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Questions and Answers of Banking

Since the equity holder’s position is equivalent to a call value on the firm’s assets, and the equity holders manage the firm’s assets, can they increase the value of their equity by increasing
What are the three risks faced by a bond in the reduced- form credit risk model?
Which risks caused the hedge fund Long- Term Capital Management to fail?
Explain why operational risk and credit risk can be modeled using similar techniques.
What assumption makes the structural model not useful for actual pricing and hedging but makes the reduced- form model appropriate for these activities?
When financial markets channel funds from savers to investors, who benefits? Explain.
The text Web site contains World Bank data on financial development. Using these data, compare bank loans as a percentage of GDP in two groups of countries: those in East Asia (8 countries) and those
In the World Bank data, examine bank loans as a percentage of GDP in the United States, Germany, and Japan. Is the level of bank loans relatively high or low in the United States? What might explain
Link at the Web site to Planet Rating a French organization that calls itself the global microfinance rating agency. What is the main function of Planet Rating? How might its work help the
Do you know someone (such as a parent) who is working and saving for retirement? Does he or she have money in a 401(k) plan? What securities does the person hold through the plan? Does he or she
Suppose an owner of a corporation needs $1 million to finance a new investment. If his total wealth is $1.2 million, would it be better to use his own funds for the investment or to issue stock in
Suppose you were required to put all your retirement savings in the securities of one company. What company would you choose, and why? Would you choose the company you work for? Would you buy stock
Suppose there are two investors. One has a project to build a factory; the other has a project to visit a casino and gamble on roulette. Which investor has a greater incentive to issue bonds? Which
Suppose a company raises funds by issuing short-term bonds (commercial paper). It uses the funds to make private loans. Such a firm is called a finance company. Is a finance company a type of bank?
Firms such as Moody’s and Standard & Poor’s study corporations that issue bonds. They publish “ratings" for the bonds—evaluations of the likelihood of default. Suppose these rating companies
National credit bureaus collect information on people’s credit histories. They are likely to know whether you ever defaulted on a loan. Suppose that a new privacy law makes it illegal for credit
When a bank makes a loan, it sometimes requires borrowers to maintain a checking account at the bank until the loan is paid off. What is the purpose of this requirement?
Microfinance institutions argue that (a) many traditional banks discriminate against women in lending and (b) women have lower default rates than men on loans from MFIs. Discuss how point (a) could
The U.S. government owns about 4,500 tons of gold, stored mainly at Fort Knox in Kentucky. Why did the government accumulate this gold? Should it continue to hold the gold, or sell it?
Using the data on the text Web site, compute the ratio of M1 to GDP and the ratio of M2 to GDP. These ratios show how much money people hold relative to total spending in the economy. Plot these
Figure 2.4 shows that sweep programs have reduced the level of M1. How do you think sweeps have affected M2? Do the M2 data on the text Web site support your answer?
The text Web site has links to several sites with information about stored-value cards. Some are maintained by card issuers, others by government agencies or consumer advocates. After visiting some
In the 1964 movie Gold finger, the title character schemes to increase the price of gold. He plans to drop an atomic bomb on Fort Knox, making the gold there radioactive. His operation is financed by
Scientists believe that the Sun will explode some billions of years from now. According to some economic theorists, this means that nobody should accept money today. What is the logic behind this
The U.S. population is approximately 300 million. Using the information in Table 2.1, calculate the average amount of U.S. currency per citizen. Do most Americans hold that much cash? If not, where
Suppose that technology completely eliminates the use of cash. People buy news-papers by putting debit cards in the newspaper box. They use the Internet to pay babysitters. With no cash, does the
Explain how each of these events affects the amount of M1 that people hold.a. ATMs are invented.b. Credit cards are invented.d. Debit cards are invented.d. Stored-value cards are invented.e. Interest
Recall the transactions that are triggered when you pay your rent (see Figure 2.2). Now suppose your check bounces because you don€™t have enough funds in your account. How does this change
For a citizen of the United States, how liquid is each of the following assets? Explain each answer.a. Bonds issued by the U.S. government.b. Bonds issued by corporations.c. Postimpressionist
Suppose you win the lottery. You have a choice between receiving $100,000 a year for 20 years or an immediate payment of $1,200,000.a. Which should you choose if the interest rate is 3 percent? If it
“I just bought my first house. Economists are predicting low inflation in the future, but I sure hope they’re wrong!" Why might it make sense for someone to say this?
