Money, Banking, and Financial Markets (Econ 353): Section 4
Midterm Examination III
November 19, 2002
Name______Univ. Id #______
Note: Each multiple-choice question is worth 4 points. Question 19 (bonus) is worth 5 points. Problems 20, 21, and 22 carry 10, 8, and 10 points, respectively.
1)If a firm must pay for goods it has ordered with foreign currency, it can hedge its foreign exchange rate risk by _____ foreign exchange futures _____.
A) selling; short
B) buying; long
C) buying; short
D) selling; long
Answer: B
2)If you buy a call option on treasury futures at 110, and at expiration the market price is 115,
A) the call will be exercised. B) the put will be exercised.
C) the call will not be exercised. D) the put will not be exercised.
Answer: A
3)All other things held constant, premiums on options will increase when the
A) exercise price increases.
B) volatility of the underlying asset increases.
C) term to maturity decreases.
D) futures price increases.
Answer: B
4) Financial intermediaries, particularly banks,
A) are experts in the production of information about firms so that it can sort good risks from bad ones.
B) overcome the free-rider problem by primarily making private loans, rather than purchasing securities that are traded in the open market.
C) play a greater role in moving funds to corporations than do securities markets.
D) all of the above.
Answer: D
5)The concept of adverse selection helps to explain
A) which firms are more likely to obtain funds from banks and other financial intermediaries, rather than from the securities markets.
B) why indirect finance is more important than direct finance as a source of business finance.
C) why direct finance is more important than indirect finance as a source of business finance.
D) only (a) and (b) of the above.
Answer: D
6)High net worth helps to diminish the problem of moral hazard problem by
A) requiring the state to verify the debt contract.
B) collateralizing the debt contract.
C) making the debt contract incentive compatible.
D) giving the debt contract characteristics of equity contracts.
Answer: C
7) Which of the following is not one of the eight basic puzzles about financial structure?
A) The financial system is among the most heavily regulated sectors of the economy.
B) Only large, well-established corporations have access to securities markets to finance their activities.
C) Collateral is a prevalent feature of debt contracts for both households and business.
D) Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrower.
E) Direct finance, in which businesses raise funds directly from lenders in financial markets, is many times more important than indirect finance, which involves the activities of financial intermediaries.
Answer: E
8)Collateral is
A) a prevalent feature of debt contracts for households.
B) a prevalent feature of debt contracts for business.
C) is property that is pledged to the lender if a borrower cannot make his or her debt payments.
D) all of the above.
Answer: D
9)The principal-agent problem
A) occurs when managers have more incentive to maximize profits than the stockholders-owners do.
B) would not arise if the owners of the firm had complete information about the activities of the managers.
C) in financial markets helps to explain why equity is a relatively important source of finance for American business.
D) all of the above.
Answer: B
10)Which of the following statements are true?
A) A bank's assets are its sources of funds.
B) A bank's liabilities are its uses of funds.
C) A bank's balance sheet shows that total assets equals total liabilities plus equity capital.
D) Each of the above.
Answer: C
11) Which of the following is an argument in support of a regulated minimum capital requirement?
A) Banks that hold too little capital are too profitable.
B) Banks that hold too little capital impose costs on other banks because they are more likely to fail.
C) Banks that hold too little capital have an unfair competitive advantage over savings and loans.
D) All of the above.
Answer: B
12)Which of the following statements most accurately describes the task of bank asset management?
A) Banks seek the highest returns possible subject to minimizing risk and making adequate provisions for liquidity.
B) Banks seek to have the highest liquidity possible subject to earning a positive rate of return on their operations.
C) Banks seek to prevent bank failure at all cost; since a failed bank earns no profit, liquidity needs supersede the desire for profits.
D) None of the above accurately describes the task of asset management.
Answer: A
13)Which of the following is not a reason for the rapid expansion of international banking?
A) The rapid growth in international trade.
B) The desire for U.S. banks to expand business to other countries with more profit opportunities.
C) The growth of multinational corporations.
D) None of the above.
Answer: D
14)As a result of restrictive banking regulations, the United States
A) has too few banks when compared to other industrialized countries.
B) has banks that are quite large relative to those in other countries.
C) has too many banks when compared to other industrialized countries.
D) both (a) and (b) of the above.
Answer: C
15)Deposit insurance
A) attracts risk-prone entrepreneurs to the banking industry.
B) encourages bank managers to take on greater risks than they otherwise would.
C) reduces the incentives of depositors to monitor the riskiness of their banks' asset portfolios.
D) does all of the above.
Answer: D
16)A bank failure is less likely to occur when
A) a bank holds less U.S. government securities.
B) a bank suffers large deposit outflows.
C) a bank holds more excess reserves.
D) a bank has more bank capital.
Answer: D
17)The main motive behind the forces that have shaped the development of the current regulatory system has been the
A) desire to prevent monopolistic practices.
B) desire to ensure a sound banking system.
C) desire to create an interstate banking system.
