actually hurt their rating because credit-scoring models may interpret the behavior as an effort to manipulate their credit rating.

9.

Distinguish between a line of credit and a letter of credit.

A line of credit authorizes the borrower to draw loan advances up to a certain limit. A letter of credit authorizes a beneficiary designated by the borrower to present drafts to the bank for payment of amounts owed the beneficiary by the borrower, up to a certain limit. These advances then become a loan balance owed the bank by the borrower.

10.

Give the reasons banks hold Treasury securities and municipal bonds in their investment portfolios.

Treasuries are held as secondary reserves. They are short-term (low price risk), highly marketable, and have low default risk. Munis are owned by banks primarily for their tax advantage.

11.

Explain why banks buy and sell federal funds. Also explain the role of the Federal Reserve System in the federal funds market. Show the T-accounts for a federal funds transaction.

Banks sell (i.e., lend) fed funds to earn income and avoid idle excess reserves. When the Fed started paying interest on reserves, keeping excess reserves with the Fed became a viable alternative to lending in the fed funds market. Banks buy (i.e., borrow) fed funds to raise shortterm funds. The Fed facilitates the fed funds market, but is not a source of funds.

Sale and purchase of $1,000 in Fed Funds:

Purchasing bank

Reserves $1,000 || Fed Funds Purchased Fed Funds Sold 12.

|| $1,000 ||

Selling bank || $1,000 || $1,000 ||

Define correspondent banking. Why do banks enter into correspondent relationships?

Correspondent banking involves the sale of bank services to other banks and nonbank financial institutions. Banks typically purchase services they cannot economically manufacture themselves, and sell services for which they can charge a profitable fee. A large bank often has many corresponding relationships with (i.e., it provides services to) smaller banks in a region.

13.

What is the prime rate? Why do some banks make loans below the prime rate?

The prime rate is a base loan rate traditionally associated with the most creditworthy commercial borrowers. Large well-known firms with excellent credit ratings and access to the commercial 4

paper market can often borrow below the posted prime rate, if the bank wants their business badly enough.

14.

What do we mean by off-balance-sheet activities? If these things are not on the balance sheet, are they important? What are some off-balance-sheet activities?

Off-balance-sheet activities are financial services which earn revenue but do not directly or immediately put assets or liabilities on the balance sheet. Examples include loan commitments, letters of credit, loan brokerage, securitization, and derivatives. These activities are important: They are a large component of the revenue of the world’s largest banks, they materially affect a bank’s overall risk profile and profitability, and yet they are not readily apparent in cursory examination of financial statements. Assessment of their full effect requires an analysis of notes to financial statements.

15.

What are the major benefits of getting assets off the balance sheet through either loan sales or securitization?

Banks earn fee income for loan origination and servicing without bearing credit and interest rate risks associated with holding an asset, the cost of funding it, or the regulatory burden of carrying it. Banks have a comparative advantage in originating loans and other asset transactions, but are at a disadvantage in carrying these assets because of regulation. Banks pay a “regulatory tax” in the form of federal deposit insurance premiums, foregone interest holding required reserves, and mandatory capital requirements exceeding what would be otherwise maintained. Firms less regulated have a comparative advantage owning loans or other assets. Advances in communications and technology have also made "direct" financing a lower cost alternative to intermediation.

16. What is a contingent asset? What is a contingent liability? Provide an example of each.

For a fee a financial institution will agree to provide services upon the request of a customer. A loan commitment to lend over a period of time at a base-price plus is a contingent asset. The customer holds an option to borrow. The asset is contingent upon the request of the customer.

Letters of credit in support of customers is an example of a contingent liability. The bank has a contingency of an obligation if the customer does not meet its obligation with its supplier.

17.

What are the major differences between large banks and small banks on the income statements?

Why are there differences between the two groups of banks? For example, why is the net interest income higher for small banks?

Compared to large banks, small banks have proportionally higher interest income from loans and securities, explained by higher proportions of loans and securities on their balance sheets, higher interest expense (due to higher reliance on deposits), lower noninterest income because they do not provide as many fee-earning services to customers, and higher noninterest expense, with the difference mostly accounted for by a higher salaries and employee benefits expense. It does not mean that small banks pay higher salaries; rather, they have lower assets per employee than large banks. As a result, it translates into a larger salaries expense when expressed in percent of total assets.

18.

Describe some of the recent trends affecting bank income statements. For example, has net interest income increased or decreased in recent years? What about other components of the income statement?

Net interest income has remained fairly stable, while its components – gross interest income and 5

gross interest expense – have been volatile and lately have both fallen along with the level of interest rates. Another key change in the banks’ aggregate income statement has been a large increase in the provision for loan losses, PLL, beginning in 2007 (see Exhibit 13.13). PLL reduces a bank’s income; it goes up and down with losses on loans and investments. The latest increase in PLL was related to the 2007-2009 financial crisis.

19.

Give the reasons that banks select the bank holding company form of organization. Why would a bank holding company seek to convert to a financial holding company?

The bank holding company structure circumvents state and federal restrictions on geographic expansion and services. Holding companies also offer tax-sheltering opportunities not available with a single bank charter. Under the Financial Services Modernization Act of 1999 a bank holding company can apply to the Fed as a “financial” holding company. With the Fed’s approval, a financial holding company may own insurance or investment banking subsidiaries as well as other financial holding companies.

6

CHAPTER 14 INTERNATIONAL BANKING CHAPTER OBJECTIVES 1. To describe the evolution and organizational forms of U.S. international banking and important legislation that influenced its growth.

2. To discuss international lending activities; to explain risks involved in international banking and discuss methods used to reduce these risks.

CHANGES FROM THE LAST EDITION 1. This chapter was Chapter 15 in the previous edition.

2. The chapter opener has been updated.

3. Tables, statistics, and surrounding discussions have been updated.

4. The first “People & Events” insert has been revised, the second and third deleted.

5.

CHAPTER KEY POINTS 1. The development of U.S. international banking should be emphasized to provide some insight into the reasons for the rapid expansion in the 1960s and the apparent slowdown in growth that has occurred in the late 1970s. The number of U.S. banks with foreign branches has declined since mid-1980s and the number of U.S. banks’ foreign branches has declined since 2000; both have happened mostly due to consolidation of the U.S. banking industry.

2. An understanding of the regulation of U.S. overseas banking activities by both the U.S. and foreign governments is important. The U.S. government's conservative banking philosophy is in contrast with the regulatory practices of many foreign governments.

3. The organizational forms that U.S. banks can use to deliver overseas banking services are varied.

They are representative offices, shell branches, correspondent banks, foreign branches, Edge Act corporations, and foreign subsidiaries. [See Exhibit 14.3] 4. The characteristics and practices of international lending should be emphasized, especially the differences in funding, syndication, pricing, and collateral compared to domestic lending. Although it is more difficult to gather information, credit analysis of international borrowers is similar to that of U.S. business firms. Country risk and currency risk are risks unique to international lending.

5. The growth of foreign bank activities in the United States is of interest because of the rapid growth in recent years. The International Bank Act (IBA) of 1978 addresses many of the inequities that existed between foreign and domestic banks. Foreign banks control about 20% of all banking assets in the U.S. The recent growth in foreign banking assets was driven by Canadian and European banks.

6. Students seem to enjoy a discussion about the future direction of international banking. A good idea is to discuss the impact that the changing U.S. financial system will have upon the international banking

1

scene.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

Why were U. S. banks slow to expand overseas? What changed to encourage overseas expansion?

While legislative impetus to expand overseas existed since 1913, U.S. banks did not really begin expanding overseas until well after World War II. Even then, it was the increase in foreign direct investment by non-financial corporations from the U.S. that forced U.S. banks to expand overseas in order to provide required services for their globally expanding domestic clients.

2.

How were the overseas expansions of U.S. non-financial corporations and banks related?

Discuss the defensive follow-the-customer strategy in your response.

As U.S. corporations expanded overseas to deal with the growing international trade, they looked to their domestic banks for continued relationships wherever they expanded. While local banks could have met the needs of the foreign subsidiaries of American corporations, the firms preferred to deal with familiar banks. If American banks had not stepped up to the plate, they risked losing business to these foreign banks, not only abroad but also at home. Thus, U.S. banks needed to also follow the multinational path and finance their clients’ need through letters of credit, banker’s acceptances, and other credit instruments.

3.

Why has the number of U.S. banks operating overseas declined in recent years?

Predominantly, the attrition in the number of banks and branches after 1985 and after 2000 is the natural consequence of mergers between the large, multination banks. [See Exhibit 14.1]

4.

What are Edge Act corporations? What advantages do they afford American banks that wish to ` engage in international banking?

Edge Act corporations are separate banking organizations that are allowed to engage in international banking transactions from which the parent bank is prohibited (for example, investing in equities).

5.

What is a shell branch? What functions do banking shell branches perform in U.S. overseas banking? Why are so many located in Caribbean island nations?

Shell branches are offices located in areas where there are few restrictions on banking activities, and operating costs are low. At shell branches, banks can perform international banking transactions with little interference. Most shell branches are located in the Caribbean islands because of the lack of bank regulation and low operating costs.

6.

What is an international banking facility? In what types of business activities can such entities engage? Why did the Federal Reserve Board create these new banking entities?

International Banking Facilities (IBFs) allow domestic banks to conduct international banking operations that domestic banks cannot engage in. They were established by the Fed to strengthen U.S. banks' international banking activities and to promote efficiency in the banking system.

2

7.

What are the basic objectives of federal bank regulations as they apply to domestic banking?

How are these basic regulatory objectives interpreted differently with respect to overseas banking? How do the BIS capital standards affect internationally active U.S. banks?

The basic objectives of U.S. banking regulatory agencies have been: a) bank safety to promote economic stability, b) separation of banking from other lines of commerce, and c) to promote competition as long as it is not detrimental to bank safety. In recent years, U.S. regulatory agencies have allowed U.S. banks to expand the range of their business activities as long as the activities do not materially affect the safety of the domestic banking system.

Uniform bank capital standards across developed nations will level the playing field between foreign and internationally active domestic banks even further.

8.

Explain the motivation behind the International Banking Act of 1978.

The primary objective of the International Banking Act of 1978 was to level the playing field between foreign banks and domestic banks within the U.S. Thus, while the foreign banks got the same powers as the U.S. banks, they were also subject to the same set of regulations as their domestic competition.

9.

What were the provisions of the International Banking Act? Are some of the provisions no longer relevant? If so, which ones? Explain.

The provisions of the International Banking Act of 1978 are as follows: a.

Allow federal chartering of foreign banking facilities. b.

Limit the ability of foreign banks to accept interstate deposits. c.

Fed may impose reserve requirements on foreign banks. d.

FDIC insurance required on domestic retail deposits in foreign banks operating in the U.S. e.

Foreign banks permitted to form Edge Act corporations. f.

Foreign banks operating in the U.S. were made subject to non-banking prohibitions of U.S. banking holding companies.

After the passage of the Financial Services Modernization Act of 1999, U.S. banks could organize themselves as financial holding companies rather than bank holding companies and own subsidiaries that could participate in any financial business. Since these laws applied to foreign firms also, both they and the domestic banks have made some of the provisions (b, f) obsolete.

10.

The recent development of microfinance led to new ways of looking at banking relationships. Do you believe that microfinance is entirely consistent with bank wealth maximization? If not, what objectives underlie these microloans?

