Practice Questions ( Final Exam)

Jannah&Mira

1) What are financial intermediaries and what do they do?

Topic: Chapter 1.2 Why Study Financial Institutions

A financial intermediary is an entity that acts as the middleman between two parties

in a financial transaction.

Eg: a commercial bank, investment banks, mutual funds and pension funds (kwsp)

Primary objective of the financial intermediaries is to channel savings into

investments. These intermediaries charge a fee for their services.

Functions:

1. It move funds from parties with excess capital to parties needing funds. The

process creates efficient markets and lowers the cost of conducting business.

2. They provide safety in accessing money and spread the risk. (prevent)

3. Providing cash facilities

4. Providing loans

5. Assist client to grow their investments (asb)

2) How does a bond differ from a stock?

Topic: Chapter 1.1 Why Study Financial Markets

Stocks, or shares of capital stock, represent an ownership interest in a corporation.

Every corporation has common stock. Some corporations issue preferred stock in

addition to its common stock. Shares of common stock do not have maturity dates.

Stocks pay dividends, which are a distribution of the corporation's profits to its

owners
Bonds are a form of long-term debt in which the issuing corporation promises to pay

the principal amount at a specified maturity date. Bonds also promise to pay a fixed

interest payment to the bondholders usually every six months until the bonds

mature.

3) Why is the stock market so important to individuals, firms, and the economy?

Topic: Chapter 1.1 Why Study Financial Markets

Individual

Bull markets (arising share price in market that encourage buying) can create a

wealth effect. People feel more confident as their investment portfolios rise in

value. They spend more on big-ticket items (brg2 mahal), such as homes and cars.

Conversely, falling stock prices create a reverse wealth effect. Falling portfolio

(basket of asset) values can create uncertainty about the future of the economy.
People hold back on their spending, especially on nonessential items. This slows down

economic growth because consumer spending is a key component of the gross

domestic product (GDP).

Effect on Business Investment

Stock prices can affect business investments. Businesses are likely to make capital

investments when they feel that these investments will lead to rising market values,

such as during rising or bull markets. Management has more operational flexibility if

sustained stock price increases lead to increased consumer spending. Merger and

acquisition (m&a) activity tends to increase during bull markets because companies

can use stock as currency. Initial public offerings (IPO) increase as new companies

take advantage of market optimism to raise capital.

Other Economic Factors

Stock markets are one of the factors that affect the economy, but there are others

as well. Interest rates affect the economy because rising rates mean higher

borrowing costs. Consumer spending and business investment slows down, which

reduces economic growth. Falling interest rates can stimulate economic growth.

Fiscal policy decisions also can affect the economy. For example, large budget

deficits can reduce government investments and purchases, which can slow down the

economy. Currency fluctuations can drive up the price of exports, which can harm

export-driven economies.
Interest rate high, cost borrow high -consumer spending low,business investment

low,economy low

Fiscal policy (budget deficit) - reduce the gov investment & purchase - slowdown

economy

4) What is the central bank and what does it do?

Topic: Chapter 1.2 Why Study Financial Institutions

A central bank is an independent national authority that conducts monetary policy,

regulates banks, and provides financial services including economic research. Its

goals are to stabilize the nation's currency, keep unemployment low, and prevent

inflation. The United States is the Federal Reserve System (also called simply the

Fed), Malaysia - Bank Negara Malaysia.

Monetary policy- Central banks affect economic growth by controlling the liquidity

in the financial system. They have three monetary policy tools to achieve this goal.

First, they set a reserve requirement. It's the amount of cash that member banks

must have on hand each night. The central bank uses it to control how much banks

can lend. Second, they use open market operations to buy and sell securities from

member banks (commercial bank-cimb). Third, they set targets on interest rates

they charge their member banks. That guides rates for loans, mortgages, and bonds.

Raising interest rates slows growth, preventing inflation.

Bank regulation- Central banks regulate their members. They require enough

reserves to cover potential loan losses. They are responsible for ensuring financial

stability and protecting depositors' funds.

Provide Financial Services- Central banks serve as the bank for private banks and
the nation's government (bsn). They process checks and lend money to their
members. Central banks store currency in their foreign exchange reserves. They use
these reserves to change exchange rates. They add foreign currency, usually the
dollar or euro, to keep their own currency in alignment.

5) Distinguish between direct financing and indirect financing.

Topic: Chapter 2.1 Function of Financial Markets

Why are direct financing transactions more costly or inconvenient than

intermediate 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

6) Distinguish between primary markets and secondary markets.

Topic: Chapter 2.2 Structure of Financial Markets

7) Distinguish between money markets and capital markets.

Topic: Chapter 2.2 Structure of Financial Markets

Money Market Capital Market

Definition Money market is part of the Capital market is part of the
financial market where financial market where lending
lending and borrowing takes and borrowing takes place for
place for short-term up to the medium term and long-term
one year more than 1 year

Types of Money markets generally Capital market deals in equity

instruments deal in promissory notes shares, debentures, bonds,
involved (contract), bills of exchange, preference shares etc.
commercial paper, T bills, call
money etc.

Institutions Money market contains Capital market involves

involved/types financial banks, the central stockbrokers, mutual funds,
of investors bank, commercial banks, underwriters, individual
financial Companies, chit investors, commercial banks,
funds (institution which stock exchanges, Insurance
accept saving at interest n Companies
lend money for house, etc)

Nature of Money markets are informal Capital markets are more formal
Market (not structured) (structured)

Liquidity of Money markets are liquid Capital Markets are

the market comparatively less liquid

Maturity The maturity of financial The maturity of capital markets

period instruments is generally up instruments is longer and they
to 1 year do not have stipulated (based on
demand) time frame

Return on The return in money markets The returns in capital markets

investment are usually low are high because of higher
duration

Risk factor Since the market is liquid Due to less liquid nature and long
and the maturity is less than maturity, the risk is
one year, Risk involved is low comparatively high
8) Why is it so important for an economy to have fully developed financial

markets?

Topic: Chapter 2.1 Function of Financial Markets

Because they channel funds from those who do not have a productive use for them

to those who do, thereby resulting in higher economic efficiency.

Financial markets help to efficiently direct the flow of savings and investment in the

economy in ways that facilitate the accumulation of capital and the production of

goods and services. The combination of well-developed financial markets and

institutions, as well as a diverse array of financial products and instruments, suits

the needs of borrowers and lenders and therefore the overall economy.

