FIL 241 quiz of end of chapter questions for exam 1 questions and answers

FIL 241 quiz of end of chapter questions for exam 1 questions and answersExplain the role of brokers, dealers, and investment bankers. How does each make a profit? ​Brokers never own the securities that they trade. Brokers bring buyers and sellers together and receive a commission if the sale takes place. Dealers on the other hand create a market for securities by owning an inventory of securities. Dealers make profits by trading from their inventory and dealing as a matchmaker. Investment Bankers help firms bring their debt or equity securities to market. They also help with helping firm determine whether a certain project is feasible. 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. Explain how you would believe economic activity would be affected if we did not have financial markets and institutions If there were no financial markets and institutions it would be almost impossible for people to get together to buy and sell interest in a company. There would be no middle man to bring the people who are willing to loan and the people who need to borrow. There would be no efficient market so the world economy would not be what it is today. Financial markets and institutions ware what keeps this country and every country in a natural progression. 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. How do financial intermediaries generate profit? Financial intermediaries make a profit from the difference from what they earn on their assets and what they pay in liabilities. So why don't people loan their money directly and earn all the interest instead of getting only a portion? Or why doesn't a business simply sell stock or bonds directly to the public to save on the investment banking fee or on interest rates that would probably be less than what a bank would charge? 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 owner of the debt, it is an asset. A financial asset always appears on two balance sheets; a real asset on just one. 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. 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. 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. 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. 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. 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. What is the "Fisher effect"? How does it affect the nominal rate of interest? The Fisher effect, espoused by Irving Fisher, theorizes 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 The one-year real rate of interest is currently estimated to be 4%. The current annual rate of inflation is 6%, and market forecasts expect the annual rate of inflation to be 8%. What is the current one-year nominal rate of interest? The approximate one-year nominal interest rate i = r + πe = 4% + 8% = 12%. The exact one-year nominal interest rate i = (1 + r) (1 + πe) - 1 = (1.04) (1.08) - 1 = 12.32. An investor purchased a one-year Treasury security with a promised yield of 10%. The investor expected the annual rate of inflation to be 6%; however, the actual rate turned out to be 10%. What were the expected and the realized real rate of interest for the investor? The expected real interest rate r = i - πe = 10% - 6% = 4%, and the realized real interest rate r = i - π = 10% - 10% = 0. 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 on the loan? If inflation were originally underestimated, borrowers would benefit at the cost of the lender for their realized real cost of borrowing would be less. If inflation were overestimated the lender would benefit at the cost of borrower for realized real returns (borrowing costs) would higher than originally anticipated. If a 3% real return (cost) were the agreed upon at the beginning of a $1000, one-year loan, and inflation expectations were 4%, lender and borrower would have been satisfied at the beginning of the loan with a 7% nominal rate. If inflation realized is 5%, the lender (borrower) only earns (pays) 2%. If realized inflation is 3%, the lender (borrower) real return (cost) is 4%. explain the nominal rate of interest is and how it is related to the real rate of interes A nominal interest rate refers to the interest rate before taking inflation into account. To calculate the real interest rate, you need to subtract the actual or expected rate of inflation from the nominal interest rate How is the equilibrium interest rate determined The equilibrium interest rate is determined by demand and supply of bonds in the bond market. The equilibrium interest rate is the interest rate where demand for bonds and supply of bonds curve intersect each other. explain how the market rate of interest is determined applying the loanable funds interest rate model The loanable funds market illustrates the interaction of borrowers and savers in the economy. It is a variation of a market model, but what is being "bought" and "sold" is money that has been saved. Borrowers demand loanable funds and savers supply loanable funds. The market is in equilibrium when the real interest rate has adjusted so that the amount of borrowing is equal to the amount of saving. What were the four goals of the legislation that established the Federal Reserve System? Have they been met today? The goal of the Federal Reserve Act was to: 1. Establish a monetary authority that could/would control the rate of growth of the nation's money supply. 2. Establish a "Lender-of-Last Resort" that could infuse liquidity into the financial system at any time. 3. Develop an efficient payments system that supports a rapidly developing industrial economy. 4. Establish an effective bank supervision system to reduce the risk of bank failure. With some failures and more successes, the Federal Reserve System has developed into an effective central bank over the 20th century. The evolution of the FOMC into an effective system for money supply/interest rate policy to stabilize the wild economic fluctuation of this capitalistic economic system has been most effective, as has the Federal Reserve's "Lender-of-Last Resort" policy during financial panics. The payments system has slowly evolved as the legal system and special interests has struggled to keep up with technological developments in data processing, communications, and computing. The classic battle between urban/rural, industry/agriculture, states vs. federal authority, large vs. small bank, bureaucratic self-preservation, and an ever-developing economy has been a challenge for the Federal Reserve. The current structure, evolving with every Congressional session for ninety years, works and serves to balance all the special interests present. 