Microfinance is a relatively new practice, and it remains to be seen whether it is entirely consistent with bank wealth maximization. Social goals seem to be even more important than maximizing bank wealth. Undoubtedly, microfinance makes a profound impact on developing countries by giving a chance to poor people to finance their health care, education, and other important needs. If microfinance is properly and successfully implemented, the resultant reduction in poverty and improvement in the population’s money management skills will lead to higher bank profits in the long run.

11.

What is a syndicated loan? In what ways do large international loans differ from typical domestic loans? Define the term LIBOR.

3

A syndicated loan is usually a large loan funded by several banks. A lead bank organizes and coordinates the origination. Several banks are involved a) to limit risk-taking; and, b) to provide funding beyond the capacity of a single institution. International loans, relative to domestic loans, are larger, unsecured, are offered by a syndicate of international banks and funded by time deposits, usually Eurodollars. Most of them are floating-rate loans with the interest rate tied to LIBOR, or London interbank offer rate. It is the rate at which large banks exchange funds in the London market; it often serves as a base rate for pricing international loans.

12.

Consider a large syndicated loan to a firm with close ties to the government in a country with a large degree of political risk. As a large U.S. bank, explain why you might wish to have other reputable lenders from other nations involved before you agree to lend to this firm.

When a foreign government or firm considers the implications of default, they are much more hesitant to violate a contract because that may hamper future relationships with multiple important parties. Thus, making sure that other important lenders participate in large loans helps mitigate default risk.

13.

What risks must be evaluated in making international loans? Which of these are unique to international lending? How might these risks be reduced?

International loans are exposed to credit risk, currency risk, and country risk. Currency or foreign-exchange risk and country or sovereign risk, the risk of foreign governmental decisions affecting the repayment of the loan, are the two added risks of international lending. Foreign or domestic government guarantees, risk pooling through syndication, hedging with foreignexchange options, futures, and forward contracts, and diversification are several risk-reduction techniques. Loan sales, though at the time of sale a market value adjustment must be made, may be used to control the amount of future risk exposure.

14.

Do you believe that the presence of foreign banks in the United States serves the public’s interest? In formulating your answer, consider the issues of bank safety and competition in banking markets.

Yes, if they are subject to the same regulations as domestic banks. Equality would include the same reserve requirements, FDIC membership requirements, and similar lending and borrowing powers.

15.

In international lending, what is meant by the phrase “rescheduling of sovereign loans”? Why has rescheduling of loans become a problem to international lenders? What countries are involved?

Rescheduling of a loan is no more than changing the term and conditions of the loan contract in order to help the borrower avoid default. Notable international loan rescheduling has been performed for Brazil, Mexico, Argentina, and Poland.

4

CHAPTER 15 REGULATION OF FINANCIAL INSTITUTIONS CHAPTER OBJECTIVES 1. This chapter explains how and why depository institutions are regulated, with particular emphasis on commercial banks as the basic model for other depository institutions.

2. The chapter summarizes major financial institutions legislation of the last several decades.

3. The chapter surveys federal deposit insurance, with particular attention to prevention of bank failures and disposition of failed banks. Crucial public policy issues in government deposit insurance include moral hazard and the “Too Big to Fail” doctrine.

4. The chapter discusses the role of bank capital and risk-based capital requirements. It also summarizes the bank examination process, a unique regulatory intervention with few parallels in other industries, and explains the “CAMELS” rating system.

5. The chapter identifies the principal regulators of banking and summarizes the seemingly convoluted relationships among them. While sufficient analysis does discern logic in these relationships, students without a career interest in banking may just prefer to learn them by rote memorization.

6. The chapter discusses other regulatory agendas, including competition, structure, and consumer protection.

CHANGES FROM THE LAST EDITION 1. This chapter was Chapter 16 in the previous edition.

2. Exhibits, data, and surrounding discussions have been updated. Exhibits 15.5-15.7 are updated Exhibits 14.8-14.10 from Ch.14, “Bank Management and Profitability”, in the previous edition, which is no longer in the text. A new “People & Events” insert on the WaMu failure has been added. The first two of the three “P&E” inserts from the previous edition have been deleted.

3. Learning Objective 5 has been revised.

4. “Do You Understand?” questions: (1) in the first set, old Q.5 has been deleted, (2) a new set of three DYU questions has been added after the new section “Safety and Soundness Regulation: Capital Requirements”. This question set was moved from Ch.14 from the previous edition, “Bank Management and Profitability”, which is no longer in the text.

5. End-of-chapter questions: Qs. 15, 16, and 17 have been added; they were Qs. 8, 16, and 17, respectively, in Ch.14 in the previous edition.

6. Section 15.1, “Reasons for Regulation”, has undergone a minor revision.

7. Changes to Section 15.2, “Bank Failures and Regulation”: - In the subsection “The 1980s and 1990s”, the discussion of the key provisions of FDICIA has been deleted; - A new subsection “Recent Years” has been added; 8. In Section 15.3, “Safety and Soundness Regulation: Deposit Insurance”, the beginning has been shortened and the subsection “Deposit Insurance in the 21st Century” deleted.

9. In Section 15.4, “Deposit Insurance Issues”, the subsection “Moral Hazard Problems” has been

shortened and the subsection “The Too Big To Fail Problem” revised.

10. Section 15.5, “Safety and Soundness Regulation: Capital Requirements”, represents an updated and revised section “Bank Capital Management” from Ch.14, “Bank Management and Profitability”, in the previous edition, which is no longer in the text. Exhibits 15.5-15.7 are updated exhibits 14.8-14.10 from the previous edition.

11. In Section 15.7, “Structure and Competition Regulation”, the subsection “Balance-sheet Restrictions” has been deleted and the subsection “The 2007-2009 Financial Crisis” added.

12. In Section 15.8, “Consumer Protection Regulations”, the subsection “Dodd-Frank Wall Street and Consumer Protection Act of 2010” has been added.

13. The last paragraph of Section 15.9, “Bank Regulators”, now discusses the role of the Financial Stability Oversight Council (FSOC).

CHAPTER KEY POINTS 1. Depository institutions are heavily regulated because society heavily depends on them. Their deposit liabilities represent most of the money supply and their operations are critical to the payments system.

Their power to allocate credit is a social and economic power so important that government inevitably seeks to share it. Unregulated banking is thus not an option in a developed country. Institutions accept regulation as a condition of their profitability and power, but try to “innovate around” regulation. This sets up a “regulatory dialectic” in which innovation prompts new regulation.

2. Most regulation focuses on safety and soundness, and particularly aims to prevent either of the main causes of bank failure: illiquidity or insolvency. Bank failures have less acceptable “fallout” than failures of other businesses: The social cost of a failure (damage to public confidence, disruption of credit) is assumed to exceed the value of the institution. Key safety and soundness measures include minimum riskbased capital standards, risk-based deposit insurance premiums, and the CAMELS rating system. Much of today’s regulatory system represents painful lessons learned in the 1980s, early 1990s, and late 2000s.

3. The FDIC has evolved from a mere backer of deposits to a proactive “policeman”. Much of the banking legislation of the late 1980s and early 1990s was concerned with enlarging the FDIC and its powers. Deposit insurance entails some interesting public policy issues, including moral hazard and the “too big too fail” doctrine. When disposing of a failed bank, the FDIC prefers to maintain it as a going concern by turning its viable assets and liabilities over to a healthy institution. This avoids the public drama of a bank closure and keeps all the depositors whole, not just the insured ones.

4. Bank capital is a “cushion” that protects the FDIC and uninsured depositors against losses. It encourages bank owners to manage the bank in a safe and sound manner.

5. The bank examination process is a regulatory intervention with few parallels in other industries. The ultimate product of this process is a “CAMELS” rating of an institution’s safety and soundness. While safety and soundness are the primary focus of regulation, other regulatory agendas include competition, structure, and consumer protection.

6. Any depository institution answers to at least three regulators: its chartering authority, the FDIC, and the Federal Reserve. These regulators have, however, divided their examination jurisdictions in a manner administratively convenient to them.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

Why are bank failures considered to have a greater impact upon the economy than other types of business failures? Do you agree with this conclusion?

Individual bank failures can hurt a community by shrinking the money supply and disrupting credit. Thus, commerce in the community suffers if other institutions cannot or do not move quickly to fill the void of money and credit left by a bank failure. If a banking panic occurs, the economy will slow down because bank reserves and the money supply will shrink abruptly unless the central bank quickly takes action to provide liquidity and restore confidence in the financial system.

2.

What are the major lessons that have been learned from past bank failures? Do you think that history can or will repeat itself?

One lesson of past bank failures is that deposit insurance for the most part prevents runs on banks.

Depositors trust the FDIC. Runs in recent years have been limited to a few banks and have not spread. Another lesson is that regional or industry depressions are a major cause of bank failures.

Another lesson is that fraud, embezzlement, and poor management are the most notable causes of bank failure. Finally, because banks are thinly capitalized, they are vulnerable to major economic shocks, such as a housing market bubble burst in the U.S. in the late 2000s, which caused mortgage-related assets of many banks to significantly shrink in value. There were 383 bank failures in the U.S. from January 2008 through July 2011. As long as banks remain thinly capitalized and hold risky assets, mass bank failures remain possible.

3.

Although the FDIC does not grant charters for banks to operate, it is said to have enormous impact upon the charter process. Explain.

To receive charter, a bank must qualify for FDIC insurance.

4.

Which of the bank safety regulations enacted in the 1930's do you believe are most important in actually achieving bank safety? Which of the safety regulations would you classify as being anticompetitive?

Answers for this question will vary, but the 1930s-era regulatory development that still plays the most significant role in safety and soundness is federal deposit insurance.

5.

How would you assess the success of consumer regulation? In what areas has it failed in stated objectives?

Answers should vary, depending on the student’s biases concerning regulation and attentiveness to the material. An important theme in assessing consumer regulation is unintended consequences. Many consumer regulations have not had the intended effect (e.g., rate ceilings).

Others appear to have been reasonably effective (e.g. truth-in-lending).

6.

Bank regulation is considered to be in the public interest. Thus, the more regulation the better.

Explain why you agree or disagree with this statement.

All regulation purports to be in the public interest. To assert categorically that more regulation is necessarily better, one must assume that (1) “the public interest” has been conclusively defined and (2) all regulations are conceived with equal deliberation and regard for likely consequences.

Too much regulation stifles innovation and competition; too little regulation may leave the public inadequately protected. Regulators are responsible for finding the balance between bank safety

and economic stability on the one hand, and an efficient banking system on the other. This is a difficult task.

7.

What is the purpose of bank examinations? How do they differ from CPA audits?

Bank examinations assess the current condition and performance of the bank, the quality of management, and if banks are in danger of failing, recommending corrective action. A CPA audit is primarily concerned with verifying the validity of the firm's financial statements according to generally acceptable accounting principles (GAAP).

8.

How do failing bank resolution policies differ between large and small banks? Why the difference?

The financial and psychological implications of a large bank failure considered far more important than those of a small bank failure. With exceptions, small bank failures are often associated with fraud or widespread losses, so liquidation is more common. Some large banks are considered “too big to fail” since their failure may cause negative consequences for the entire economy. When disposing of a failed bank, especially a large one, the FDIC prefers to maintain a going concern by turning viable assets and liabilities over to a healthy institution, avoiding both the public drama of a bank closure and a large payout from the insurance fund.

