Capital Markets Midterm Questions and Solutions Essay

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2 per centum for each inquiry 1. Liquidity… is the easiness with which an plus can be exchanged for money 2. The construct of inauspicious choice helps to explain… why the ?nancial system is to a great extent regulated 3. The Fed can in?uence the Federal fund involvement rate by selling T-bills. which ____reserves. thereby ____the federal fund rate. removes. raising 4. Standard Repos… are really low hazard loans 5. A 4-year bond pays an one-year voucher of 3. 5 % . If the involvement rate peers 2. 75 % per twelvemonth. how much do you hold to pay to purchase the equivalent of a $ 1. 000. 000 bond face value? $ 10 0280 000 6. Unanticipated de?ation implies a… a diminution in net worth. as monetary value degrees fall while debt load remains unchanged. 7. What is the annualized price reduction rate on a Treasury measure that you purchase for $ 9. 900 and that will maturate in 91 yearss for $ 10. 000? 3. 96 % 8. Moral jeopardy is a job originating from… merely A and B of the above 9. A price reduction loan by the Fed to a bank causes a ( N ) ____ in militias in the banking system and a ( N ) ____ in the pecuniary base. addition ; increase 10. The standard de?nition of the shadow banking systemt includes… money market financess. hedge financess. and pools of securitized assets

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Comprehensive Questions ( 30 per centum )

6 per centum for each inquiry 1 ) The ?nancial system is of import because it channels financess. reduces asymmetric information jobs. provides an e?cient payment system. and helps to pull off hazard. Explain the staying maps that the ?nancial system performs.

Besides these maps. the ?nancial system provides ways for invididuals to pool their resources. For case. some investing undertakings generate a positive NPV. but require a big initial down payment. Dividing ownership into many single portions provides an e?cient manner to pool single resources in order to ?nance these investing undertakings. The ?nancial system besides provides liquidness to market participants. This is of import because corporations and persons do non hold the same time-horizon.

Therefore. it would be really di?cult for corporations to acquire long-run beginnings of support without these liquidness services. Finally. the ?nancial system provides of import information to ?nancial investors. corporate directors. and political leaders. This information is critical to better the decision-making procedure. For case. directors may utilize the information observed in the ?nancial system to calculate the NPV of investing undertakings. 2 ) One of your friend tells you: “The chief map of the ?nancial system is to impart financess from loaners to borrowers. This map can be performed interchangeably by capital markets or ?nancial establishments. ” Do you hold? Why?

It is true that both capital markets and ?nancial establishments are utile in imparting financess from loaners to borrowers. However. they di?er in a cardinal manner. Contrary to capital markets. ?nancial establishments are highly good at covering with asymmetric information jobs. This is due to the private nature of their activities. By avoiding free-riding. Bankss can bare the significant costs of testing and supervising borrowers. Therefore. corporations for which asymmetric information jobs are significant ( e. g. . little corporations ) . rely to a great extent on banks’ support. If Bankss cut loaning. as it was the instance during the recent crisis. these companies do non hold the option of having support from capital makets. and must cut down their activities. Therefore. some of the maps performed by Bankss can non be performed interchangeably by capital markets.

3 ) What is Quantitative Easing and how does it di?er from the standard tool used by the Fed to spread out the pecuniary base? What was the declared intent of Quantitative Easing?

Quantitative Easing refers to the cardinal bank’s policy of purchasing long-run securities. speci?cally mortgage-backed securities and 10—year Treasury bonds. This is di?erent from the standard attack used by the Fed. Traditionally. the Fed expands the pecuniary base by implementing an open-market purchase of T-bills. The declared intent of Quantitative Easing was to diminish the output of these long-run securities. From the point of view of borrowers. this lessening would assist them acquire lower re?nancing conditions. therefore easing force per unit area in these markets.

From the point of view of loaners. this lessening in output may render these securities less attractive. Therefore. loaners may be willing to get down purchasing hazardous assets once more. therefore bettering economic conditions. 4 ) One pupil argues: “If more clients want to borrow financess at the prevalent involvement rate. a ?nancial establishment can easy increase its pro?ts by raising involvement rates on its loan. ” Is this statement true. false. unsure? Explain your reply.