Efficient financial markets and institutions tend to lower search and transactions

costs in the economy. The financial market makes available every type of information

without spending any money. In this way, the financial market reduces the cost of

transactions.

Help maintaining the competitiveness of an economy today given the strongly

increased international competition, rapid technological progress and the increased

role of innovation for growth performance.

9) Why are financial intermediaries so important to an economy?

Topic: Chapter 2.4 Function of Financial Intermediaries: Indirect Finance

-Financial institutions (intermediaries) perform the vital role of bringing together

those economic agents with surplus funds who want to lend, with those with a

shortage of funds who want to borrow. In doing this they offer the major benefits
of maturity and risk transformation. It is possible for this to be done by direct

contact between the ultimate borrowers, but there are major cost disadvantages of

direct finance.

-Financial intermediaries help improving capital allocation to encourage technological

innovation by identifying and funding those entrepreneurs with profitable projects,

hence promoting economic development.

-Financial intermediaries could increase the real investment rate by reducing the

intermediation cost & provide additional resources for economic development.

-Financial intermediaries may help improving the saving rate, s, to influence the

economic development by improving the quality of financial services and reducing the

transaction cost to narrow the spreads between borrowing and lending rates.

-Financial liberalization and financial deepening would increase the efficiency of

financial intermediaries and help promote economic development through financial

intermediation.

10) What are adverse selection and moral hazard?

Topic: Chapter 2.4 Function of Financial Intermediaries: Indirect Finance

Moral hazard occurs when a party that has agreed to a transaction provides

misleading information or changes their behavior because they believe that they

won't have to face any consequences for their actions.

Moral hazard is the risk that one party has not entered into the contract in good

faith or has provided false details about its assets, liabilities, or credit capacity.

Adverse selection describes a situation in which one party in a deal has more

accurate and different information than the other party. The party with less
information is at a disadvantage to the party with more information. This asymmetry

causes a lack of efficiency in the price and quantity of goods and services.

11) Why can a financial intermediary's risk-sharing activities be described as

asset transformation?

Topic: Chapter 2.4 Function of Financial Intermediaries: Indirect Finance

Financial intermediaries do this through a process known as risk sharing they create
and sell assets with risk characteristics that people are comfortable with, and the
intermediaries then use the funds they acquire by selling these assets to purchase
other assets that may have far more risk. This process of risk sharing is also
sometimes referred to as asset transformation.

Asset transformation by financial intermediaries is purchasing primary asset or

securities and transforming them into different asset in terms of risk and maturity
date. The types of asset transformation by a financial institution is maturity
transformation, denomination transformation and risk transformation.

More specifically, asset transformation is the process of transforming bank

liabilities (deposits) into bank assets (loans). By nature, deposits are subject to
withdrawal by customers (depositors) at any point in time or as stipulated in the
deposit contract/agreement. Loans are bank assets because they represent money
that the bank lends and expect to receive back in the form of principal and interest
payments.

12) What concept is used to value a bond?

Topic: Chapter 3.1 Measuring Interest Rates

Bond valuation is a technique for determining the theoretical fair value of a particular bond.

Bond valuation includes calculating the present value of a bond's future interest payments,

also known as its cash flow, and the bond's value upon maturity, also known as its face value

or par value. Because a bond's par value and interest payments are fixed, an investor uses

bond valuation to determine what rate of return is required for a bond investment to be

worthwhile.

Bond valuation, in effect, is calculating the present value of a bond’s expected future coupon

payments. The theoretical fair value of a bond is calculated by discounting the present value

of its coupon payments by an appropriate discount rate. The discount rate used is the yield

to maturity, which is the rate of return that an investor will get if s/he reinvested every

coupon payment from the bond at a fixed interest rate until the bond matures. It takes into

account the price of a bond, par value, coupon rate, and time to maturity.

13) Why are long-term bonds more risky than short-term bonds?

Topic: Chapter 3.3 Distinction Between Interest Rates and Returns

A longer-term bond carries greater risk that higher inflation could reduce the

value of payments, as well as greater risk that higher overall interest rates could

cause the bond's price to fall.

Bonds with maturities of one to 10 years are sufficient for most long-term

investors. They yield more than shorter-term bonds and are less volatile than longer-

term issues.

For typical bonds the longer the maturity the higher the duration (or price

volatility from interest rate movements), and the smaller the coupon the higher the

interest rate risk.

Short-term (five year maturity or less) paper has historically a much better

risk-return tradeoff than long-term bonds.

Investors who lock into long-term bonds are taking on huge interest rate and

inflation risk.

14) What is meant by the risk structure of interest rates?

Topic: Chapter 5.1 Risk Structure of Interest Rates

Risk Structure of Interest Rates -Interest rates and yields on credit market

instruments of the same maturity vary because of differences in default risk,

liquidity, information costs, and taxation. These determinants are known collectively

as the risk structure of interest rates.

1. Default Risk is the probability that a borrower will not pay in full the promised

interest, principal, or both. The risk premium on a financial instrument is the

difference between its yield and the yield on a default-risk-free instrument of

comparable maturity. Generally, the larger the default risk, the larger the risk

premium, the higher the interest rate.

2. Liquidity because investors care about the cost required to convert a financial

instrument into cash, an increase in liquidity can make an instrument more desirable

to investors, who will then accept a lower rate of return. Thus a less liquid asset,

called an illiquid asset, must pay a higher yield in order to compensate savers for

their sacrifice of liquidity. This liquidity premium is commonly combined with default

risk as part of the risk premium.

3. Information Costs gathering information requires resources and reduces the

expected return on a financial asset. Government bonds such as Treasury bills have
the lowest information costs because all savers know with certainty that the

principal and interest will be repaid. Information costs increase if the borrowers are

not that well known and research needs to be conducted before potential lenders

are willing to buy bonds from such borrowers. In short the higher the information

costs, the higher the interest rate.

4. Taxation -Whether the financial instrument is exempted from taxation for

interest payments or capital gains affects the interest rate of the instrument.

Generally instruments that are tax exempt, are able to offer lower interest rates.

15) Explain why a flight to quality occurred following the subprime collapse and

how this affected the interest rates on lower-quality corporate bonds and

Treasury bonds.

Topic: Chapter 5.1 Risk Structure of Interest Rates

Flight to quality - as market collapsed, bond issuers were deemed more likely to
default, increased risk made Treasuries more attractive. Interest rates on low
quality corporates went up, rates on Treasuries went down.

16) Does the efficient market hypothesis imply that financial markets are

efficient? Explain.