9.

Why has Congress passed more regulatory acts for financial institutions in recent years? Cite all acts passed since 1980 and the major provisions of each.

Regulation is often reactive rather than deliberative (i.e., playing “catch-up”), is generally embroiled in politics, and is seldom satisfactory to all interest groups. Exhibit 15.1 details the major depository institutions legislation of the last generation.

10.

What is moral hazard, and how is it created by deposit insurance?

Moral hazard exists whenever a decision-maker is protected from the full consequences of a bad decision. This problem is inherent in all insurance contracts. The insured faces temptation to pursue riskier behavior, knowing that the insurance will pay if losses occur. Do some bankers, knowing the FDIC will pay off depositors, take less prudent risks than they would without the insurance? Do some depositors pay less attention to the safety and soundness of their institution?

Risk-based insurance premiums help reduce risk-taking behavior without extensive added supervision.

11.

Why did bank failures increase, with a lag, after deposit insurance became available to banks?

What else contributed to the increase in bank failures in the 1980's?

The inflation of the late 1970s seduced many lenders into relying on rising market values of agricultural production, oil and gas production, and real estate as primary sources of repayment, without adequate regard for borrowers’ operating cash flows or other sources of repayment.

Expanded lending, subsidized in part by deposit insurance, financed a boom in energy and real estate but also fueled historic rates of inflation. As the Fed boosted rates decisively in the early 1980s to fight inflation, the market values of these forms of collateral collapsed, as did the profitability of the borrowers. Rising rates caught many institutions with the wrong exposure to interest rate risk, decimating any net worth not already eroded by loan losses.

12.

How can an effective lender of last resort prevent financial panics from developing? Why was the Fed unable to prevent the Great Depression of the 1930's?

General financial panics develop with a loss of confidence in future values. Everyone wants to

sell or redeem, and the concept of normal, fair market prices is lost. Knowing and (equally important) quickly demonstrating that the central bank will cover obligations of banks (who in turn are lending to cover liquidity needs) is a major deterrent to panic. The Great Depression was a worldwide stagnation of real economic activity. Its causes were economic and political. Its effects were in part monetary and financial. Whether the Fed could have prevented it cannot be known with certainty. However, the Fed could have likely mitigated it had it expanded money supply instead of contracting it. In the latest financial crisis of 2007-2009 the Fed expanded the money supply dramatically and provided support to many financial markets by purchasing shortterm and long-term assets. These measures appeared to have a calming effect on market participants.

13.

Why do banks and other financial institutions willingly comply with financial regulation, even though they may complain about it?

A business will choose the least cost or highest return path to its objectives. Regulation and deposit insurance promote public confidence in the banking system. This not only keeps cost of funds low, but keeps returns on equity high by enabling depository institutions to operate at much higher leverage than ordinary firms.

14.

How might possibilities for regulatory capture contribute to the large number of financial regulators and deposit insurance funds?

Regulators over time develop close ties with the regulated. Employees move from industry to regulator and back. Both parties soon have a vested interest in maintaining the relationship.

Regulators maintain their employment; the regulated seek favorable regulatory treatment. Each keeps close contact with legislators. Thus the creation or expansion of regulatory agencies is more common than the termination or curtailment of them.

15.

What are risk-based capital standards? What are they designed to do?

Risk-based capital standards are required minimum capital ratios expressed in terms of credit risk-weighted assets. Regulators assign higher weights to assets deemed to have higher credit risk, increasing the asset total against which capital is measured. Risk-based capital standards force banks to support higher credit risk with higher levels of capital.

16.

Why is capital adequacy more of a problem for commercial banks than for most other businesses?

Banks have relatively little equity capitalization compared to other business firms. With less of a “cushion” to absorb losses, they must pay close attention to the risk assumed in carrying each asset.

17.

Explain why bank regulators are so concerned about capital adequacy for the banking system.

Banks are both thinly capitalized and vital to the economy. Capital standards have emerged as the primary control on bank risk assumption. With the shift to a risk-weighted asset capital policy, including capital requirements for off-balance sheet liabilities, bank capital ratios have increased. Bank regulators are trying to incorporate other banking risks into the capital adequacy measure, including interest rate risk, derivative risks, liquidity, etc., and will be promulgating more sophisticated risk assessments in the wake of “Basel II”. If large numbers of banks have inadequate capital, the possibility of massive bank failure increases, risking a sharp decline in aggregate economic activity. To prevent this scenario during the 2007-2009 financial crisis, the U.S. government added capital into largest U.S. banks via mandatory preferred stock injections.

Many banks have repaid the government since. Large U.S. banks have improved their capital positions in the aftermath of the crisis, in many cases through asset sales.

CHAPTER 16 THRIFT INSTITUTIONS AND FINANCE COMPANIES CHAPTER OBJECTIVES 1. This chapter describes depository financial institutions that are not commercial banks. They are known collectively as “thrift institutions” and include savings associations (traditionally called savings and loan associations or S&Ls), savings banks, and credit unions.

2. The chapter also describes finance companies, nondepository lending institutions which are funded and regulated quite differently from depository institutions.

3. The chapter summarizes similarities and differences among these various types of nonbank lending institutions in terms of: Historical origins and purposes, Balance sheet and operational structure, Key management issues, Unique terminology, and Regulation.

CHANGES FROM THE LAST EDITION 1. This chapter was Chapter 17 in the previous edition.

2.

Time-sensitive data, exhibits, and surrounding discussions have been updated.

3. The internet exercise has been updated.

4. In Section 16.2, “Operations of Savings Institutions”, the last paragraphs of the subsection “Assets” and “Capital” have been deleted and the subsection “Income and Expenses of Savings Associations” has been revised.

5. In Section 16.3, “Credit Unions”, the subsection “Credit Union Regulators” has been shortened.

CHAPTER KEY POINTS 1. Savings banks and savings and loan associations originated in “mutual” (depositor-owned) form to pool savings and make loans among ordinary individuals overlooked or disregarded by the financial establishment of the era (particularly commercial banks). Credit unions, which remain exclusively mutual in form, united small savers and borrowers with a "common bond" of occupation, association, or residence. Compared to commercial banks, all these nonbank depository institutions rely more on savings and time deposits. Savings institutions focus more of their lending on home mortgages; credit unions concentrate more on small consumer loans. Finance companies are simply firms in the business of lending money and do not have depositors. They have existed for many years in many different forms, and provide many different types of credit.

2. Federal tax laws historically promoted a “franchise” in mortgage lending for savings associations and savings banks. They are still among the key providers of home loans. Since deregulation in the early 1980s, however, they have been free to compete more or less directly with commercial banks on both sides of the balance sheet—loans and deposits. They traditionally assumed considerable interest rate risk, using relatively short-term, fixed-rate time and savings deposits to fund relatively long-term, fixed-

rate mortgage loans. They suffered major losses in the late 1970s and early 1980s as sharply rising interest rates caught them in a negative maturity GAP with loan portfolios too reliant on collateral value over other sources of repayment. Today their lending practices are much more proactively monitored by regulators, their funding sources are much more diversified, and they commonly sell or securitize mortgage loans into secondary markets to maintain liquidity, diversify their loan portfolios, and manage interest rate risk.

3. The Federal Home Loan Bank Board (FHLBB) and FSLIC (Federal Savings and Loan Insurance Corporation) were the chief regulators of mortgage-oriented federally chartered thrifts. With the FIRRE Act of 1989, the FHLBB was superseded by the Office of Thrift Supervision, a part of the Department of the Treasury. The FSLIC was folded into the FDIC. The Resolution Trust Corporation, created under FIRRE, used mostly FDIC staff to liquidate failed thrifts. The RTC disbanded at the end of 1995, turning all unresolved cases over to the FDIC. The 12 regional Federal Home Loan Banks, which once functioned to some extent as a central banking mechanism for the thrift industry under the FHLBB, are still in place but no longer have any regulatory functions. They borrow in national capital markets and make loans, called “advances”, to savings associations in their regions. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 mandated the OTS to be merged into the Office of the Comptroller of the Currency (OCC). The OTS became part of OCC on July 21, 2011, and ceased to exist on October 19, 2011.

4. Credit unions are relatively small, not-for-profit, tax-exempt depository institutions owned entirely by member-customers who share a "common bond." Because traditional common bond definitions limited potential membership and ability to attain economies of scale, regulators have substantially relaxed common bond criteria in recent years. In many markets, credit unions have thus been the fastest growing financial institutions and have emerged as major (and unwelcome) competitors of commercial banks for deposits, consumer loans, and other banking services. Credit unions have a unique, club-like operating philosophy, oriented more toward member service than profit maximization.

5. Credit unions are regulated either by state authorities or the National Credit Union Administration and, because they rarely compete among themselves for the same customers, are encouraged to cooperate extensively for the overall sake of the industry. The NCUA oversees the National Credit Union Share Insurance Fund and the Central Liquidity Facility. The CLF is little used, however, because the major trade association (CUNA), beyond providing many types of service and training to member credit unions at low cost, has formed a network of “centrals”—credit unions of credit unions. The U.S. Central Credit Union combines aspects of a lead bank in a holding company, a correspondent, and a central bank for credit unions, channeling funds and services among member institutions. The NCUA is chiefly interested in the growth and well being of the industry, and does not have responsibilities for monetary policy or the nation's payment system. Following enactment of DIDMCA in 1980, the NCUA moved quickly to eliminate deposit rate restrictions and relax loan rate ceilings. DIDMCA also allowed credit unions to borrow from the Fed, subjected them indirectly to reserve requirements, and granted them powers essentially parallel to those of banks. Their retention of tax-exempt status despite this enhanced competitive ability is a perennial “sore spot” with commercial bankers. The antipathy of the two industries for each other is legendary, as is CUNA’s lobbying power.

6. Finance companies are unique: With the exception of "industrial banks" (which may issue savings instruments under detailed regulatory guidelines) they obtain funds "wholesale" and lend funds "retail."

Captive finance companies, such as GE Capital, finance goods sold by their parent companies.

Commercial paper, long-term debt, and bank borrowing are major sources of funds. They are highly leveraged, with capital less than 20% of assets. They lend in relatively small amounts to consumers and businesses seeking specialized lending services. They often specialize in small consumer loans, tailoring credit availability to borrower characteristics and emphasizing speed and convenience. Their costs (including loan losses) are thus higher than for depository lenders, as are the rates they charge on loans.

Because finance companies are not part of the insured-deposit banking system, safety and soundness is not a focus of their regulators. Finance company regulation centers heavily on consumer protection.

Facing rising compliance costs, some finance companies have shifted toward business lending and leasing, and toward larger, longer maturity loans for which net returns are higher, such as real estate loans, home equity lines, and other second mortgage products. On such loans, one-time loan production costs are lower relative to total finance charges. In recent years, large finance companies have formed or joined financial conglomerates, offering a wide range of financial services nationwide and hoping to obtain low-cost funds and high-quality borrowers. During the 2007-2009 financial crisis, the commercial paper market – one of the key borrowing sources for finance companies – shrank, and some finance companies had difficulties raising funds and had to cut back on their lending.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

Why were each of the U.S. thrift institutions started, and when? Why are they now greater competitors with commercial banks than they were originally?