The state of affairs faced by the bank is the undermentioned: it has limited resources and sees a batch of clients willing to borrow money. making extra demand. The statement above is unsure. A priori. we might believe that if the bank increases the involvement rate. it is able to extinguish this extra demand and generate extra pro?ts ( there would be an addition in both the pro?t per loan and the measure of loans ) . However. this concluding assumes that the recognition quality of the borrowers stays changeless. This may non be true because raising the involvement rate besides increases inauspicious choice. To exemplify. see the used-car market. If purchasers observe an addition in the figure of people interested in selling their autos. they may desire to o?er a lower monetary value. But a lower monetary value gives inducement to the Sellerss of good autos to go forth the market. go forthing lone Sellerss of lemons.

As a consequence. the mean quality of the autos purchased by purchasers will diminish. A big portion of the extra demand observed by the bank is driven by hapless recognition ?rms. After increasing the involvement rate. the bank observes that these ?rms still agree to borrow. i. e. . their hapless recognition quality should be charged an even higher involvement rate. On the contrary. this higer involvement rate may deter good ?rms from borrowing from this bank because the loan becomes excessively expensive. As a consequence. the comparative importance of bad ?rms over good 1s additions. taking to a lessening in the mean ?rm quality. This lessening in quality may take to higher default rates and to a lessening in the bank’s pro?t.

5 ) What is meant by a ?ight to safety/liquidity? When does it happen? How can it trip these negative spirals on the value of the banks’ balance sheet? A ?ight to safety/liquidity normally describes the behavior of investors when they attempt to sell the risky/illiquid assets they hold in their portfolio and move towards safe/liquid assets. This ?ight typically occurs in times of crisis when the investors’ willingness to take hazards decreases signi?cantly. Since Bankss largely hold hazardous and illiquid assets. these ?ights to safety hold a strong impact on their plus value. As their capital gets curtailed. their hazard pro?le additions. doing investors and depositors more disquieted about the possible losingss they may incur.

Because these loaners give money on a short-run footing. they can rapidly travel to the bank and inquire for their money back. Then. Bankss have to scramble for liquidness and sell their risky/illiquid assets. When many Bankss try to sell at the same time. the monetary value of these assets will travel farther down. For case. say that in normal times. the bank would hold to sell 15 % of its assets to reimburse loaners. As many establishments sell at the same time. the bank has to sell more than 15 % . Detecting these extra losingss. investors and depositors may desire to farther cut down the sum they are willing to impart. worsening the liquidness issues face by Bankss. Overall. these e?ects reinforce each other. making a spiraling e?ect.

Understanding Interest Ratess ( 30 per centum )

15 per centum for inquiry 1. 10 for inquiry 2. and 5 for inquiry 3 1 ) In February 2010. a column in the Wall Street Journal warns: “Be wary of long-run bonds… The hazard of higher expected in?ation is in due class. Longer-term bonds are the most at hazard. ” Using the supply and demand analysis studied in category. secret plan a graph that clearly explains the e?ect of an addition in expected in?ation on the bond monetary value. Why are longer-term bonds more at hazard? Explain whether your analysis would be di?erent if you were to analyze the impact on the monetary value of TIPS.

Since the voucher rate paid by US authorities bonds is ?xed in nominal footings. intelligence of higher expected in?ation leads to a lessening in the existent rate of return o?ered by these bonds. As a consequence. the demand curve moves to the left as investors want to put their money in securities with better return chances. In add-on. the supply curve moves to the right as corporations can borrow at lower costs in existent footings. Because of these two displacements. we observe a big extra supply of bonds at the initial involvement degree. This extra supply will take to a lessening in the bond monetary value and a addition in the involvement rate until the new equilibrium is reached. This e?ect. called the Fisher e?ect. is shown in the graph below:

The e?ect is likely to be stronger for long-run bonds because investors are stuck with ?xed nominal payments for a long-time period. As a consequence. the lone manner to be compensated for higher in?ation during many old ages is to purchase the bond at a su?ciently low monetary value today. Intuitively. we can capture this monetary value sensitiveness utilizing continuance. as we know that the continuance of a long-run bond is above that of a short-run bond. The analysis would be wholly di?erent for TIPS because their voucher payments adjust for alterations in in?ation. As a consequence. any intelligence of future in?ation merely means that the hereafter voucher payments in nominal footings will be higher. As a consequence. the monetary value is non sensitive to alterations in expected in?ation.