Topic: Chapter 6.3 Why the Efficient Market Hypothesis Does Not Imply That

Financial Markets Are Efficient

The efficient market hypothesis does not imply that financial markets are

efficient. It does not imply the stronger view of market efficiency but rather just

that prices in markets like the stock market are unpredictable. Indeed, the
existence of market crashes and bubbles, in which the prices of assets rise well

above their fundamental values, casts serious doubt on the stronger view that

financial markets are efficient but provides less of an argument against the basic

lessons of the efficient market hypothesis.

17) What are economies of scale in financial transactions? How can financial

intermediaries achieve these economies?

Topic: Chapter 7.2 Transaction Costs

Economies of Scale refers to the cost advantage experienced by a firm when it

increases its level of output. The advantage arises due to the inverse relationship

between per-unit fixed cost and the quantity produced. The greater the quantity of

output produced, the lower the per-unit fixed cost. Economies of scale also result in

a fall in average variable costs (average non-fixed costs) with an increase in output.

This is brought about by operational efficiencies and synergies as a result of an

increase in the scale of production.

Economies of scale. A bank can become efficient in collecting deposits, and lending.

This enables economies of scale – lower average costs. If you had to seek out your

own savings, you might have to spend a lot of time and effort to investigate the best

ways to save and borrow.

Financial intermediaries enjoy economies of scale since they can take deposits from

a large number of customers and lend money to multiple borrowers. The practice

helps to reduce the overall operating costs that they incur in their normal business

routines. Unlike borrowing from individuals with inadequate funds to loan the

requested amount, financial institutions can often access large amounts of liquid cash

that they can loan to individuals with a strong credit history.

18) Distinguish between adverse selection and moral hazard.

Topic: Chapter 7.3 Asymmetric Information: Adverse Selection and Moral

Hazard

Moral hazard Adverse Selection

Moral hazard occurs when a party that Adverse selection describes a situation
has agreed to a transaction provides in which one party in a deal has more
misleading information or changes their accurate and different information
behavior because they believe that than the other party.
they won't have to face any
consequences for their actions.

The problem created by asymmetric The problem created by asymmetric

information after transaction occur information before the transaction
occur

19) What facts about financial structure can be explained by adverse selection?

Topic: Chapter 7.4 The Lemons Problem: How Adverse Selection Influences

Financial Structure

Can lead to failure of markets. Good companies unwilling to sell at average market price, bad

companies are only to happy to sell for more than they are worth. Investors wind up not

investing

“lemons problem,” because it resembles the problem created by lemons in the used-car

market.3 Potential buyers of used cars are frequently unable to assess the quality of the
car; that is, they can’t tell whether a particular used car is a car that will run well or a lemon

that will continually give them grief. The price that a buyer pays must therefore reflect the

average quality of the cars in the market, somewhere between the low value of a lemon and

the high value of a good car.

The owner of a used car, by contrast, is more likely to know whether the car is a

peach or a lemon. If the car is a lemon, the owner is more than happy to sell it at the price

the buyer is willing to pay, which, being somewhere between the value of a lemon and a good

car, is greater than the lemon’s value.

However, if the car is a peach, the owner knows that the car is undervalued at the

price the buyer is willing to pay, and so the owner may not want to sell it. As a result of this

adverse selection, few good used cars will come to the market. Because the average quality

of a used car available in the market will be low and because few people want to buy a lemon,

there will be few sales.

20) What facts about financial structure can be explained by moral hazard?

Topic: Chapter 7.6 How Moral Hazard Influences Financial Structure in Debt

Markets

Risk of moral hazard leads lenders to require complex contracts with restrictive and

prescriptive covenants.

Moral hazard occurs when there is asymmetric information between two parties and a

change in the behavior of one party after a deal is struck.

Moral hazard is postcontractual asymmetric information. It occurs whenever a borrower or

insured entity (an approved borrower or policyholder, not a mere applicant) engages in

behaviors that are not in the best interest of the lender or insurer. If a borrower uses a

bank loan to buy lottery tickets instead of Treasuries, as agreed upon with the lender, that’s
moral hazard. If an insured person leaves the door of his or her home or car unlocked or

lets candles burn all night unattended, that’s moral hazard. It’s also moral hazard if a

borrower fails to repay a loan when he or she has the wherewithal to do so, or if an insured

driver fakes an accident.

We call such behavior moral hazard because it was long thought to indicate a lack of morals

or character and in a sense it does. But thinking about the problem in those terms does not

help to mitigate it. We all have a price. How high that price is can’t be easily determined and

may indeed change, but offered enough money, every human being (except maybe Gandhi,

prophets, and saints) will engage in immoral activities for personal gain if given the chance.

It’s tempting indeed to put other people’s money at risk. As we’ve learned, the more risk,

the more reward. Why not borrow money to put to risk? If the rewards come, the principal

and interest are easily repaid. If the rewards don’t come, the borrower defaults and suffers

but little. Back in the day, as they say, borrowers who didn’t repay their loans were thrown

into jail until they paid up. Three problems eventually ended that practice. First, it is

difficult to earn money to repay the loan when you’re imprisoned! (The original assumption

was that the borrower had the money but wouldn’t cough it up.) Second, not everyone

defaults on a loan due to moral hazard. Bad luck, a soft economy, and/or poor execution can

turn the best business plan to mush. Third, lenders are almost as culpable as the borrowers

for moral hazard if they don’t take steps to try to mitigate it. A locked door, an old adage

goes, keeps an honest man honest. Don’t tempt people, in other words, and most won’t rob

you. There are locks against moral hazard. They are not foolproof but they get the job done

most of the time.

Because a debt contract requires the borrowers to pay out a fixed amount and lets them

keep any profits above this amount, the borrowers have an incentive to take on investment

projects that are riskier than the lenders would like.

21) What factors usually cause an increase in moral hazard?

Topic: Chapter 7.6 How Moral Hazard Influences Financial Structure in Debt

Markets

Asymmetric information

moral hazard occurs when someone increases their exposure to risk when insured, especially

when a person takes more risks because someone else bears the cost of those risks. A moral

hazard may occur where the actions of one party may change to the detriment of another

after a financial transaction has taken place.

Moral hazard also arises in a principal-agent problem, where one party, called an agent, acts

on behalf of another party, called the principal. The agent usually has more information

about his or her actions or intentions than the principal does, because the principal usually

cannot completely monitor the agent. The agent may have an incentive to act inappropriately

(from the viewpoint of the principal) if the interests of the agent and the principal are not

aligned.