Thrifts trace their origins to the early to mid-19th century, when they originated as associations, or clubs in “mutual” (depositor-owned) form to pool savings and make loans among ordinary individuals overlooked or disregarded by the financial establishment of the era (particularly commercial banks). Traditionally, regulators enforced sharp distinctions among depository institutions as to types of deposits allowed or prohibited, types of loans encouraged or discouraged, types of customers who could or could not be solicited, and relationships with the Federal Reserve System. Since the early 1980s, deregulation has blurred traditional distinctions among depository institutions, enabling commercial banks, credit unions, savings associations (commonly called “savings-and-loans”) and savings banks to compete more or less directly.

Some have taken more advantage of this competitive freedom than others and thus retain more of their “traditional” character than others. Many savings institutions, for example, still have large portfolios of mortgage loans because they still enjoy tax advantages for that type of lending.

2.

What were the two major types of problems that caused savings institution failures during the 1980s?

One major problem was unsound lending practices. The inflation of the late 1970s seduced many lenders into relying on rising asset values as primary sources of repayment. Thrifts were especially susceptible, as their tax treatment had historically encouraged them to emphasize real estate lending. The expansion of lending, subsidized by deposit insurance, financed a boom in energy and real estate but also fueled historic rates of inflation. As the Fed tightened monetary policy decisively in the early 1980s to fight inflation, collateral values collapsed, as did borrower wealth and income, and many loans defaulted.

The other major problem was unmanaged interest rate risk. The traditional thrift operating model involved a wide negative maturity GAP: Relatively short-term, fixed-rate deposits funded relatively long-term, fixed-rate mortgage loans. The sharply rising interest rates of the early 1980s thus decimated any of the thrift industry’s profitability and net worth not already eroded by loan losses.

Both these problems had a common root in traditional thrift management culture. For generations the industry had been conditioned to assume a more or less “guaranteed spread” between its cost of funds and its return on funds, and had enjoyed substantial insulation from competition. Most managers (and most regulators) were unprepared for deregulation or the economic forces which prompted it. A noted economist likened the abrupt deregulation of the thrift industry to “releasing family pets in the jungle”.

3.

How did regulatory weakness contribute to some of the savings institutions’ problems?

In the 1980s, regulators did not have authority, motivation, or foresight to adjust to changing economic forces. As the crisis unfolded, a new generation of regulators had to be recruited and trained. Regulatory reforms obvious in hindsight (e.g., risk-based deposit insurance and capital standards) were not adopted until the crisis was nearly over.

4.

What changes in market interest rates can hurt savings institutions? Why? What can savings institutions do to minimize their problems? Explain the kind of market interest rate changes that might help savings institutions.

Most thrifts tend to have a negative maturity GAP, which hurts earnings and net worth when interest rates rise. Ways of managing the risk inherent in this situation include variable-rate assets, shorter-term assets, longer-term liabilities (deposit and non-deposit), sale or securitization of fixed-rate assets into secondary markets, and off-balance sheet hedging techniques (swaps, financial futures, and financial futures options). When rates fall as they did in the 1990s, net interest margins improve. In mid-1992 the industry returned to profitability and by 1996 the last traces of the crisis had faded into history.

5.

What are (a) the major regulations and (b) the major regulatory bodies that affect savings institution operations? How do these regulations and regulatory bodies affect them?

Aside from tax provisions which still promote a major role for the industry in financing home ownership, savings institutions are now regulated in a manner analogous to commercial banks.

They have parallel access to and regulatory input from the Federal Reserve (reserve requirements, check clearing, holding company governance, and Fed-series regulations such as Reg Z Truth-inLending). They purchase deposit insurance from the FDIC, paying risk-based premiums. Most of them answer to the Office of the Comptroller of the Currency (OCC) within the Treasury Department. The rest of them answer to state authorities which in most cases have long since been consolidated with state banking agencies, and which enforce codes of regulations drafted largely on the OCC model. They are subject to risk-based capital standards and to the other safety and soundness regulations adopted in the 1980s and 1990s, including the “CAMELS” rating system in examinations.

6.

How have savings institutions altered their deposit and liability structures to reduce their interest rate risk exposure in recent years? Would you say they have totally eliminated their interest rate risk? Why or why not?

Savings institutions now rely on a wider variety of deposit and nondeposit sources of loanable funds, embodying a wider range of levels of interest rate sensitivity. They also make much more extensive use of duration matching, along with off-balance sheet hedges such as futures, futures options, and swaps. Depending on their interest rate forecasts, they may opt to originate and service only, selling or securitizing mortgage assets to reduce interest rate and credit risk. Fixedrate mortgages regain popularity when interest rates are low or stable. Thrifts opting to capture a share of that market must manage interest rate risk. Smaller institutions would tend to be more conservatively managed and would put more emphasis on minimizing or eliminating interest rate risk. Larger institutions, particularly those answerable for returns to shareholders of financial holding companies, would tend toward more aggressive maneuvering to capture the “upside” of interest rate risk. Thus it is unlikely that the industry as a whole would eliminate interest rate risk.

7.

How do finance companies differ from banks and thrift institutions?

Finance companies cannot issue demand deposits. They cannot issue savings instruments unless chartered as “industrial banks” under detailed regulatory guidelines. Thus they have almost nothing to do with the money supply or with safety, soundness, or public confidence in the banking system. They chiefly obtain loanable funds by borrowing from other financial institutions (particularly commercial banks), issuing commercial paper in the money markets, and issuing notes or bonds in the capital markets. As private firms which simply lend money, they are regulated more for the sake of consumer protection than for any of the other rationales associated with regulation of depository institutions. They typically underwrite higher credit risks and longer maturities than depository institutions, differentiate themselves in speed and convenience, and consequently charge higher interest rates. Even though some finance companies are very large, we do not see them on the list of largest financial institutions; they are captive finance companies – subsidiaries of large industrial corporations such as GE or Ford Motor that help finance their parent companies’ sales.

8.

Why have finance companies shifted from consumer to real estate and business lending in recent years?

Consumer protection regulations involve high compliance costs. Business loans, leases, and real estate loans offer better collateral, lower default risk, and lower production costs than consumer loans.

9.

Why have second mortgages grown in popularity with finance company consumer lenders?

Unsecured consumer loans present lenders with two major challenges: Collection practices are tightly regulated at both state and federal level, and unsecured debts are routinely canceled in bankruptcy proceedings. By contrast, second mortgages are reasonably well-secured if the lender properly ascertains the value of the mortgagor’s equity. Thus the mortgagor has more incentive to perform (less incentive to default) than an unsecured or undersecured borrower.

Should the mortgagor default or take bankruptcy, the mortgagee is in a better position than an unsecured creditor. Moreover, higher net returns are available on larger, longer maturity loans because costs of loan origination and collection are smaller relative to total finance charges. Such loans are a popular way of leveraging what, for most households, is the most significant asset: the equity in the home.

10.

What effect have growing consumer credit regulations had on finance companies' lines of business? What about their future opportunities?

Consumer protection regulations involve high compliance costs on loans which already embody a narrow margin of return over risk. Denied the opportunity to price or collect consumer loans in a manner they judge consistent with profit maximization, some finance companies have shifted toward business lending and leasing, and toward larger, longer maturity loans for which net returns are higher, such as real estate loans, home equity lines, and other second mortgage products. Large finance companies can expand and refine their opportunities by creating or joining financial holding companies or choosing particular states in which to do business. Small finance companies must choose philosophically between more regulated types of loans and less regulated types of loans.

11.

How can finance companies manage their interest rate, liquidity, and credit risks? What are their advantages or disadvantages vis-à-vis depository institutions?

Allowing for the absence of deposits from the funding mix, all lending institutions consider essentially the same set of options for managing interest rate risk: Manipulation of GAP, use of variable-rate financial instruments, sale or securitization of assets, and off-balance-sheet hedging.

Larger institutions have wider access to these options than smaller institutions. Depository institutions enjoy a number of liquidity “fixes” not available to finance companies—a lender of last resort, insurance to the providers of most of the loanable funds, and cooperative liquidity management resources such as fed funds and correspondent banking. On the other hand, liquidity is less of an issue for finance companies because they both borrow and lend at fixed maturities and do not market liquidity as a financial service to their creditors. It is relatively easy for larger finance companies to sell or securitize assets to raise liquidity. Credit risk is an unsystematic risk which can be managed through underwriting standards and portfolio diversification. Depository institutions receive a lot of “help” from regulators in managing credit risk, and cannot assume too much of it without predictable and significant consequences. Finance companies are left alone to make their own philosophical choices about credit risk, subject to such policing as creditors, shareholders, and the markets may care to do.

12.

What are the major asset and liability accounts for credit unions?

The major assets and liabilities are summarized in Exhibit16.13. Credit unions raise loanable funds chiefly by issuing share and share draft (savings and checking) accounts to their members, and employ loanable funds chiefly to make consumer loans to their members. They maintain high levels of liquidity in the form of cash reserves, government securities, and advances to other credit unions through the industry’s correspondent system.

13.

What are share drafts? Why are they important to credit unions?

A share draft is the credit union version of a check. Share draft accounts are essentially NOW accounts—interest-bearing accounts with extensive (if not practically unlimited) demand privileges. They are a major way in which credit unions compete aggressively and directly with banks: the credit union member not only earns a little interest, but usually pays no service charges because of the not-for-profit nature of the credit union—one of the main reasons banks view credit unions about as affectionately as a cobra views a mongoose.

14.

What are the advantages and disadvantages of the credit union common bond requirement?

Common bond is an advantage to credit unions because it promotes institutional loyalty, which is thought to account for their much lower loan losses compared to other lenders. It also frees credit unions from the need to compete much with each other and enables them to cooperate in competing with other depository institutions. The major disadvantage is that it can limit the potential for growth, and thus limit the potential for economies of scale. Understanding this, credit unions have lobbied successfully for relaxation of common bond criteria even as they have retained their tax-exempt status.

15.

Compare and contrast the retail operations of a commercial bank with those of a typical credit union in operation today. Taking into account the expanded powers of credit unions, how will they compare in the future?

Traditionally and for the present, banks are more thoroughly diversified on both sides of the balance sheet. They raise loanable funds through many more types of deposit and nondeposit liabilities, and they employ loanable funds to make many more types of loans. Credit unions mostly retain their focus on consumer loans funded by share and share draft (savings and checking) deposits. Since receiving expanded powers in 1980, however, credit unions have competed successfully with banks and have taken retail market share from them. This trend continues as the credit union industry grows, experiments with nontraditional financial services, and perfects its own cooperative mechanisms for adjusting liquidity. Whether banks and credit unions will be more alike or more different in the future will depend on changes in the regulation

of the financial services industry.

16.

Individual credit unions are very small in size. If there is going to be increased competition in the consumer credit market, and greater regulatory equalization among competing institutions, how do you expect credit unions to survive?

Credit unions will enlarge common bonds where feasible, and form large cooperative ventures to achieve economies of scale and offer their customers a wide range of services. The varied services offered by CUNA are an important example. The industry also deploys one of the most formidable political lobbies in the U.S. Hence it is likely that, even as credit unions compete more directly with other depository institutions in every respect, they will retain their tax exemption and other favored treatment.

17.

What is the U.S. Central Credit Union? Why is it important to the future development of the credit union industry?