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 Board of Governors, and especially the Chairman, has concentrated the authority/power of the Federal Reserve System into their meeting room over the last fifty years. The Board appoints a majority of board members for Federal Reserve Banks and has gradually collected the "tools" of monetary policy into its "tool shed." The seven members of the Board make up a majority of the twelve-member FOMC, the most important power of the Board. Explain why the FOMC is the key policy group within the Federal Reserve The Federal Open Market Committee, made up of the seven members of the Board of Governors, the president of the New York Federal Reserve, and four of the remaining eleven presidents of the Federal Reserve Banks, is the key policy making group within the Federal Reserve. The FOMC establishes the monetary policy of the world's largest, powerful country, impacting interest rates, exchange rates, and economic growth. Its decisions at election time can effect presidential and Congressional elections. At the helm of the FOMC, the Chairman of the Board of Governors is the second most powerful person in Washington, D.C. Explain why Regulation Q caused difficulties for banks and other depository institutions, especially during periods of rising interest rates. Regulation Q, one of many "lettered" Federal Reserve regulations, was used for a variety of reasons since the time of the Great Depression. Forbidding interest on demand deposits, Regulation Q served to limit price competition for deposits in a period when stability was the primary objective. Later, Regulation Q served to reinforce "tight money" policies of the Federal Reserve. By establishing deposit rate maximums below market rates, deposit withdrawal (disintermediation) further drained liquidity from banks at a time when the Federal Reserve wanted banks to curtail lending. Later, in the 1960's and 1970's Regulation Q served to promote home ownership by allowing savings associations to pay higher rates on deposits than commercial banks. At present, except for business demand deposits, Regulation Q is on "stand-by," with the Federal Reserve depending on market factors to determine the flow of funds through markets and financial institutions. A bank has $3,000 in reserves, $9,000 in bank loans, and $12,000 of deposits. If the reserve requirement is 20%, what is the bank's reserve position? What is the maximum dollar amount of loans the bank could make? With a 20% required reserve ratio the bank has required reserves of $2,400 ($12,000 x 0.2) and excess reserves of $600. A bank can lend only to the extent of its excess reserves, in this case, $600. If the required reserve ratio were decreased to 10%, the bank would have required reserves of $1,200 ($12,000 x 0.1) and excess reserves of $1,200 to lend and expand deposits. For all banks, a halving of the required reserve ratio would double the potential deposit level - a good reason not to use the required reserve ratio as an active monetary policy tool Why does the Federal Reserve not use the discount rate to conduct monetary policy? How does the Federal Reserve use the discount rate? In the early part of the twentieth century, it was common for businesses to discount their accounts receivable with financial institution. When the Federal Reserve was formed, the discount rate was the primary tool of monetary policy. The Federal Reserve would discount "commercial paper" (bank loans and bills of exchange), providing liquidity to business via banks. This was a time before money markets as we know it and the federal funds markets were developed. The banking industry was the primary source of seasonal and working capital loans and the Federal Reserve's discount policy was reasonably effective. As the money markets evolved, the federal funds market developed, and the FOMC developed its processes, discounting became history. Today changes in the discount rate serves as a signal of policy intent or changes, and the open market operations reigns as monetary king! There are three components of discount window policy: borrowing for reserve deficiency (monetary policy), seasonal credit for agricultural banks, and loans to problem banks. So, to small "agricultural" banks and large banks in distress, discount policy is an important item Explain how the Federal Reserve changes the money supply with an open market purchase of Treasury securities. There are three requisites for U.S. monetary policy: (1) banks must keep reserves against transaction deposits, (2) the banks must keep their reserves in the Federal Reserve or in vault cash, and (3) the Federal Reserve controls the level/growth of bank reserves via open market operations. Every Federal Reserve transaction with the private sector clears through the bank reserve account. When the Federal Reserve purchases U.S. Treasury securities the Federal Reserve pays with a credit to their bank reserve account, giving banks immediate excess reserves to lend/invest and create deposits and increase the money supply. 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=80000+= Required reserves=*0.06=99000 Excess reserves=-99000=91000 What effects are decreases in reserve requirements likely to have on: A. Bank reserves B. Federal funds rate C. Bank lending D. Treasury bill rates E. The bank "prime rate" A. None B. Reduce them C. Increase it D. reduce them E. Reduce it Reductions in reserve requirements will not directly affect the amount of reserves available to financial institutions. However, such a reduction would provide depository institutions with additional excess reserves. As financial institutions sought to invest their excess reserves to earn an interest return, first federal funds rates then Treasury bill rates and other short-term rates (such as the prime rate) would fall. Simultaneously, institutions with excess reserves would be more willing than before to make loans, and the demand for such loans would increase as the rate falls. What are the six goals the Fed is required by government legislation to achieve. which two goals are the most important? 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. 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.. 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. In your opinion, what were the three most important factors that caused the 2008 financial crisis? 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. Find the price of a corporate bond maturing in 5 years that has a 5% coupon (annual payments), a $1,000 face value, and is rated Aa. A local newspaper's financial section reports that the yields on 5 year bonds are Aaa = 6%, Aa = 7%, and A = 8%. P = 50/(1.07)1 + 50/(1.07)2 + 50/(1.07)3 + 50/(1.07)4 + 1,050/(1.07)5 = $918