22) What factors usually cause an increase in adverse selection?

Topic: Chapter 7.4 The Lemons Problem: How Adverse Selection Influences

Financial Structure

Assymetric information
23) What is the principal-agent problem?

Topic: Chapter 7.5 How Moral Hazard Affects the Choice Between Debt and

Equity Contracts

Particular type of moral hazard. Stock holders, "the principals" are not the
managers. Managers are "agents" of the principles. Problem is that without close
supervision by principles, managers (agents) do not always act in the best interest
of the principals.

Definition: The principal agent problem arises when one party (agent) agrees to work

in favor of another party (principal) in return for some incentives. Such an agreement

may incur huge costs for the agent, thereby leading to the problems of moral hazard

and conflict of interest. Owing to the costs incurred, the agent might begin to pursue

his own agenda and ignore the best interest of the principal, thereby causing the

principal agent problem to occur.

Description: The costs to agent and subsequent conflict of interest arise due to the

skewed information symmetry and the risk of failure faced by the principal.

For example: Shareholders of a company appoint managers to look after the

proceedings of the company and earn profits on their behalf. The shareholders

expect the managers to distribute all the profits to the shareholders. But the

managers sensing their own growth and salary expectation try to retain the profits

for future as a safe side. This can lead to principal agent problem. It is one of the

most noticed problems in the current situation when most companies are not being

managed by the owners themselves.

24) Why should we be concerned about conflicts of interest in the financial

services industry? Topic: Chapter 7.7 Conflicts of Interest

Conflicts of interest in financial industries cause financial markets and the economy

to become less efficient. The interests of financial services competing can lead to

concealing of information or misleading information. A decrease in the quality of

information in financial markets increases moral hazard and prevents financial

markets from doing their job, channeling funds into the most productive investment

opportunities.

25) What conflicts of interest can arise in investment banking, accounting firms

and credit rating agencies? Topic: Chapter 7.7 Conflicts of Interest

Conflicts of interest are a type of moral hazard problems that arise when a person

or institution has multiple objectives (interests) and, as a result, has conflicts among

those objectives. Conflicts of interest are especially likely to occur when a financial

institution provides multiple services.

1. Underwriting and Research in Investment Banking

Investment banks perform two tasks: They research companies issuing

securities, and they underwrite these securities by selling them to the public on

behalf of the issuing corporations. Investment banks often combine these distinct

financial services because information synergies are possible: That is, information produced

for one task may also be useful in the other task. COI arises between the brokerage and

underwriting services because the banks are attempting to simultaneously serve

two client groups—the security-issuing firms and the security-buying investors.

Issuers benefit from optimistic research, whereas investors desire unbiased

research

Another conflicts of interest is spinning. Spinning occurs when an investment

bank allocates hot, but underpriced, initial public offerings (IPOs)—that is, shares of

newly issued stock—to executives of other companies in return for their companies’

future business with the investment banks. Because hot IPOs typically immediately

rise in price after they are first purchased, spinning is a form of kickback meant to

persuade executives to use that investment bank

2. Auditing and Consulting in Accounting Firms

an auditor checks the books of companies and monitors the quality of the information

produced by firms to reduce the inevitable information asymmetry between the

firm’s managers and its shareholders. In auditing, threats to truthful reporting arise

from several potential conflicts of interest. The conflict of interest that has

received the most attention when an accounting firm provides its client with both

auditing services and nonaudit consulting services such as advice on taxes,

accounting, management information systems, and business strategy. The auditor

may be a bias towards the companies as there will be involved in managing the activity

of the companies.

3. Credit Assessment and Consulting in Credit-Rating Agencies

Investors use credit ratings (e.g., Aaa or Baa) that reflect the probability of default

to determine the creditworthiness of particular debt securities. As a consequence,

debt ratings play a major role in the pricing of debt securities and in the regulatory

process. Conflicts of interest can arise when multiple users with divergent interests

(at least in the short term) depend on the credit ratings. Investors and regulators

are seeking a well-researched, impartial assessment of credit quality; the issuer

needs a favorable rating. In the credit-rating industry, the issuers of securities pay

a rating firm such as Standard & Poor’s or Moody’s to have their securities rated.

Because the issuers are the parties paying the credit-rating agency, investors

and regulators worry that the agency may bias its ratings upward to attract more

business from the issuer.

26) Explain the relationship between agency theory and a financial crisis.

Topic: Chapter 8.1 What Is a Financial Crisis?

The financial credit crash of 2007 and 2008, based on various explanations of debt

derivatives and housing bubbles that caused many financial institutions to lend money

to those who could not repay, has its foundations in agency theory and faulty

business strategy. Agency theory is the conflict of interest that may arise between

the agent (the Chief Executive Officer or CEO or other managers) and the principals

(shareholders). This conflict can cause the firm – and ultimately, the shareholders –

to lose money. In the eyes of the shareholders, the goal of every CEO should be to

maximise shareholder wealth. Agency theory comes into play when the CEO does not

act in the best interest of the shareholders. Investment banks are now trying to

recoup funds from homeowners, only to find out that they cannot afford the

payments; they are then stuck with a foreclosed home and have to try to sell it in an

economy where house values have dropped in the last year. Examples from the

mortgage, financial and automotive industries are cited to illustrate certain points

associated with agency theory-based problems.

 Asymmetric information problems can generate adverse selection and moral

hazard problems agency theory. Agency theory provides the basis for our definition

of a financial crisis. Asymmetric information problems act as a barrier to financial

markets channeling funds efficiently from savers to households and firms with

productive investment opportunities and are often described as financial frictions.

When financial frictions increase, it is harder for lenders to ascertain the

creditworthiness of borrowers. They need to charge a higher interest rate to

protect themselves against the possibility that the borrower may not pay back the

loan, which leads to a higher credit spread, the difference between the interest

rate on loans to businesses and the interest rate on completely safe assets that are

sure to be paid back, such as default-free U.S. Treasury bills, notes, and bonds.

A financial crisis occurs when information flows in financial markets

experience a particularly large disruption, with the result that financial frictions and

credit spreads increase sharply and financial markets stop functioning. Then

economic activity will collapse.

27) Describe the sequence of events in a financial crisis in an advanced economy

and explain why they can cause economic activity to decline.