“Buying an inflation-indexed bond is risky. If I buy a conventional bond, I know what interest rate I will receive. With an indexed bond, the rate can rise or fall depending on inflation.
The text Web site contains data from the Bernanke-Kuttner paper on the Fed and the stock market. The data cover 68 days from 1995 through 2002 when the Fed either changed interest rates or decided
The text Web site links to www.bloomberg.com, which provides daily data on the Dow Jones stock index. Find a day within the last year when the index rose or fell by at least 2 percent. Consult news
The text Web site contains data on interest rates for Treasury bonds. For the most recent data, compare the rates on 10-year conventional bonds and 10-year inflation- indexed bonds. What do these
Suppose a bond has a maturity of 3 years, annual coupon payments of $5, and a face value of $100.a. If the interest rate is 4 percent, is the price of the bond higher or lower than the face value?
Suppose that people expect a company’s earnings to grow in the future at the same rate they have grown in the past. Does this behavior satisfy the assumption of rational expectations? Explain.
Describe how each of the following events affects stock and bond prices.a. The economy enters a recession.b. A genius invents a new technology that makes factories more productive.c. The Federal
Consider two stocks. For each, the expected dividend next year is $100 and the expected growth rate of dividends is 3 percent. The risk premium is 3 percent for one stock and 8 percent for the other.
Consider two bonds. Each has a face value of $100 and matures in 10 years. One has no coupon payment, and the other pays $10 per year. a. Calculate the price of each bond if the interest rate is 3
Suppose a bond has a face value of $100, annual coupon payments of $4, a maturity of 5 years, and a price of $90. a. Write an equation that defines the yield to maturity on this bond. b. If you have
Suppose the price of the bond in Problem 7 falls from $90 to $85 over a year. Calculate the bond’s rate of return over the year.
Suppose the yield to maturity on a 1-year bond is 6 percent. Everyone expects inflation over the year to be 3 percent, but it turns out to be 5 percent. What is the nominal interest rate on the bond,
Using the loanable funds theory, show in a graph how each of the following events affects the supply and demand for loans and the equilibrium real interest rate:a. A war leads the government to
Suppose a Treasury bond costs $100 and promises a payment of $105 in 1 year. A bond from the Acme Corporation costs $100 and promises $107 in a year. Assume that Acme pays the $107 with probability
From the text Web site, link to the site of the Federal Reserve Bank of St. Louis; also, see the “Guide to St. Louis Fed Data." Get data on the inflation rate and the interest rate on 90-day
From the text Web site, link to the St. Louis Fed site for data on the high-yield spread and on the unemployment rate. a. Graph unemployment on the horizontal axis and the spread on the vertical
Link through the text Web site to the “Ratings" page of the Standard & Poor’s Web site. Find a country or corporation whose debt rating has recently changed and explain why S&P made the change.
aSuppose the real interest rate rises. Using the loanable funds theory, discuss whether this event is likely to reflect good economic news or is a sign of trouble.
Comment on this statement: “People care about real interest rates, not nominal rates. Therefore, money demand should depend on the difference between the real rates on money and bonds, not the
Suppose that discount brokers make bonds more liquid. It becomes quick and in-expensive to sell bonds. In the liquidity preference theory, how does this development affect money demand and the
Suppose again that discount brokers make bonds more liquid. What should the central bank do if it doesn’t want the interest rate to change? Explain your answer.