2 ) In the Financial Times in February 2011. Professor Siegel from the Wharton School negotiations about the diminution in the existent output of TIPS: “Recently. the outputs on these bonds have collapsed to degrees that would hold been uninimaginable merely a few old ages ago. Last October. the existent output on the US 10-year TIPS plunged to 36 footing points. ” Professor Siegel argues that an of import factor driving this consequence is the addition in in?ation hazard. Why do US investors presently perceive that in?ation hazard is higher than usual? Explain why this addition in in?ation hazard can take to ( I ) an addition in the demand for TIPS comparative to bonds ; and ( two ) a lessening in the TIPS involvement rate.

There are two beginnings of concerns sing future in?ation. First. the cardinal bank has greatly expanded its pecuniary base during the recent ?nancial crisis—at the terminal of 2009. its value was close to $ 2 trillion. For the minute. Bankss are non sharply imparting. connoting that the growing rate of the pecuniary base is slightly staccato from that of the money supply. But failure from the Fed to cut down the pecuniary base as loaning activity sketchs may take to higher in?ation. Second. the ?scal place of the US authorities has deteriorated well over the past few old ages. taking to a downgrade of the recognition evaluation attached to its bonds. If the future growing rate in the economic system is non su?ciently high and if the US authorities is non able to cut down de?cits. it may hold no option but in?ate the debt off.

This will of class lead to higher in?ation. Overall. these two issues create of import uncertainness about the future way of in?ation. Contrary to bonds. Tip are protected against in?ation. If there is higher in?ation hazard. bonds become hazardous comparative to TIPS. Using our supply and demand model. the demand for bonds moves to the left. while the demand for TIPS moves to the right. At the initial monetary value. there is an extra demand for TIPS. driving the TIPS monetary value up and its involvement rate down. consistent with Professor Siegel’s statements. 3 ) Professor Siegel besides argues that: “As economic growing recovers and existent rates rise. the monetary value of TIPS will fall. ” Can you ?nd a simple account of this statement based on our supply and demand model?

Economic growing means that the concern rhythm is in an spread outing stage. In this instance. we can trust on the relation between concern rhythm enlargements and the involvement rate seen in category. First. the demand curve for bonds move to the right because of the wealth e?ect. as people have more money to put in the capital market ( bonds. stocks. … ) . On the supply side. concern rhythm enlargements are related to an addition in the ?rms’ expected pro?tability. As a consequence. the supply curve moves to the right. Based on empirical grounds. the move of the supply curve tends to be more of import than the one observed for the demand. At the initial degree of involvement rate. there is an extra supply. taking to an lessening in bond monetary value. and an addition in the involvement rate. This is consistent with the output reaction discussed by Professor Siegel.

Chemical bond Market ( 20 per centum )

5 per centum for each inquiry See the undermentioned bonds: Annual involvement rate Maturity Annual voucher Price Duration Bond X 5 % 8 old ages 3 % 87. 1 7. 2 Bond Y 8 % 3 old ages 3 % 87. 1?

1 ) One of your friends tells you: “the fact that the monetary value of these two bonds is the same is non consistent with theory. ” Without doing any calculation. explicate whether you agree with your friend.

Your friend is non right. These two bonds are both quoted below par value. because their several output to adulthood is lower than the voucher rate. If these two bonds had the same adulthood. the monetary value of bond Y should be lower than the monetary value of bond X because investors require a higher involvement rate to keep bond Y. However. the adulthood of bond Y is lower.

Although the one-year di?erential between the involvement rate and the voucher rate is higher for bond Y. this di?erential has to be given during 3 old ages merely. For bond X. the one-year di?erential between the involvement rate and the voucher rate is lower. but it has to be given during 8 old ages. In our instance. these two e?ects ( di?erent evaluations and di?erent adulthoods ) o?set each other and the two monetary values are precisely the same. The information shown in the tabular array is hence absolutely consistent with theory. 2 ) Calculate the continuance of bond Y and compare it with that of bond X. Is the di?erence consistent with theory?

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