Topic: Chapter 8.2 Dynamics of Financial Crises in Advanced Economies

Stage One: Initiation of Financial Crisis Crises in advanced economies can be

triggered by a number of factors. But in emerging market countries, financial crises

develop along two basic paths—either the mismanagement of financial liberalization

and globalization or severe fiscal imbalances. The first path of mismanagement of

financial liberalization/globalization is the most common culprit, precipitating the

crises in Mexico in 1994 and many East Asian countries in 1997.

Path A: Credit Boom and Bust The seeds of a financial crisis in emerging market

economies are often sown when countries liberalize their domestic financial systems

by eliminating restrictions on financial institutions and markets, a process known as

financial liberalization, and opening up their economies to flows of capital and

financial firms from other nations, a process called financial globalization. Countries

often begin the process with solid fiscal policy. In the run-up to crisis, Mexico ran a

budget deficit of only 0.7% of GDP, a number to which most advanced countries

would aspire. And the countries in East Asia even ran budget surpluses before their

crisis struck. It is often said that emerging market financial systems have a weak

“credit culture” with ineffective screening and monitoring of borrowers and lax

government supervision of banks. Credit booms that accompany financial

liberalization in emerging market nations are typically marked by especially risky

lending practices, sowing the seeds for enormous loan losses down the road. The

financial globalization process adds fuel to the fire because it allows domestic banks

to borrow abroad. Banks pay high interest rates to attract foreign capital and so

can rapidly increase their lending. The capital inflow is further stimulated by

government policies that fix the value of the domestic currency to the U.S. dollar,

which provides foreign investors a sense of comfort. Just as in advanced countries

like the United States, the lending boom ends in a lending crash. Significant loan

losses emerge from long periods of risky lending, weakening bank balance sheets and

prompting banks to cut back on lending. The deterioration in bank balance sheets

has an even greater negative impact on lending and economic activity than in

advanced countries, which tend to have sophisticated securities markets and

large nonbank financial sectors that can pick up the slack when banks falter. So

as banks stop lending, there are really no other players to solve adverse selection
and moral hazard problems (as shown by the arrow pointing from the first factor in

the top row of Figure 25.1). The story told so far suggests that a lending boom and

crash are inevitable outcomes of financial liberalization and globalization in emerging

market countries, but this is not the case. These events occur only when there is an

institutional weakness that prevents the nation from successfully navigating the

liberalization/globalization process. More specifically, if prudential regulation and

supervision to limit excessive risk-taking were strong, the lending boom and bust

would not happen. Why is regulation and supervision typically weak? The answer is

the principal–agent problem which encourages powerful domestic business interests

to pervert the financial liberalization process. Politicians and prudential supervisors

are ultimately agents for voters-taxpayers (principals): that is, the goal of politicians

and prudential supervisors is, or should be, to protect the taxpayers’ interest.

Taxpayers almost always bear the cost of bailing out the banking sector if losses

occur.

Once financial markets have been liberalized, however, powerful business interests

that own banks will want to prevent the supervisors from doing their jobs properly,

and so prudential supervisors may not act in the public interest. Powerful business

interests that contribute heavily to politicians’ campaigns are often able to persuade

politicians to weaken regulations that restrict their banks from engaging in high-

risk/high-payoff strategies. After all, if bank owners achieve growth and expand

bank lending rapidly, they stand to make a fortune. But if the bank gets in trouble,

the government is likely to bail it out and the taxpayer foots the bill. In addition,

these business interests can make sure that the supervisory agencies, even in the

presence of tough regulations, lack the resources to effectively monitor banking

institutions or to close them down. Powerful business interests also have acted to

prevent supervisors from doing their job properly in advanced countries like the
United States. The weak institutional environment in emerging market countries

adds to the perversion of the financial liberalization process. In emerging market

economies, business interests are far more powerful than they are in advanced

economies, where a better-educated public and a free press monitor (and punish)

politicians and bureaucrats who are not acting in the public interest. Not surprisingly,

then, the cost to society of the principal–agent problem we have been describing

here is particularly high in emerging market economies.

Path B: Severe Fiscal Imbalances The financing of government spending can also

place emerging market economies on a path toward financial crisis. The financial

crisis in Argentina in 2001–2002 is of this type; other crises, for example in Russia

in 1998, Ecuador in 1999, and Turkey in 2001, also have some elements of this type

of crisis. When Willie Sutton, a famous bank robber, was asked why he robbed banks,

he answered, “Because that’s where the money is.” Governments in emerging market

countries sometimes have the same attitude. When they face large fiscal imbalances

and cannot finance their debt, they often cajole or force domestic banks to purchase

government debt. Investors who lose confidence in the ability of the government to

repay this debt unload the bonds, which causes their prices to plummet. Banks that

hold this debt then face a big hole on the asset side of their balance sheets, with a

huge decline in their net worth. With less capital, these institutions must cut back

on their lending and lending will decline. The situation can even be worse if the

decline in bank capital leads to a bank panic in which many banks fail at the same

time. The result of severe fiscal imbalances is therefore a weakening of the banking

system, which leads to a worsening of adverse selection and moral hazard problems

(as shown by the arrow from the first factor in the third row of Figure 25.1).

Additional Factors Other factors also often play a role in the first stage in crises.
For example, another precipitating factor in some crises (such as the Mexican crisis)

was a rise in interest rates from events abroad, such as a tightening of U.S.

monetary policy. When interest rates rise, high-risk firms are most willing to

pay the high interest rates, so the adverse selection problem is more severe.

In addition, the high interest rates reduce firms’ cash flows, forcing them to

seek funds in external capital markets in which asymmetric problems are

greater. Increases in interest rates abroad that raise domestic interest rates

can then increase adverse selection and moral hazard problems (as shown by the

arrow from the second factor in the top row of Figure 25.1).