Suppose it is 2020 and the 1-year interest rate is 4 percent. The expected 1-year rates in the following four years (2021 to 2024) are 4 percent, 5 percent, 6 percent, and 6 percent.a. Assume the
Suppose it is 2020, the 1-year interest rate is 8 percent, and the 10-year rate is 6 percent.a. Draw a graph showing a likely path of the 1-year rate from 2020 through 2029.b. Why might people expect
Using the expectations theory without term premiums, derive a formula giving the 4-year interest rate in 2020 as a function of 2-year rates in 2020 and the future.
Suppose that some event has no effect on expected interest rates but raises un-certainty about rates. What happens to the yield curve? Explain.
When investment banks underwrite IPOs, they typically sell stock for 5-10 percent more than they pay for it. When they underwrite new stock for companies that are already public, the typical markup
Suppose you hold most of your wealth in stock. What kinds of options should you buy or sell in each of the following circumstances?a. You think the stock market will probably do well, but you worry
Suppose you buy call options on Microsoft stock. Each option costs $2 and has a strike price of $40 and an expiration date of July 1. Discuss whether you would exercise the options in each of the
Suppose company A has a stable stock price. The price is not likely to change much in the next year. Company B has an uncertain stock price: it could either rise or fall by a lot. Would you pay more
The text Web site provides data on rates of return for selected mutual funds. Choose 20 actively managed funds and rank them by their average returns over the period 2000-2004. Then rank the same
Link through the text Web site to buffettsecrets.com and study Warren Buffett’s principles for choosing stocks. Do you think you could beat a stock index by following these principles? Explain.
As in Section 5.4, assume that bonds pay a real return of 2 percent. Stocks pay 22 percent half the time and -6 percent half the time. Suppose you initially have wealth of $100, and let X be your
Suppose two people are the same age and have the same level of wealth. One has a high-paying job and the other has a low-paying job. Who should hold a higher fraction of his or her wealth in stock?
Chapter 3 presented the classical theory of asset prices. In this chapter, we discussed two ideas that follow from the classical theory: the Modigliani-Miller theorem and the efficient markets
Suppose everyone in the world becomes convinced that the efficient markets hypothesis is true. Will it stay true? Explain.
Research around 1980 showed that stocks of small firms had higher average returns than stocks of large firms. This finding gained much attention, as it seemed to contradict the efficient markets
Recall that U.S. mutual fund companies offer about 8,000 separate funds. Suppose each fund has a 50 percent chance of beating the S&P 500 each year.a. Over a 5-year period, how many funds will
In 1989, the economist Paul Samuelson rated Warren Buffett the greatest stock picker in the country. Yet Samuelson warned against buying Berkshire Hathaway stock. He wrote that “knowledge of
On its Web site, one mutual fund company describes its “disciplined and sophisticated investment strategies." (The term investment is used to mean the choice of securities.) Let’s change the
Suppose it takes $1.05 to buy one euro. What is the nominal exchange rate for the euro countries against the U.S. dollar? What is the nominal exchange rate for the U.S. dollar against the euro?
Using graphs show how each of the following events affects a country’s net capital outflows, net exports, and equilibrium real exchange rate.a. A rise in foreign interest rates.b. A fad for buying
Suppose a country’s central bank wants to keep the real exchange rate constant. What should it do to the real interest rate if foreign economies enter recessions?