D) desire to foster a highly competitive banking system.
Answer: B
18)In 1987, Far West Savings & Loan Association, with a negative net worth of $290 million, persuaded the Federal Home Loan Bank of Seattle to lend the thrift more than $1 billion. This regulatory response to insolvency is an example of
A) loophole mining. B) regulatory forbearance.
C) securitization. D) none of the above.
Answer: B
19. (Bonus Question: 5 points) The news story "Firms Repeatedly Dodged Efforts To Rein In Off-the-Books Deals" highlights that the regulators in this case faced a lot of opposition from the firms who would have been affected by the proposed new measures. Who are the regulators in this case?
Compare this with the Savings and Loans banking crisis in the 80s. How is the problem of regulators in the present case different than that in the Savings and Loans crisis in terms of the politicians’ role?
Ans. The regulators in question are the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC). In the Savings and Loans case, politicians restrained regulators. This does not seem to be the case in the present story
20. Suppose you bought ten (10) futures for treasurys of 2012, deliverable in March 2003, each at a price of $100,000. You were asked to open a margin account with $ 15,000 for the whole transaction.
- (5 points) If the spot market price of treasurys of 2012 on the delivery date is $100100, what is the future price of these treasurys on the delivery day? Why?
- (5 points) How much total money you would have gained or lost? If you never got a margin call before this date, how much money would be in your margin account in the end? (Show your work)
Ans.
- The price of a future deliverable on the same day is equal to the security’s spot market price (otherwise, one can always profit from buying at a lower price in the lower price market and selling at higher price in the higher price market. Therefore, the equilibrium outcome will be having the same price in both markets). Thus, the future price of Treasurys of 2012 on delivery day will be equal to its spot price = $100,100.
- You have to pay $100, 000 as per the contract. Hence, you make a profit of $100*10=$1000 (on ten futures in total) on this account. As you deposited $15,000 in your margin account and never put any more money in it (because you never got a margin call), your margin account balance, after accounting for the profit of $1000, will be
$15000+$1000= $16000.
21. Here are the summary balance sheets of two banks A and B.
A
Assets / LiabilitiesReserves: $10 m / Deposits: $105m
Loans: $100m / Bank’s Capital: $5m
B
Assets / LiabilitiesReserves: $10 m / Deposits: $102m
Loans: $100m / Bank’s Capital: $8m
- (4 points) Suppose both banks have similar loans in regard to their expected returns and default risk. If, for each bank, $5 m loans become non-performing i.e., and the borrowers default, the banks will have to write them off. Which bank is in trouble now? Why? (Show your work)
- (4 points) Suppose there is no default problem and both banks have equal net profits of $ 2m from interest on their loans. Which bank’s shareholders are happier? Why? (Show your work)
Ans.
a. When the banks write of $5 m of loans that default, their new balance sheets will be
A
Assets / LiabilitiesReserves: $10 m / Deposits: $105m
Loans: $95m / Bank’s Capital: $0m
B
Assets / LiabilitiesReserves: $10m / Deposits: $102m
Loans: $95m / Bank’s Capital: $3m
We can see that bank A has a zero net worth ($0m). If the loss were any more than $5m, say $6m, the bank would have a negative net worth, (-$1m, if the loss was $6m). Although bank is not yet insolvent, in case of any more loan default it is likely to become insolvent or bankrupt. Thus, bank A is in trouble.
b. In the no-default situation, the return on capital for bank B is
Return on capital (B) = net profit/equity capital = 2/8 = 0.25 = 25%
On the other hand, for bank A
Return on capital (A) = net profit/equity capital = 2/5 = 0.4 = 40%
Shareholders of bank A are better off compared with bank B’s shareholders.
22. Suppose that two types of firms, H-type and L-type, are issuing new stocks. You know that the stock of L-type firms is worth $10/share whereas those of H-type firms are worth $ 60/share. You have to invest your money in buying stocks. Unfortunately, you have no way to find out which one is L-type or H-type. However, you know that, overall, the proportion of L-type firms is 40% whereas that of H-type firms is 60%.
- (5 points) If both firms were selling their stocks in the market, what price you would be willing to pay for each share without knowing the quality of the firm? (Show your work)
- (5 points) Suppose now that H-type firms are not willing to sell at a price lower than $60/share. Which firms would be selling their stocks now and at what price? (Show your work)
Ans.
- With no knowledge about the quality of a firm an investor will be willing to pay the expected price, i.e E(P) = Probability that it is a H-type stock * dollar value of H-type stock + Probability that it is a L-type stock * dollar value of L-type stock, or
E(P) = 0.6*60 + 0.4*10 = 40$
Hence, an investor will be willing to pay $40/share.
- When H-type firms don’t sell their stock at $60, investors know that only L-type stocks are being sold in the market. Then the expected price of a share will be equal to the dollar value of a L-type stock with probability one, i.e., equal to $10. We can see that because of the adverse selection problem only L-type stocks will be sold at a price of $10.
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