Because asset markets are not as large in emerging market countries as they are in

advanced countries, they play a less prominent role in financial crises. Asset price

declines in the stock market do, nevertheless, decrease the net worth of firms and

so increase adverse selection problems. There is less collateral for lenders to seize

and increased moral hazard problems because, given their decreased net worth, the

owners of the firm have less to lose if they engage in riskier activities than they did

before the crisis. Asset price declines can therefore worsen adverse selection

and moral hazard problems directly and also indirectly by causing a deterioration

in banks’ balance sheets from asset write-downs (as shown by the arrow pointing

from the third factor in the first row of Figure 25.1). As in advanced countries, when

an emerging market economy is in a recession or a prominent firm fails, people

become more uncertain about the returns on investment projects. In emerging

market countries, notoriously unstable political systems are another source of

uncertainty. When uncertainty increases, it becomes hard for lenders to screen out

good credit risks from bad and to monitor the activities of firms to whom they have

loaned money, again worsening adverse selection and moral hazard problems (as

shown by the arrow pointing from the last factor in the first row of Figure 25.1).
Stage Two: Currency Crisis As the effects of any or all of the factors at the top

of the diagram in Figure 25.1 build on each other, participants in the foreign

exchange market sense an opportunity: they can make huge profits if they bet on a

depreciation of the currency. A currency that is fixed against the U.S. dollar now

becomes subject to a speculative attack, in which speculators engage in massive sales

of the currency. As the currency sales flood the market, supply far outstrips

demand, the value of the currency collapses, and a currency crisis ensues (see the

Stage Two section of Figure 25.1). High interest rates abroad, increases in

uncertainty, and falling asset prices all play a role. The deterioration in bank balance

sheets and severe fiscal imbalances, however, are the two key factors that trigger

the speculative attacks and plunge the economies into a full-scale, vicious downward

spiral of currency crisis, financial crisis, and meltdown. Deterioration of Bank

Balance Sheets Triggers Currency Crises When banks and other financial institutions

are in trouble, governments have a limited number of options. Defending their

currencies by raising interest rates should encourage capital inflows, but if the

government raises interest rates, banks must pay more to obtain funds. This increase

in costs decreases bank profitability, which may lead them to insolvency. Thus when

the banking system is in trouble, the government and central bank are now between

a rock and a hard place: If they raise interest rates too much, they will destroy their

already weakened banks and further weaken their economy. If they don’t, they can’t

maintain the value of their currency. Speculators in the market for foreign currency

recognize the troubles in a country’s financial sector and realize when the

government’s ability to raise interest rates and defend the currency is so costly that

the government is likely to give up and allow the currency to depreciate. They will

seize an almost sure-thing bet because the currency can only go downward in value.
Speculators engage in a feeding frenzy and sell the currency in anticipation of its

decline, which will provide them with huge profits. These sales rapidly use up the

country’s holdings of reserves of foreign currency because the country has to sell

its reserves to buy the domestic currency and keep it from falling in value. Once the

country’s central bank has exhausted its holdings of foreign currency reserves, the

cycle ends. It no longer has the resources to intervene in the foreign exchange

market and must let the value of the domestic currency fall: that is, the government

must allow a devaluation. Severe Fiscal Imbalances Trigger Currency Crises We have

seen that severe fiscal imbalances can lead to a deterioration of bank balance sheets

and so can help produce a currency crisis along the lines described previously. Fiscal

imbalances can also directly trigger a currency crisis. When government budget

deficits spin out of control, foreign and domestic investors begin to suspect that

the country may not be able to pay back its government debt and so will start pulling

money out of the country and selling the domestic currency. Recognition that the

fiscal situation is out of control thus results in a speculative attack against the

currency, which eventually results in its collapse.

Stage Three:

In contrast to most advanced economies that typically denominate debt in domestic

currency, emerging market economies denominate many debt contracts in foreign

currency (usually U.S. dollars) leading to what is referred to as currency mismatch.

An unanticipated depreciation or devaluation of the domestic currency (for example,

pesos) in emerging market countries increases the debt burden of domestic firms in
terms of domestic currency. That is, it takes more pesos to pay back the dollarized

debt. Since most firms price the goods and services they produce in the domestic

currency, the firms’ assets do not rise in value in terms of pesos, while their debt

does. The depreciation of the domestic currency increases the value of debt relative

to assets, and the firms’ net worth declines. The decline in net worth then increases

adverse selection and moral hazard problems described earlier. A decline in

investment and economic activity then follows (as shown by the Stage Three section

of Figure 25.1). We now see how the institutional structure of debt markets in

emerging market countries interacts with the currency devaluations to propel the

economies into fullfledged financial crises. A currency crisis, with its resulting

depreciation of the currency, leads to a deterioration of firms’ balance sheets that

sharply increases adverse selection and moral hazard problems. Economists often

call a concurrent currency crisis and financial crisis the “twin crises.” The collapse

of a currency also can lead to higher inflation. The central banks in most emerging

market countries, in contrast to those in advanced countries, have little credibility

as inflation fighters. Thus, a sharp depreciation of the currency after a currency

crisis leads to immediate upward pressure on import prices. A dramatic rise in both

actual and expected inflation will likely follow, which will cause domestic interest

rates to rise. The resulting increase in interest payments causes reductions in firms’

cash flow, which lead to increased asymmetric information problems since firms are

now more dependent on external funds to finance their investment. This asymmetric

information analysis suggests that the resulting increase in adverse selection and

moral hazard problems leads to a reduction in investment and economic activity. As

shown in Figure 25.1, further deterioration in the economy occurs. The collapse in

economic activity and the deterioration of cash flow and firm and household balance

sheets means that many debtors are no longer able to pay off their debts, resulting
in substantial losses for banks. Sharp rises in interest rates also have a negative

effect on banks’ profitability and balance sheets. Even more problematic for the

banks is the sharp increase in the value of their foreign-currency-denominated

liabilities after the devaluation. Thus, bank balance sheets are squeezed from both

sides—the value of their assets falls as the value of their liabilities rises. Under

these circumstances, the banking system will often suffer a banking crisis in which

many banks are likely to fail (as in the United States during the Great Depression).

The banking crisis and the contributing factors in the credit markets explain a

further worsening of adverse selection and moral hazard problems and a further

collapse of lending and economic activity in the aftermath of the crisis.

28) What are the major types of securities and who are the major participants

in the money markets? Topic: Chapter 11.3 Who Participates in the Money

Markets?

Money Market Securities are short-term assets typically with a maturity of one

year or less. Treasury Bills (T-bills), Commercial Paper, Certificates of Deposit

(CDs), and Bankers' Acceptances are all types of Money Market Securities.

The major participants in the money market are commercial banks, governments,

corporations, government-sponsored enterprises, money market mutual funds,

futures market exchanges, brokers and dealers, and the Federal Reserve.

Commercial Banks Banks play three important roles in the money market. First,

they borrow in the money market to fund their loan portfolios and to acquire funds

to satisfy noninterest-bearing reserve requirements at Federal Reserve Banks.

Banks are the major participants in the market for federal funds, which are very
short-term—chiefly overnight—loans of immediately available money; that is, funds

that can be transferred between banks within a single business day. The funds

market efficiently distributes reserves throughout the banking system. The

borrowing and lending of reserves takes place at a competitively determined interest

rate known as the federal funds rate.