The U.S. Central Credit Union, the credit union of all the central credit unions, is the nation’s only wholesale corporate credit union. The USCCU can also lend money to credit unions or their centrals, in the event they need liquidity, and it is empowered to borrow from the CLF on behalf of its members. Thus it serves the credit union industry in some respects as a central bank, in some respects as a correspondent bank, and in some respects as a “holding company lead bank”.

CHAPTER 17 INSURANCE COMPANIES AND PENSION FUNDS CHAPTER OBJECTIVES 1. This chapter examines the contractual financial institutions: Insurance companies and pension funds. Both types of institutions provide risk intermediation to consumers by allowing them to make present provisions for future financial needs.

2. The chapter describes the operations, services, and social contributions of insurance and pension entities, highlighting financial and social issues inherent in their purposes and functions.

CHANGES FROM THE LAST EDITION 1. This chapter was Chapter 18 in the previous edition.

2. All time-sensitive data, exhibits, and surrounding discussions have been updated. The first “People & Events” insert from the previous edition has been deleted. A new “People & Events” insert “The Rise, Fall, and Return of American International Group” has been added.

3. “Learning by Doing”: There are two LBD inserts, on pp.564-565 and 568.

4. There are four new end-of-chapter questions (Qs. 17-20).

5. In Section 17.3, “Life and Health Insurance”, a paragraph discussing the Patient Protection and Affordable Care Act of 2010 has been added to the subsection “Health Insurance”. In the same section, the very last paragraph has been revised.

CHAPTER KEY POINTS 1. Insurance transfers the burden of a “pure risk” to an entity that pools risk and pays compensation if loss occurs. “Pooling” means losses suffered by a small number of insureds are spread over the entire group—an insured substitutes the small average loss for the uncertainty that they might suffer a large loss.

“Pure risks” are situations with two possible outcomes, loss or no loss. Emphasize the economic benefits of insurance and how insurers determine insurance premiums. It is important to stress that insurance provides financial compensation for losses but does not prevent losses from occurring. Foreshadow the pension material by describing pensions as a special kind of insurance.

2. Various types of life insurance may correspond to insurance needs of individuals during different periods of their life cycle. For example, what insurance needs would a single college student have versus a married middle manager with a family?

3. Casualty insurance is something of a vocabulary challenge for the uninitiated. While the various types of policies should be clearly compared and contrasted, the most important theme is similarities and differences in the operating characteristics of life insurers and casualty insurers. These are readily evident in their balance sheets. Emphasize that life insurers have more predictable cash outflows and can thus invest more for total return and less for liquidity.

4. Key pension concepts include: (a) insured versus noninsured pension funds, (b) fully funded versus nonfunded or unfunded pension plans, (c) vested versus nonvested pension plans, (d) defined benefit versus defined contribution pension plans, and (e) portability of benefits. An important theme is portfolio

management—types of investments and the reasons for selecting them. The ongoing political debate over reform of the Social Security System may offer an opportunity for class discussion of several major issues affecting the economy and financial system.

5. In the context of a course in financial markets and institutions, the importance of insurance companies and pension funds as major primary market suppliers of long-term capital cannot be over-emphasized.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

Throughout this chapter, the role of insurance companies and pension funds as financial intermediaries was stressed. Discuss the financial intermediation process as it applies to insurance companies and pension funds.

Insurance companies and pension funds are capital market intermediaries, financing real capital investment through investment in mortgages, bonds, and stocks. The deficit units are the businesses and governments issuing these securities; the surplus units are buyers of insurance and participants in pension plans. Key intermediation services provided by contractual institutions include denomination intermediation and credit risk diversification.

2.

What is the difference between pure risk and speculative risk? Provide an example of each of these types of risk.

“Pure risks” are situations with two possible outcomes, loss or no loss In the case of fire insurance, for example, a fire either occurs or not. There is no opportunity for gain; only loss.

Insurance indemnifies or "makes whole again" in case of losses. Speculative risk is associated with the variability of returns around an expected return, as in investments or wagers. Insurance companies pool the pure risk of insureds: each insured submits to a small average planned loss now (the premium) in order to avoid the financial cost of a large individual unplanned loss later.

The larger the risk pool and the more measurable the chance of loss, the better the system works.

3.

According to the law of large numbers, as the number of insureds increases, risk is reduced.

However, as an insurance company writes more policies, it exposes itself to the potential for greater insured losses, which is riskier. Explain this apparent contradiction.

The Law of Large Numbers provides that, as the number of insured risks increases, deviation between actual and expected losses declines. By analogy, as a coin is tossed repeatedly, the actual distribution of heads and tails more closely approaches the expected distribution of 50%.

The net outcome of 10 or 20 tosses is more predictable than that of 3 or 4. A life insurer cannot predict when any particular one of its 50-year-old nonsmoking male policyholders will die, but if it has 10,000 such policyholders it can predict with reasonable certainty the year in which perhaps 80% of them will die. Armed with the predictability of an event, the insurer decides whether and on what terms it can prudently cover the event. The rest of the problem is thus a matter of underwriting—selecting and classifying insurable risks, rejecting uninsurable risks, and charging an appropriate premium based on the risk profile of an insured. Thus a 30-year-old in good health can buy life insurance cheaply, but an 80-year-old probably cannot buy it at any price.

4.

To what extent do (1) the risk of unemployment and (2) the risk of war satisfy the requirements of privately insurable risks?

The U.S. economy is sufficiently diverse that the risk of unemployment distributes insurably. As

the principle of pure risk would dictate, however, unemployment insurance normally covers workers who are laid off for economic reasons, not workers who quit or are terminated for cause.

War, insurrection, riots, and exercise of police power are traditional exclusions from coverage in insurance policies, although special coverage may be obtained for such risks at high and individually negotiated cost, as when Lloyds of London insures ships and cargos moving through unstable areas of the world.

5.

What problem is likely to develop for a stock life insurance company that issues participating policies?

Under the mutual form of organization, insurance companies collected above average premiums and “paid” a dividend (return of premium) if occurrences were low. A participating policy issued by a stock company is similar to a preferred stock issue, where the “preferred” or contractual “participating” insured will expect a share of the underwriting profits before common dividends are paid. Stock companies are likely to issue fixed premium policies.

6.

What are the primary sources of insurance regulation? What areas are regulated?

Insurance regulation follows the same general theme as all financial intermediaries: (1) assure safety and soundness and availability of coverage for insureds, (2) provide for a high level of competitiveness, and (3) protect consumers from asymmetric information (disclosure and remedies). Insurance companies are almost entirely regulated by the states in which they sell insurance. Some degree of uniformity in state regulation is promoted through the National Association of Insurance Commissioners. The SEC regulates “equity-related” contracts and some federal regulation comes into play on issues of consumer protection and fair competition.

Insurance claims are often the subject matter of litigation, so federal and state judicial precedents are also important sources of regulation for insurance.

7.

What is meant by the phrase “adverse selection” in insurance? Although discussed in this chapter in connection with term insurance, adverse selection is a problem in all insurance markets. What is the adverse selection risk for insurers marketing life annuities?

Those most expectant of a loss are more likely to seek insurance for that loss, and may even conceal the full truth about their risk profile in order to obtain insurance. Insurance companies deal with adverse selection through thorough underwriting practices, sophisticated pricing models, and systematic claims investigation. Exclusion of preexisting conditions from health insurance is a familiar example of a way of managing adverse selection risk. The adverse selection risk for life annuities would, ironically, be the risk of what actuaries call “superannuation”. The annuitant might live (and collect annuity payments) much longer than the insurer expects. Someone in excellent health with a family history of longevity and a low-risk lifestyle would be more interested in a life annuity than someone who did not expect to live long.

8.

Term insurance becomes cost prohibitive for older individuals. However, the same insurance companies that do not offer term policies at advanced ages sell whole life insurance. How are these insurers able to offer life insurance for all of life under whole life insurance but not under term insurance?

Whole life policies, especially ones that include a significant lump sum deposit of cash value, provide opportunities for investment income to offset or subsidize the significant mortality risk of advanced age. Insurance companies are not charitable institutions in any sense.

9.

Why did universal life insurance become popular in the 1980s? What explains the popularity of

variable life insurance in the 1990s?

Universal life is another name for whole life insurance, which includes two separate financial services: life insurance and savings. In the high interest rate environment of the early 1980s, many insured opted for universal life policies whose savings components are tied to market interest rate. Later, after interest rates went down, ambiguity about the cost of the insurance component and the return on the savings component convinced most people to “buy term and invest the difference”. Variable life became popular when the equity markets were providing double-digit returns in the late 1990s.

10.

Why are annuities and life insurance often described as opposites? If they are opposites, when why do insurance companies marketing life insurance also commonly market life annuities?

Life insurance provides economic protection for early death; annuities provide protection against late death—living beyond one’s assets. The life insurance policy pays beneficiaries upon the death of the insured. A life annuity pays income for the life of the annuitant. Both involve actuarial science, development of accurate mortality tables to price contracts based on life expectancy, and management of assets to provide payments in the remote future. Thus an insurer who has done the necessary work to offer life insurance profitably has done the necessary work to offer annuities, and can achieve economies of scope in offering both.

11.

What is the relationship between the level of policy loans taken by policy owners and the level of interest rates in the general economy?

Policy loan levels vary directly with the level of interest rates. As interest rates rise, policy loans, which traditionally have had relatively low interest rates, increase.

12.

Why is the liability risk much more difficult to gauge than the property risk?

Liability is often established in litigation or in settlement in lieu of litigation. Consequently, the assessment or stipulation of damages may occur long after the loss event, and the amount of damages assessed or stipulated may reflect several factors more behavioral and less predictable than the economic value of the loss or the merits of the case. A defendant may agree to a high settlement to avoid admitting liability on the record, or to avoid the stress and distraction of a long legal proceeding. A jury may award excessive damages out of sympathy for a plaintiff, antipathy toward a defendant, or inability to understand the case. One state’s law may treat a particular cause of action differently than another’s. One county’s judges may be more sympathetic to plaintiffs—or more politically beholden to plaintiffs’ lawyers—than another’s.

By contrast, property risks such as fire or theft can be more systematically estimated from past occurrences and losses can be measured quickly.

13.

What are the advantages of purchasing a package policy versus purchasing the same coverage included in a package policy separately?

Package policies such as auto, home, and umbrella liability are cheaper to underwrite as diversified collections of risks. High losses on autos may be offset by low losses on homeowner’s policies, stabilizing premium income. Low risk customers are likely to be low risk in all areas of insurance.

14.

What are the major similarities between the balance sheets of life insurance companies and property and liability insurance companies? What are the major differences?

The long-term and relatively predictable nature of life insurance liabilities (unearned premium reserves, cash value reserves, loss reserves, and pension reserves) enables LICs to commit a significant proportion of assets to long-term, less marketable, capital market securities. LICs are a major institutional investor in corporate bonds, and common stock has become an increasing part of their portfolios. LICs are able to deduct the cash value premium contribution for tax purposes, thus lowering their tax exposure and enabling them to invest profitably in taxable securities. P/L companies usually have more uncertainty about future payouts and must pay more attention to liquidity and inflation-adjusted positive investment returns. Investment in securities for which there is a ready market (liquidity), investment for tax sheltering (municipal bonds and preferred stock), and a need for investment returns to cover replacement cost increases are the major portfolio concerns for P/L companies.