Events in South Africa between 2000 and 2010 included the following:a. At the start of the decade, a corruption scandal hurt the government's reputation, and the AIDS epidemic intensified.b. From
Suppose the U.S. real exchange rate against the British pound rises by 6 percent from one year to the next. U.S. inflation is 2 percent and British inflation is 3 percent. What is the change in the
We discussed three techniques for speculating on exchange rates: economic analysis, monitoring of order flows, and technical analysis. Assume a key part of the efficient markets hypothesis (EMH): It
Compute the changes in the U.S. trade-weighted real exchange rate from 2008 to 2009 and from 2009 to 2010. Use data on exchange rates, price levels, and trade shares from the text Web site. What
For 43 countries, Figure 6.5 plots the difference between a country€™s inflation rate and the U.S. inflation rate, and the percentage change in the U.S. exchange rate against the
Using data from the text Web site, compute the real exchange rate for the Russian ruble against the U.S. dollar from 1992 to 2009.a. Do a bit of Internet research on Russia and try to explain the
Recall from Section 6.1 that most currency trades involve the U.S. dollar. How would William Stanley Jevons explain this fact? (Hint: We met Jevons in Section 2.1.)
Suppose the U.S. dollar appreciates for a period of time and then returns to its initial level. Compare a 10 percent appreciation that lasts for 2 years and a 50 percent appreciation that lasts 6
On July 15, 2002, a CNN headline reported, “Euro tops dollar." The value of a euro had risen from slightly below $1.00 to slightly above $1.00. Discuss the importance of this event.
Suppose it takes $1.05 to buy 1 euro, the U.S. price level is 120, and the European price level is 125.a. Calculate the real exchange rate for the U.S. against the euro.b. Suppose the U.S. price
Section 6.2 defined the U.S. real exchange rate against the euro as the price of American goods divided by the price of European goods. We measured both prices in euros. Suppose we measured both
For decades, one British pound has been worth more than one U.S. dollar. One Japanese yen has been worth less than 0.01 U.S. dollar (1 cent). So a pound is more than 100 times as valuable as a yen.
Suppose that, at a certain real exchange rate, a country’s net exports exceed its net capital outflows. Is the equilibrium exchange rate higher or lower than this level? Explain both in words and
Suppose country A sends most of its exports to country B. It gets most of its imports from country C. If A’s currency appreciates against B’s currency and depreciates against C’s, what happens
Would each of the following events increase or decrease the volume of bank loans? Explain.a. New regulations make it easier for shareholders to replace company directors.b. A new law makes it a
Suppose you take out a 30-year mortgage of $100,000 with a fixed interest rate of 5 percent. You must make 360 equal monthly payments. Write an equation that defines what the payment is.
Figure 7.3 presents data on IPOs and shareholder rights. The figure gives averages for four groups of countries. On the text Web site, get data for the 49 individual countries in the groups. Make a
Do some Internet research to find out what it means for a company to create a “poison pill.” Why might a company do that? Some economists think poison pills should be illegal. What is their
a. Suppose you are hiring a worker for your firm. You advertise a position for $50,000, but an applicant offers to work for $40,000. Should you jump at this offer?b. Suppose you have $1,000 to lend
In what ways is an asset price bubble similar to a Ponzi scheme? In what ways is a bubble different?
Some U.S. companies have 1-year terms for directors. The entire corporate board must run for election at each annual meeting. Other companies have 3-year terms; only a third of directors face votes
Why do people commit each of the following crimes? Who is hurt by the crimes? Discuss who is hurt directly and also the broader effects on the financial system. (As an analogy, shoplifting hurts
Edward C. Johnson, III was the CEO of Fidelity mutual funds and also the chair of the Fidelity board. In 2004, the SEC issued a regulation requiring that chairs at mutual funds be independent of
Consider the example in Figure 7.2. Assume that neither firm knows whether its project is safe or risky. For each firm, there is a 1/2 chance that the project is safe, producing $125 for sure. There
Consider the example in Figure 7.2 with asymmetric information: the two firms know which one is risky and which is safe, but savers do not. Keep the example the same as in the figure, except for the
Consider the example of collateral in Section 7.5. The example assumes that collateral is $50. Determine the smallest level of collateral that causes the firm to choose the safe project. Assume the
HSBC has over $1 trillion in assets and operates in about 100 countries. It calls itself “the world’s local bank." What business strategies does this phrase suggest? Why might these strategies be

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