29) What is the purpose of the capital market? How do capital market securities

differ from money market securities in their general characteristics? Topic:

Chapter 12. 1 Purpose of the Capital Market

Purpose: To allow for the efficient allocation of capital across industries, and by

extension, society as a whole. To enable income smoothing over time by letting

some borrow from future earnings for consumption today and others lend today in

the hopes of higher consumption in the future. To pro-vide a reasonable measure

of safety and fair deal-ing in the buying and selling of securities.

(difference refer ques 7)

30) What are the advantages and disadvantages of Electronic Communications

Networks (ECNs) for trading stocks?

Topic: Chapter 13.1 Investing in Stocks

Advantages of using ECN account

1. Security and privacy of trades

Privacy and safety of Forex trades is the foremost benefit of using ECN accounts.

The Forex market has so many players and every person needs to enjoy utmost
privacy and security. It is very possible to maintain high level of privacy and safety

because the brokers are only acting as middlemen in the market but not market

makers. So when a trader makes trade on an ECN network, he remains very secure

and his trades can neither be distinguished nor traced by others in the market.

2. Trade continuity

Another benefit of holding this type of account is the continuity of the trade which

is enjoyed by the traders. A trader neither requires nor does experience break

between different trades. Using ECN account allows you trade continuously during

news and events. We all know that continuous trading potentially increase the price

volatility. This gives the trade opportunity to benefit from the price volatility thus

becoming more profitable.

3. Enhanced execution

When using ECN account, the trader enjoys the benefit of an enhanced execution

of trade orders. This is because you will not be trading with the broker but simply

using their network to place your trade orders. This way, the ECN broker is by no

means responsible for executing orders but rather matching them to other market

participants. This is done as soon as possible allowing every trader to enjoyed

enhanced trade execution.

Disadvantage of using ECN account

1. High fees

The high levels of fees and commissions charges are the greatest disadvantage of

using ECN account. The design of ECN network is to charge commission on every

trade. When these commissions are accumulated it becomes too expensive as more
trades are executed every day. The profit level is thus lowered by the high

commissions making it less preferred by many traders.

2. Dishonesty

Sometimes the market markets can practice dishonesty. The design of this account

allows every participant to act as his own market maker. This promotes the practice

of dishonesty to crop in the market. There are higher chances of dishonest people

start introducing high volume trades so as to influence the market. Some people

would decide to deceive others that they are ECN brokers while they are not.

31) What is the role of the required return on equity investments in stock

valuation Models? Topic: Chapter 13.2 Computing the Price of Common Stock

32) Using the Gordon growth model, explain why the 2001 terrorist attacks and

the Enron financial scandal caused stock prices to decline.

Topic: Chapter 13.2 Computing the Price of Common Stock

The September 11 terrorist attack raised the possibility that terrorism against the United

States would paralyze the country. These fears led to a downward revision of the growth

prospects for U.S. companies, thus lowering the dividend growth rate g in the Gordon model.

The resulting rise in the denominator in Equation 5 should lead to a decline in P0 and hence

a decline in stock prices.

Increased uncertainty for the U.S. economy would also raise the required return on

investment in equity. A higher ke also leads to a rise in the denominator in Equation 5, a

decline in P0, and a general fall in stock prices. As the Gordon model predicts, the stock

market fell by over 10% immediately after September 11.

Subsequently, the U.S. successes against the Taliban in Afghanistan and the absence of

further terrorist attacks reduced market fears and uncertainty, causing g to recover and

ke to fall. The denominator in Equation 5 then fell, leading to a recovery in P0 and the stock

market in October and November. However, by the beginning of 2002, the Enron scandal

and disclosures that many companies had overstated their earnings caused many investors

to doubt the formerly rosy forecast of earnings and dividend growth for corporations. The

resulting revision of g downward, and the rise in ke because of increased uncertainty about

the quality of accounting information, should have led to a rise in the denominator in the

Gordon Equation 5, thereby lowering P0 for many companies and hence the overall stock

market. As predicted by our analysis, this is exactly what happened. The stock market

recovery was aborted and it entered a downward slide.

Equation 5 = = use for valuation of stock

33) What are the objectives of the Securities and Exchange Commission?

Topic: Chapter 13.6 Regulation of the Stock Market

Corporate Disclosure of Information

The Division of Corporation Finance assists SEC in the implementation of the

Securities Act of 1933 -commonly known as the truth in securities law -- which has

the objective of ensuring that corporations provide investors with material

information regarding securities offered for sale and preventing misrepresentation

and fraud when transacting securities.

Fair, Orderly and Efficient Markets

The SEC's Division of Trading and Markets provides daily oversight of the major

participants in the securities markets including the exchanges, clearing agencies,

credit rating agencies and securities firms to ensure orderly and efficient markets.

Investor Protection

The SEC's responsibility for protecting investors is carried out by the Division of

Investment Management. It regulates the activities of businesses whose own

securities are publicly offered and are engaged in investing, reinvesting and trading

in securities.

Law Enforcement

The SEC is a law enforcement agency and utilizes the Division of Enforcement to

obtain evidence of possible violations of the securities laws to bring civil actions in

federal court. Such evidence is obtained from sources like investor tips and

complaints, market surveillance activities, other SEC divisions, securities industry

sources and media reports.

33) What is the asymmetric information problem and how does it contribute to

our understanding of the structure of bank regulation in the United States and

other Countries? Topic: Chapter 18.1 Asymmetric Information and Financial

Regulation

Asymmetric information, also known as "information failure," occurs when one party

to an economic transaction possesses greater material knowledge than the other

party. This typically manifests when the seller of a good or service possesses greater

knowledge than the buyer; however, the reverse dynamic is also possible

34) Why is international financial regulation becoming more important in recent

years? Topic: Chapter 18.1 Asymmetric Information and Financial Regulation

35) One way to avoid the too-big-to-fail problem with banks is to break-up

large systemically important financial institutions. What are the downsides to

this solution? Topic: Chapter 18.6 Too-big-to-fail and Future Regulation

One problem with the too-big-to-fail policy is that it increases the moral

hazard incentives for big banks. If the bank were willing to close down using the

payoff method, paying depositors only up to the current limit, which the large

depositor with more than the current limit will suffer losses if the bank failed. Thus

they would have to monitor the bank by examining the bank activities and pulling out

their money from the bank if the bank taking on too much risk. To prevent such a

loss of deposits, the bank would be more likely to engage in less risky activities.