15.

How are Social Security old-age benefits funded? What is the age for full retirement benefits for those retiring under Social Security today? What is the age under current law for full retirement benefits when someone who is 20 years old today retires?

The federal government levies a payroll tax. The proceeds are deposited in the “Social Security Trust Fund”, which purchases special nonmarketable Treasury securities—i.e., the intake of the Social Security System is immediately lent to the U.S. Treasury, which in turn pays monthly social security benefits out as general expenditures. Money is of course fungible, so the excess of payroll tax receipts over benefits funds other current federal budget outlays. Thus the “trust fund” is a mere accounting artifice, and not an especially clever one. Imagine a private sector company taking its employees’ pension contributions and investing them exclusively in its own commercial paper! If one grants the premise of social insurance, this system worked well—or at least attracted no attention—when 15 or 20 workers paid in for every retiree drawing benefits. As birth rates have declined and life expectancies have lengthened, however, the proportion of contributors to beneficiaries has dropped steadily. Under current social security regulations, individuals retiring today at age 62 or 65 receive less than the 80% or 100% benefits or must wait months beyond 62 or 65 to receive 80% or 100% of plan benefits. For today’s 20-year old, current law requires that he/she work or wait until age 67 for 100% of benefits; 70% at age 62. It is likely that the age will continue to increase, or benefits decrease, or the payroll tax increase in the future.

16.

Differentiate between defined benefit and defined contribution pension plans. Who bears the investment risk under each of these alternatives? Which type of plan is easier to fund and manage?

Traditional defined benefit plans, originally negotiated in labor agreements and later extended to white-collar workers, place the burden of investment risk on the employer, who is responsible for benefits defined by some formula based on the worker’s years of service and average pay. These arrangements worked well when workers stayed with the same company for 25 or 30 years.

Today, most defined-benefit pension arrangements are government- or union-sponsored. Modern defined contribution plans (e.g. 401k plans) shift the investment risk to the worker. Contributions are defined as fixed amounts or some percentage of salary, and the worker decides how they are invested.

17.

An insurance company’s total assets were $400 million. Its total liabilities were $340 million.

What was the insured policyholder surplus?

Surplus = Total Assets – Total Liabilities = $60 million

18.

Assume it was determined that the insurer in Question 17 had overestimated its loss reserves by $20 million. If the loss reserve estimate was corrected, what is the impact on policyholders’ surplus?

Total liabilities were overstated by $20 million. After reducing total liabilities to $320 million, the policyholder surplus increases to $80 million.

19.

Granite Insurance Company had claims and expenses of $425 million last year. The company’s premium income was $450 million. What was the company’s combined ratio?

The combined ratio is the ratio of claims and expenses to premium income. This ratio is $425 million by $450 million, or 0.9444. The ratio indicates the company made money underwriting risks.

20.

Granite Insurance Company’s combined ratio two years ago was 1.035. A review of that year’s financial statements showed the company paid $4.5 million in income taxes. Why was the company required to pay income taxes when its underwriting activities produced a loss?

While the insurer lost money underwriting risk, it made more money from its investments than it lost underwriting risk, thus creating taxable profit.

CHAPTER 18 INVESTMENT BANKING CHAPTER OBJECTIVES 1. To explain core business activities of investment banking both in primary and secondary markets.

2. Discuss how the Glass-Steagall Act of 1933 and the Gramm-Leach-Bliley Act of 1999 influenced commercial and investment banking in the U.S. 3. Describe the role of private equity and explain why it is important to economic growth.

CHANGES FROM THE LAST EDITION 1. This chapter was Chapter 19 in the previous edition.

2. The chapter preview has been revised.

3. Time-sensitive data, exhibits, and surrounding discussions have been updated. Both “People & Events” inserts from the previous edition have been deleted; a new “People & Events” insert has been added. Exhibit 18.2 is new to this edition.

4. Learning Objectives: LO 4 is new, LO 5 was LO 4 in the previous edition, LO 6 is a revised LO 5 from the previous edition.

5. “Learning by Doing”: There is one LBD insert on pp. 599-600.

6. The second set of “Do You Understand?” questions has been revised.

7. End-of-chapter questions: old Qs. 1, 3, 6-8, and 10 have been deleted, new Qs. 3, 4, and 6-11 added. Qs. 1, 2, and 12 were Qs. 2, 4, and 9, respectively, in the previous edition. The Internet exercise has been revised.

8. Exhibit 18.1 has been revised to measure the size of investment banks based on the amount of fees earned rather than on the number and volume of underwritten offerings.

9.

Changes to Section 18.2, “Primary Services of an Investment Bank”: - The beginning of the section has been revised. It refers to the new exhibit, 18.2; - Private placements and mergers & acquisitions, which were discussed in separate subsections, are now part of the subsection “Bringing New Securities to Market”; - The subsections “Trading and Principal Investments” and “Asset Management and Securities Services” represent a revised subsection “Trading and Brokerage” from the previous edition. The former subsection discusses proprietary trading of investment banks.

10. The section “Venture Capital” has been replaced with Section 18.3, “Private Equity”, which covers two categories of private equity: venture capital and buyout private equity.

CHAPTER KEY POINTS 1. Two financial organizations that work in the background of finance are analyzed in this chapter.

Investment banks serve the money and capital market in a variety of ways, but underwriting is their most

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important economic function. Working in the primary market, investment banks buy the securities from governments and corporations and sell them into the market, providing financing and investment opportunities. Private equity funds provide necessary early stage financing for new technology, ideas, and entrepreneurs (venture capital) or for making publicly traded companies private.

2. Investment banks function in the direct, primary market, originating, underwriting, and selling new direct security issues. Most new securities sold in the primary markets are underpriced to ensure a quick sale. The broker-dealer function is a secondary market function and is also an important source of revenue for many investment banks. Stress the functions performed rather than companies that perform the services.

3. Many investment banking houses are part of financial conglomerates that have evolved for a variety of reasons: a desire for low-cost funding, a need to assist customers with credit as products of the firm are sold, profit opportunities in the financial services area, a desire to serve their present customers with a full range of financial services, achieving economies of scope. Acquisitions has been the favorite strategy of financial conglomerates. In an attempt to build shareholder value various subsidiaries and divisions are bought, sold, or spun off very quickly. The merger of Citicorp, Travelers Insurance, and Salomon Brothers into Citigroup provided the momentum for Congress to pass the Financial Services Modernization Act of 1999. This law provided a legal means for combining investment banking, commercial banking, and insurance underwriting.

4. The chapter examines one of the most significant finance issues of the last seventy years: the GlassSteagall controversy. Should commercial banks be permitted to return to unlimited investment banking and investment services? If investment and commercial banks are kept apart by law, will either be competitive with the universal banks of the world? The Financial Services Modernization Act of 1999 finally, and officially, resolved the issue. The financial crisis of 2007-2009 claimed the five largest independent U.S. investment banks. Discussing the reasons for investment bank struggles during the crisis may be a good way to engage students.

5. Venture capital investments provide the early stage financing for new ideas, inventions, and entrepreneurial dreams. Review the stages of firm development and financing needs where venture capital financing is needed. Buyout private equity firms purchase public corporations and make them private. Buyout deals are larger because they usually are for more mature, bigger firms.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

What are the major business activities of investment banks?

The major services include: a) bringing new securities to market, b) trading and brokerage in the secondary market, and c) asset management and securities services.

2.

Explain why underwriting new securities issues can be a risky business.

In a full underwriting, the investment banker commits to pay a specific price to the business or government and bears inventory risk until the securities are sold in the market. Competition keeps the margins (spread) thin, and the capital ratios of investment banking firms are rather low, so any rapid decline in the market price during the selling period would cause significant losses and possible insolvency.

3.

Explain each of the following parts of bringing a new issue to market: origination, underwriting,

2

and distribution.

At the origination stage, the investment bank analyzes the feasibility of the project for the client, determines the amount of money to raise, decides on types of financing needed, designs the securities, and advises the client on the best sale date. For publicly sold securities, it also helps prepare the SEC registration statement, including the preliminary prospectus that contains details about the issue.

At the underwriting stage, the investment bank guarantees to buy the new securities from the issuer at a fixed price. It hopes to sell them for more than it purchased them for but bears the risk of selling them for less.

At the distribution stage, the investment bank attempts to resell the securities to retail and institutional investors as quickly as possible at the offering price.

4.

Explain why there were no large independent investment banks left in the United States at the end of 2008.

During the financial crisis in 2008, two of the five largest independent investment banks were purchased by commercial banks (Bear Sterns was purchased by JP Morgan Chase and Merrill Lynch was purchased by Bank of America), one went bankrupt (Lehman Brothers), and two converted to bank holding companies (Goldman Sachs and Morgan Stanley).

5.

How does a private placement differ from a public offering?

In a traditional private placement, the banking firm serves as a go-between (broker) and earns a finder's fee, and other origination fees. Inventory or dealer risk is not present as it is in an underwriting agreement. The expenses of a public distribution of securities are avoided, and the investor becomes directly involved in the security contract terms and becomes a major participant in the less liquid investment.

6.

What is the difference between an IPO and a seasoned offering?

An IPO is the first offering of securities to the public markets. A seasoned offering is an additional issue of securities that have already traded in the public markets.

7.

What does a broker-dealer do? How does a broker-dealer make money?

In brokerage, firms earn a commission for bringing buyers and sellers together, while dealers carry inventory of securities from which it executes buy and sell orders and trades for its own account. Dealers are said to make markets for securities.

8.

What is proprietary trading?

Proprietary trading refers to the investment bank using its own capital to make investment bets or engage in arbitrage activities.

9.

What is prime brokerage?

Prime brokerage is a package of services (which include lending money and securities) provided by an investment bank to hedge funds and other professional investors.

10.

How does private equity differ from public equity?

3

Both represent ownership of a company. Unlike public equity, private equity does not trade on public stock markets such as NASDAQ or NYSE. 11.

What are the two primary categories of private equity? How do they differ?

They are venture capital and buyout private equity. Venture capital funds finance new firms, most often with the ultimate goal to take them public. In contrast, buyout private equity funds purchase public companies to take them private again, either with cash raised by investors or with borrowed funds, in which case it’s referred to as a leveraged buyout.

12.

Assume a venture capitalist requires a 40% rate of return per year. If the venture capitalist thinks that a company will be worth $50 million in five years, what percentage of ownership in the company will the venture capitalist require today in exchange for a $3 million investment?

An investment of $3 million at 40% for five years would be $3(1.40)5 = $16.135 million or a $16.135/$50 = 32.2% share of ownership.

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CHAPTER 19 INVESTMENT COMPANIES CHAPTER OBJECTIVES 1. To distinguish among, describe, and analyze open-end mutual funds, closed-end funds, and exchange-traded funds.

2. To discuss other types of investment companies, such as unit investment trusts, hedge funds, and REITs.

CHANGES FROM THE LAST EDITION 1. This chapter was Chapter 20 in the previous edition.

2. Data, exhibits, and surrounding discussions have been updated. Old Exhibits 20.2 and 20.8 have been deleted. Exhibits 19.5, 19.7, and 19.10 are new to this edition. Exhibits 19.1, 19.2, 19.3, 19.6, 19.8, 19.9, 19.11, and 19.13 are updated Exhibits 20.5, 20.6, 20.7, 20.1, 20.3, 20.4, 20.9, and 20.12; Exhibits 19.4 and 19.11are revised Exhibits 20.10 and 20.11 from the previous edition.

