Capital Markets Midterm Questions and Solutions

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SOLUTIONS 1 Multiple Choice Questions (20 percent)

2 percent for each question 1. Liquidity... is the ease with which an asset can be exchanged for money 2. The concept of adverse selection helps to explain... why the financial system is heavily regulated 3. The Fed can influence the fed fund interest rate by selling T-bills, which ____reserves, thereby ____the federal fund rate. removes, raising 4. Standard Repos... are very low risk loans 5. A 4-year bond pays an annual coupon of 3.5%. If the interest rate equals 2.75% per year, how much do you have to pay to buy the equivalent of a $1,000,000 bond face value? $10 0280 000 6. Unanticipated deflation implies a... a decline in net worth, as price levels fall while debt burden remains unchanged. 7. What is the annualized discount rate on a Treasury bill that you purchase for $9,900 and that will mature in 91 days for $10,000? 3.96% 8. Moral hazard is a problem arising from... only A and B of the above 9. A discount loan by the Fed to a bank causes a(n) ____ in reserves in the banking system and a(n) ____ in the monetary base. increase; increase 10. The standard definition of the shadow banking systemt includes... money market funds, hedge funds, and pools of securitized assets

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Comprehensive Questions (30 percent)

6 percent for each question 1) The financial system is important because it channels funds, reduces asymmetric information problems, provides an efficient payment system, and helps to manage risk. Explain the remaining functions that the financial system performs.

Besides these functions, the financial system provides ways for invididuals to pool their resources. For instance, some investment projects generate a positive NPV, but require a large initial down payment. Dividing ownership into many individual shares provides an efficient way to pool individual resources in order to finance these investment projects. The financial system also provides liquidity to market participants. This is important because corporations and individuals do not have the same time-horizon. Therefore, it would be very difficult for corporations to get long-term sources of funding without these liquidity services. Finally, the financial system provides important information to financial investors, corporate managers, and political leaders. This information is critical to improve the decision-making process. For instance, managers may use the information observed in the financial system to compute the NPV of investment projects. 2) One of your friend tells you: "The main function of the financial system is to channel funds from lenders to borrowers. This function can be performed interchangeably by capital markets or financial institutions." Do you agree? Why?

It is true that both capital markets and financial institutions are useful in channeling funds from lenders to borrowers. However, they differ in a fundamental way. Contrary to capital markets, financial institutions are extremely good at dealing with asymmetric information problems. This is due to the private nature of their activities. By avoiding free-riding, banks can bare the substantial costs of screening and monitoring borrowers. Therefore, corporations for which asymmetric information problems are substantial (e.g., small corporations), rely heavily on banks’ funding. If banks cut lending, as it was the case during the recent crisis, these companies do not have the option of receiving funding from capital makets, and must reduce their activities. Therefore, some of the functions performed by banks cannot be performed interchangeably by capital markets.

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3) What is Quantitative Easing and how does it differ from the standard tool used by the Fed to expand the monetary base? What was the stated purpose of Quantitative Easing?

Quantitative Easing refers to the central bank’s policy of buying long-term securities, specifically mortgage-backed securities and 10—year Treasury bonds. This is different from the standard...
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