I) What Does the Trader Gain by Selling These Options?

Question I

a)  The Dow Jones Industrial Average (DJIA) fell 46.51 points on Tuesday. What does that mean, that is, how is the DJIA computed? (5 points)

b)  Desperate to cover up hundreds of millions of dollars in losses, a currency trader for a global bank sells a series of deep in-the-money call options to generate $200 million in cash. She reports it as income this year.

i)  What does the trader gain by selling these options?

ii)  What do you suppose will happen to her when the options expire next year? What do you suppose she hopes will happen?

iii)  How can this transaction be interpreted as something other than the simple sale of call options? (10 points)

Question II

a) On average, the return on assets (a bank’s holdings of securities and loans) is the same for small and as for large banks. The return on bank equity, however, is higher for large banks than for small banks. i) Can this be one explanation of the trend toward bank mergers? Explain why or why not. ii) What do you suppose explains the higher return on equity that large banks enjoy? (10 points)

b)  How is the creditworthiness of potential borrowers affected by i) a sharp rise in interest rates; ii) deflation? Explain your answers. (10 points)

c) A bank that makes most of its long term loans at adjustable interest rates is reducing its interest rate risk but increasing its credit risk. Explain why. (5 points)

d)  How does the existence of a lender of last resort create moral hazard? (5 points)

e) Why do regulators insist that banks hold a minimum level of capital? (5 points)

Question III

a) Sketch the balance sheet of a typical central bank, the assets it owns and the liabilities it owes. (10 points)

ASSETS LIABILITIES

b)  Why does it make sense for a central bank to serve as a clearinghouse for checks? Refer to the balance sheet in part (a) above. (5 points)

c) How can a central bank act as a lender of last resort to a single bank that is in trouble? Refer to the balance sheet in part (a) above. (5 points)

d)  A bank can be in trouble when it is illiquid and when it is insolvent. What is the difference between illiquidity and insolvency? Should a central bank treat these maladies differently? (5 points)

e) A central bank should maintain price stability (a steady and predictable rate of inflation), without regard to other objectives of central banking. True? False? All of the above? None of the above? Discuss. (10 points)