Both “People & Events” inserts have been replaced by new ones.

3. Learning Objectives 1-5 have been revised.

4. “Learning by Doing”: There is one LBD insert on pp. 607-608.

5. “Do You Understand?” questions: In the first set, Q.1 has been revised; the last set of DYU questions has been deleted.

6. End-of-chapter questions: old Qs.8 and 9 have been deleted and new Qs. 8 and 11 added; Qs. 9 and 10 were Qs. 10 and 11, respectively, in the previous edition. The internet exercise has been revised.

7.

Section 19.1, “Investment Companies”, now plays a role of an introduction and does not have subsections on different types of investment companies. The material previously covered in the (deleted) subsection “Regulation and Taxation of Investment Companies” has been moved to this introductory section. Exhibit 19.1 provides a starting point for the discussion of types of investment companies.

8. Section 19.2 provides coverage of open-end mutual funds, which are now covered before all other types of investment companies. Money market funds are now covered in this section. Closed-end funds and ETFs are now covered in the separate sections devoted to them, 19.3 and 19.4. Unit investment trusts are now covered in the section on ETFs. 9. Most sections have undergone significant revisions. Some subsections have been deleted and others added. Most of the revisions relate to changes in the order of coverage, while the chapter content remains about the same it was in the previous edition.

CHAPTER KEY POINTS 1. Investment funds provide cost reduction and diversification benefits for the investing public. As tax and economic conditions have changed, fund managers have brought forth a variety of funds to serve the investing public. This chapter discusses the basic attributes of different types of investment companies and traces their recent developments. The chapter also reviews hedge funds and real estate investment

1

trusts, which are technically not investment companies.

2. Investment companies, dominated by mutual funds, have been the primary means for individuals’ defined contribution pension plans in the last two decades. Here we will study the terms, types of funds, fees, and valuation of funds.

3. Make sure that your students differentiate among open-end mutual funds, closed-end funds, and ETFs. Emphasize the role of money market mutual funds. Discuss how and why MMMFs emerged and how their emergence influenced commercial banks and bank regulation.

4. Money market mutual funds invest in safe and liquid short-term debt but they are not risk-free. They compete with government-insured bank deposits, such as money market deposit accounts (MMDAs).

5. Mutual funds (including money market funds) accounted for over 90% of investment companies’ assets under management in 2009, but ETFs has been the fastest-growing category since the mid1990s.Technology and competition have made ETFs popular.

6. Differentiate hedge funds from mutual funds.

7. Discuss the operations of REITs.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

How can the pricing of closed-end funds possibly indicate that market inefficiencies exist? What are the pros and cons of that argument? If market inefficiencies exist, how can they be exploited to make money? Explain, and think of any possible problems that might occur.

The price per share of a closed-end fund is often below the NAV per share. With little or no inefficiencies, the price per share should equal the NAV. Alas, there are factors associated with the fund manager performance, operating efficiencies, unrealized taxes, etc. that provide “real value discount” arguments. Most pricing differential would have been “closed” by hedge fund investors. Since the discount persists, real discount factors must exist.

2.

What type of fund would you want to buy if you believed that stock markets were always fully and completely efficient? Explain why. Why do you think people don’t all buy the same kinds of funds?

If the market were efficient, no one mutual fund, and its fund manager, could beat the market over the long term. In that case, buy the market portfolio via an index fund, which should also have low trading expenses. Keep the expenses down and buy the market.

People buy different funds because they may want exposure to different asset classes or sectors, have different expectations about future performance of different investment classes or different mutual funds, as well as because they may not be aware of all of the alternatives.

3.

If you invested $10,000 in a mutual fund that charged a 1 percent of net assets management advisory fee and a 1 percent 12b-1 fee, and the fund matched the stock market’s return of 10 percent per year for 10 years, who much would your shares in the fund be worth at the end of that time (assuming no taxes, all income net of fees was reinvested at year end, and that all fund charges were levied at the end of the year)?

2

With Fees: Assuming the one percent advisory fee and 12b-1 fee were taken one at a time, Value at the end of the first year (pre-expenses) = $10,000 (1.10)1 = $11,000 Value at the end of the first year (post-expenses) = $11,000(0.99)(0.99) = $10,781.11.

At the end of the tenth year one will have accumulated: $10,000(1.10)10(0.99)10(0.99)10 = $21,214.40, Without fees 4.

➢

($10,000 (1.10)10 = $25,937.42.

If you invested $10,000 in a closed-end fund that invested in stocks that matched the market return of 10 percent for 10 years, levied a management fee of 2 percent of net assets per year, and sold at a 15 percent discount to its NAV both when your bought it and when you sold it ten years later, how much would you have at the end of the time (assuming no taxes, all income was reinvested, and that all fund charges were levied at the end of each year)?

If the $10,000 invested were 85% of the NAV (representing a 15% discount), the NAV at the beginning was $10,000/0.85 = $11,764.71.

Invested at 10%, fees taken at the end of the year, the NAV at the end of 1 year is: $11,764.71(1.10) (0.98) =$12,682.36 Invested at 10%, fees taken at the end of the year, the NAV at the end of 10 years is: $11,764.71(1.10)10(0.98)10 = $24,932.66 If discounted 15%, the selling price would be $24,832.66*0.85 = $21,192.76.

5.

If you invested $10,000 in an index fund that matched the market return of 10 percent per year for ten years, and levied a 0.25 percent management fee and no other fees, how much would you have at the end of the ten years (assuming no taxes, all income was reinvested, and that all fund charges were levied at the end of each year)?

Invested at 10%, fees taken at the end of the year, the NAV at the end of 10 years is: $10,000(1.10)10(1 – 0.0025)10 = $25,296.24 The quarter of one percent has a small impact on the investment value over time. The final value of $25,296.24 is not far under the $25,937.42 found by compounding $10,000 at 10 percent for 10 years. Keep the expenses down and earn the market rate of return.

6.

(a) If you earned 3 percent per year in a tax-free money market fund and you were in the 31 percent federal income tax bracket and were fortunate enough to live in a state that had no state income tax, what interest rate would you have to earn in a taxable money market fund or bank account to be equally well off? (b) What if your state had a 6 percent income tax but did not levy it on interest earned on municipal security obligations issued in your state – which were the only type of securities that your tax-exempt fund bought? (a) The tax-equivalent rate on a 3% tax-free MMMF, with a 31% marginal tax bracket is 3%/(1 0.31) = 4.35% pre-tax equivalent return. (b) The fully taxable equivalent rate with a 6% state income tax would be 3%/(1 - 0.31 - 0.06) = 4.76% fully taxable equivalent rate. If the fund invested only in the municipal bonds issued

3

by your state, then you would disregard the 6% state income tax rate when comparing your fund return to returns on taxable money market funds or bank accounts.

7.

What is the major difference between open-end and closed-end investment companies? Why have open-end companies been more popular?

Open-end companies are always ready to buy back or sell more shares at their present asset value.

Closed-end companies issue shares and let the market determine their value. Open-end funds are more popular because their value is more certain to be related to the value of the fund's assets.

Further, they provide greater assurance that their value can be realized when desired by standing ready to redeem shares at NAV. Finally, because open-end funds issue and retire shares when they have net inflows or redemptions, it is easy to make regular contributions or withdrawals to and from the fund.

8.

Why have ETFs grown so popular so quickly? What advantages do ETFs have over open-end index funds?

First, ETF shares can be purchased and sold throughout the trading day, just like any other publicly traded stock. Open-end mutual fund shares, on the other hand, can only be bought or redeemed at the day’s closing NAV. Second, when a mutual fund’s redemption requests exceed new share purchases by investors, the fund is likely to sell some of its holdings, with realized capital gains/losses passed on to the fund shareholders. ETFs rarely sell securities; instead they trade one set of securities for another (i.e., an authorized investor receives the underlying securities in exchange for ETF shares).

Third, ETFs can be sold short and have tradable options available. If, for example, you believe that the price of oil will fall, you may sell short shares of an ETF that traces the price of oil, such as United States Oil Fund (the ticker is USO) or buy put options on this ETF.

9.

Why are money market funds included in the broader measures of the money supply (M2 and M3) that the Federal Reserve introduced in 1980?

Because money can be withdrawn from MMFs by check and all are available with, at most, one day's notice. Thus, they provide a highly liquid source of assets for the public.

10.

Give examples from this chapter to illustrate how different forms of financial institutions may either grow rapidly or decline as economic and regulatory conditions change.

REITs grew rapidly after receiving favorable tax treatment but too many took excessive risks that caused them to decline when interest rates rose sharply and new construction declined during the "credit crunch" of 1973 to 1974. In 1980s and 1990s REITs thrived due to favorable regulatory environment and economic conditions.

The MMMFs grew rapidly in the late 1970s as interest rates rose above rate ceilings imposed by regulators on financial institutions deposits. However, when rate ceilings were relaxed with the introduction of bank money market deposit accounts in December 1982 and Super NOW accounts in January 1983, MMMFs quickly lost one-fourth of their assets and had to develop new strategies to retain the rest.

Competition between stock exchanges and mutual fund families resurrected the exchange-traded fund which, with technological developments in computing, provides economical investing.

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11.

Explain how a hedge fund differs from a mutual fund.

Most hedge funds’ investment strategies focus on relative performance of assets or asset classes; market risk is often removed by taking short positions in one asset or asset class and long positions in another.

Hedge funds are not technically considered investment companies and are available only to accredited investors – wealthy individuals or large financial institutions. A hedge fund cannot have more than 100 or 499 investors, depending on the type of an exemption it uses to avoid registering as an investment company.

Hedge funds do not have to report their performance and have high management fees (e.g., 2% of assets under management plus 20% of profits is a common arrangement). While the Dodd-Frank Act of 2010 required hedge funds with more than $150 million in assets under management to register with the SEC, hedge funds still enjoy much more privacy about their asset holdings and transactions (at least until further regulation changes).

12.

What is a REIT? How did REITs perform during the most recent U.S. real estate bubble and crash?

A real estate investment trust is similar to a closed-end investment company that invests funds, raised by selling small denomination shares, in a variety of real estate investments, including direct ownership or leasing of real estate, acquisition of mortgages, real estate development financing, and other real estate investment activities. The market capitalization of U.S. REITs grew from $9 billion to $438 billion from 1990 to 2006, but declined to $271 billion in 2009 due to the housing bubble burst. Thus, most REITs performed poorly during the crisis.

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CHAPTER 20 RISK MANAGEMENT IN FINANCIAL INSTITUTIONS CHAPTER OBJECTIVE 1. The chapter describes bank management strategy in terms of tradeoffs between safety (solvency and liquidity) and profitability.

2. The chapter summarizes the ways in which banks either choose or are compelled to manage liquidity, credit risk, and interest rate risk. A recurring theme is the different choices available to small banks and large banks.

CHANGES FROM THE LAST EDITION 1. Most of the material covered in this chapter was covered in Ch.14 in the previous edition, “Bank Management and Profitability”, which is no longer in the text. The changes outlined hereby are relative to Ch.14 in the previous edition.

2. Since this chapter is about financial institutions in general, discussions and questions have been rewritten to relate to all financial institutions rather than commercial banks where appropriate.

3. Exhibits 20.1, 20.2, and 20.3-20.8 were Exhibits 14.6, 14.7, and 14.11-14.16, respectively, in the previous edition. The second “People & Events” exhibit has been replaced.

4. Learning Objectives: LOs 1 and 2 have been deleted because the corresponding material has been moved to other chapters. The remaining LOs have been revised to relate to all financial institutions rather than commercial banks.

5. “Learning by Doing”: There is one LBD insert at the very end of the chapter.

6. “Do You Understand?” questions: in the second set, Qs.1-3 have been replaced with new ones and Q.5 revised.

7. End-of-chapter questions: old Qs.1, 2, 8, 11, 16, and 17 have been deleted and new Qs. 7-9, 11, and 13 added. Qs. 1-5, 6, and 14-16 were Qs. 3-7, 9, and 13-15, respectively, in the previous edition. The internet exercise has been revised.

8. The sections “Bank Earnings” and “Bank Performance” have been moved to Ch. 13, “Commercial Bank Operations”, and the section “Bank Capital Management” has been moved to Ch.15, “Regulation of Financial Institutions”.

CHAPTER KEY POINTS 1. Bank management must balance profitability, liquidity, and solvency to satisfy each of 3 constituencies: shareholders, depositors, and regulators. This dilemma is the central theme of bank management. Each risk managed by banks has material implications for each constituency.

2. Liquidity management is essentially a constraint optimization exercise. Analyze liquidity from a sources and uses perspective, implicating both sides of the balance sheet. On the asset side, primary reserves are highly liquid but earn little, while various loan and investment categories have less liquidity.

Liability management does not supersede asset management and is more a tool of large banks that have direct access to the money markets. You may discuss how banks grew reluctant to lend to each other during the latest financial crisis, and even large banks started hoarding cash (asset management – primary reserves) rather than relied on money market borrowings (liability management).

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4. Credit risk is both a transactional issue and a portfolio issue to financial institutions. Credit risk may be effectively managed through prudent loan approval practices, systematic identification of problem loans, adequate loan loss reserves, portfolio diversification (both industrial and geographical), loan sales, or use of credit derivatives.

5. Financial institutions must measure and manage interest rate risk. When maturities or cash flows are “gapped”, changes in market interest rates affect the cash flow, earnings, and equity value of the bank.

Matching maturities alone does not hedge the bank: Most assets and liabilities have varied cash flow patterns. Matching durations, while operationally difficult, is a better way to manage interest rate risk.

Students should not confuse maturity GAP with duration GAP and should, in fact, understand their “opposite sign” relationship: A positive maturity gap sets up the same exposure to a given change in rates as a negative duration gap, and vice versa. The depth of coverage to give the various hedging techniques depends on whether Chapter 11 has, been covered before this chapter. VAR is a technique that measures a loss potential up to a certain probability.

ANSWERS TO END-OF-CHAPTER QUESTIONS 1.

Explain the profitability versus solvency and liquidity dilemma facing bank management.

Because of banks' large proportion of short-term liabilities and low equity capitalization, banks are more subject to failure than other businesses. Too many liquid assets mean high safety but low profitability. Too many risky loans or investments may mean higher profit because of higher expected yield; but higher than expected losses can cause bank failure because of low equity capitalization.

2.

What are the two ways a bank can fail? Explain how these two conditions cause failure. Give examples of times when we have had the two different types of failures.

First, a bank can become insolvent by suffering losses on its loans or investments (credit risk or interest rate risk), depleting its capital. Second, a bank can be a profitable but become illiquid— unable to meet the cash demands of depositors or borrowers (liquidity risk). Many bank failures of the early 1930s were liquidity-based: Depositors lost confidence in the banking system and appeared in large numbers to withdraw funds. Most of the bank failures of the 1980s and 2000s were insolvency-based: Loan and investment losses quickly absorbed banks’ thin equity capital.

3.

Liquidity management can be practiced on either side of the balance sheet. How are asset and liability management similar and how do they differ? Why do smaller banks have limited access to liability management?

The goal of either technique is the minimum liquidity that will keep the bank operational and compliant with regulations. Asset management emphasizes differing liquidity characteristics of various bank assets. Liability management emphasizes the money market as a tool for borrowing liquidity as needed. Large banks are more able to consider liability management because they may tap the money market more easily.

4.

Discuss the debt instruments used in liability management. What are the common characteristics of these debt instruments and what type of bank is most likely to issue them?

The debt instruments commonly used in liability management are: (a) negotiable CDs, (b) federal funds, (c) repurchase agreements, and (d) Eurodollar deposits. These instruments are all short-term, large-denomination money market instruments with highly rate-sensitive investor

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constituencies. Accordingly, a large bank is more likely to use them.

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6.

How do banks decide on the proper amount of primary and secondary reserves to hold?

The decision is a function of (a) deposit variability, (b) availability and cost other sources of liquidity (e.g., federal funds), (c) bank regulations, and (d) risk posture of the bank's management.

Liquidity management is essentially a constraint-optimization exercise in which the bank seeks the minimum liquidity consistent with operational stability and regulatory compliance.

Assume you are the manager of a bank with the balance sheet as shown below. Determine the maturity GAP and duration GAP for the bank. What will happen to the value or net income for the bank if interest rates go up or down?

Maturity GAP = RSA –RSL = ($55M - $15M) = +$40M = +50% Duration GAP = DA – (MVL/MVA)(DL) DA = (15mln.*0 + 30mln.*0.35 + 5mln.*5 + 25mln.*0.5 + 5mln.*10)/80mln. = 1.225; DL = (10mln.*0 + 10mln.*0.4 + 45mln.*2.5 + 5mln.*0.25)/70mln. = 1.682; Duration GAP = 1.225 – 1.682*(70/80) = –0.247.

Notice that duration and maturity gaps are of opposite signs, as they should be. An increase in interest rates will cause proportionally more downward repricing of liabilities than of assets. If interest rates increase, the bank’s net interest income and equity will increase. A decrease in interest rates will cause proportionally more upward repricing of liabilities than of assets. If interest rates decrease, the bank’s net interest income and equity will also decrease.

7.

Distinguish between the credit risk of individual loans and the credit risk of loan portfolios. How are they related? Which is more important?

The credit risk associated with individual loans concerns potential losses in the event the borrower does not repay the loan. The credit risk associated with a bank’s loan portfolio is the aggregate credit risk of a financial institution. While both must be managed, the latter is more important, of course. Financial institutions manage credit risk of their loan portfolios by diversifying across geographic regions, loan types, and borrower types, securitizing and selling loans, and/or using credit derivatives.

8.

How do financial institutions identify problem loans?

Other than a borrower missing a scheduled payment, the following are indicators of potential problem loans: adverse changes in the borrower’s credit rating, adverse changes in the borrower’s deposit balances at the bank, adverse changes in the borrower’s sales or earnings, and delays in supplying financial statements or other documents.

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9.

Describe what banks do when they identify a problem loan.

The goal is to recover as much as possible from the borrower. In some cases, loans are restructured such that the borrower has a greater chance of repaying the new loan. The lender is concerned with the following issues in the loan recovery process: (a) other creditors and other claims against the borrower’s assets, (b) the ability of the borrower to service its debt if it is restructured, (c) expected losses if the loan is not restructured.

10.

Describe how internal credit risk ratings can be used to allocate funds to different types of loans.

Many banks use internal risk ratings to analyze profitability of different loan types. Ratings can be used to identify expected losses and expenses associated with individual loans. These losses and expenses can be subtracted from the yield to determine the net yield. This analysis is especially useful to bank managers who decide what types of loans a bank should pursue or avoid.

11.

Describe how credit default swaps can be used to manage credit risk exposure.

CDS work like credit insurance. The buyer (a financial institution that wants to reduce its credit risk) pays the seller a periodic fee specified as a percentage of the face value of the insured loan (e.g., 0.8% per year), and the seller has an obligation to pay the buyer the face value of the loan if the loan defaults.

12.

Explain what happens to the cash flows or market value of a typical bank when interest rates decline. What happens if interest rates increase?

When interest rates decline the value of financial assets increases, but the reinvestment rate on cash flows declines. As rates decrease below outstanding liability costs, the liability value of bank interest-bearing liabilities increases. As rates increase, financial asset values decrease, while cash flows are reinvested at higher rates. The ultimate net effect on the bank’s financial condition depends on the relative proportions, maturities, and durations of all the bank’s interestbearing assets and liabilities.

13.

Suppose a financial institution holds a portfolio of bonds with a value of $50,000,000 and duration of 3.5. The portfolio currently yields 4 percent and you don’t anticipate any changes in the yield over the next month. If the average monthly change in the yield is 0 basis points and the monthly standard deviation of changes in the yield is 75 basis points, what is the portfolio’s monthly VAR at the 95% confidence level? Assume normal distribution of yield changes (the appropriate critical value is 1.65).

VAR = –[D/(1+i)]×PB×i* i* = 0 ± 0.0075*1.65 = 0.012375 or 1.2375% (we are 95% sure that the yield will not rise by more than 1.2375% over the next month).

VAR = –(3.5/1.04)×50,000,000*0.012375 = $2,082,332.

We are 95% sure that the bond portfolio will not lose more than $2,082,332 over the next month.

In other words, there is only a 5% chance that the portfolio will lose more value.

14.

Explain how financial futures are used to reduce bank interest rate risk. How does the value of a futures contract change when interest rates change?

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If financial futures are used for interest rate hedging, the type of financial futures contract, the number of contracts, and the buy or sell decision must be made. The selection of the specific contract is related to how closely changes in interest rates would affect the bank versus the futures contract. The amount is a function of the size of the GAP one wishes to hedge or retain. The buy/sell decision is related to the GAP position of the bank. The manager must position (buy/sell) the futures contracts so that interest rate movements unfavorable to the balance sheet would be offset by favorable changes in the value of the futures contracts. For example, a positive maturity GAP bank would be hurt if interest rates decreased. Purchasing financial futures would hedge the bank. If interest rates declined, the value of the financial futures would be rising, providing a gain to offset the business loss.

15.

Explain how one can use options on financial futures to manage interest rate risk.

Options on financial assets can reduce downside risk without eliminating the upside potential. A common use of options on financial futures is to create so-called caps, floors, and collars on interest rates. A cap on interest rates is created by purchasing a put on an interest rate futures contract. Banks use caps to limit increases in the cost of their liabilities without sacrificing the possibility of some benefit from a fall in interest rates. A floor on interest rates is created by selling a call on an interest rate futures contract. The floor sets a lower limit for liability costs. By simultaneously buying a cap and selling a floor, the bank creates a collar. Collars limit the movement of a bank’s liability costs within a specified range. Purchasing a cap is equivalent to buying an insurance policy against increasing interest rates. Selling a floor is equivalent to selling an insurance policy to someone who fears a decline in interest rates.

16.

A bank economist projects that interest rates in the future are expected to decline. What is the bank's proper funds management strategy? Why? A negative GAP is desirable--fixed-rate assets and rate-sensitive liabilities. The bank would want to lock in current high rates of interest on assets and let its cost of funds to decline. Any significant GAP, given the uncertainty of future interest rates, adds risk to the bank.

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