The too-big-to-fail policy increases the moral hazard incentives for nonbank

financial institutions that are extended a government safety net. Knowing that the

financial institution will be bailed out, creditors have little incentive to monitor the

institution and pull their money out when the institution is taking on excessive risk.
As a result, large or interconnected financial institutions are more likely to engage

in highly risky activities, making a financial crisis more likely

36) How does Dodd-Frank claim to eliminate the too-big-to-fail problem?

Topic: Chapter 18.6 Too-big-to-fail and Future Regulation

1. Break Up Large, Systemically Important Financial Institutions

One way to eliminate the too-big-to-fail problem is to make sure that no financial

institutions are so large that they can bring down the financial system. Then

regulators will no longer see the need to bail out these institutions, thereby

subjecting them to market discipline. One way to shrink these institutions is to

reimpose the restrictions in place before Glass-Steagall was repealed, thereby

forcing these large SIFIs (A systemically important financial institution (SIFI) is a bank, insurance or

other financial institution that U.S. federal regulators determine would pose a serious risk to the economy if it

were to collapse) to break up their different activities into smaller, cohesive companies.

Alternatively, regulations could specify that no financial institution can have assets

over a specified maximum limit, forcing SIFIs to break up into smaller pieces.

2. Higher Capital Requirements

Institutions that are too big to fail have incentives to take on excessive risk. So

another way to reduce their risk taking is to impose higher capital requirements on

them. With higher capital, these institutions will not only have a larger buffer to

withstand losses but also suffer greater losses, hence have more “skin in the game,”

which reduces moral hazard and giving them less incentive to take on excessive risk.

Another way of describing this approach is to say that higher capital requirements

reduce the subsidy to risk taking for institutions that are too big to fail.
 3. Leave It to Dodd-Frank

By making it harder for the Federal Reserve to bail out financial institutions, by

increasing stricter regulations for SIFIs, and through the application of the Volcker

rule. The Volcker Rule prohibits banks from using customer deposits for their own

profit. They can't own, invest in, or sponsor hedge funds, private equity funds, or

other trading operations for their use.

37) What financial innovations are best explained as attempts to avoid

regulations? Topic: Chapter 19.2 Financial Innovation and the Growth of the

Shadow Banking System

1. Reserve requirements.

The key to understanding why reserve requirements led to financial innovation

is to recognize that they act, in effect, as a tax on deposits. Because up until 2008

the Fed did not pay interest on reserves, the opportunity cost of holding them was

the interest that a bank could otherwise earn by lending the reserves out. For each

dollar of deposits, reserve requirements therefore imposed a cost on the bank equal

to the interest rate, i, that could be earned if the reserves could be lent out times

the fraction of deposits required as reserves, r. The cost of i * r imposed on the

bank is just like a tax on bank deposits of i * r per dollar of deposits.

It is a great tradition to avoid taxes if possible, and banks also play this game.

Just as taxpayers look for loopholes to lower their tax bills, banks seek to increase

their profits by mining loopholes and by producing financial innovations that allow

them to escape the tax on deposits imposed by reserve requirements.

 2. Restrictions on interest paid on deposits.

Until 1980, legislation prohibited banks in most states from paying interest on

checking account deposits, and through Regulation Q, the Fed set maximum limits on

the interest rate that could be paid on time deposits. To this day, banks are not

allowed to pay interest on corporate checking accounts. The desire to avoid these

deposit rate ceilings also led to financial innovations.

If market interest rates rose above the maximum rates that banks paid on

time deposits under Regulation Q, depositors withdraw funds from banks to put them

into higher-yielding securities. This loss of deposits from the banking system

restricted the amount of funds that banks could lend (called disintermediation) and

thus limited bank profits. Banks had an incentive to get around deposit rate ceilings

because by so doing, they could acquire more funds to make loans and earn higher

profits.

38) What are the reasons for the decline of traditional banking?

Topic: Chapter 19.2 Financial Innovation and the Growth of the Shadow Banking

System

1. Decline in Cost Advantages in Acquiring Funds (Liabilities)

Until 1980 banks were subject to deposit rate ceilings that restricted them from

paying interest on checkable deposits and (under Regulation Q) limited them to

paying a maximum interest rate of a little more than 5% on time deposits. Until the

1960s, these restrictions worked to the banks’ advantage because their major

source of funds (in excess of 60%) was checkable deposits, and the zero interest

cost on these deposits meant that the banks had a very low cost of funds.

Unfortunately, this cost advantage for banks did not last. The rise in inflation

beginning in the late 1960s led to higher interest rates, which made investors more

sensitive to yield differentials on different assets. The result was the

disintermediation process, in which people began to take their money out of banks,

with their low interest rates on both checkable and time deposits, and began to seek

out higher-yielding investments. At the same time, attempts to get around deposit

rate ceilings and reserve requirements led to the financial innovation of money

market mutual funds, which put the banks at an even further disadvantage because

depositors could now obtain checking account-like services while earning high

interest on their money market mutual fund accounts. One manifestation of these

changes in the financial system was that the low-cost source of funds, checkable

deposits, declined dramatically in importance for banks, falling from more than 60%

of bank liabilities to around 10% today.

2. Decline in Income Advantages on Uses of Funds (Assets)

The loss of cost advantages on the liabilities side of the balance sheet for American

banks is one reason that they have become less competitive, but they have also been

hit by a decline in income advantages on the assets side from the financial

innovations we discussed earlier—junk bonds, securitization, and the rise of the

commercial paper market. The resulting loss of income advantages for banks relative

to these innovations has resulted in a loss of market share and has led to the growth
of the shadow banking system, which has made use of these innovations to enable

borrowers to bypass the traditional banking system.

3. Banks’ Responses

In any industry, a decline in profitability usually results in exit from the industry

(often due to widespread bankruptcies) and a shrinkage of market share. This

occurred in the banking industry in the United States during the 1980s via

consolidations and bank failures. In an attempt to survive and maintain adequate

profit levels, many U.S. banks face two alternatives. First, they can attempt to

maintain their traditional lending activity by expanding into new and riskier areas of

lending. The second way banks have try to maintain former profit levels is to pursue

new off-balance-sheet activities that are more profitable and in effect embrace the

shadow banking system.

39) Why must insurance companies screen applicants so carefully?

Topic: Chapter 21.2 Fundamentals of Insurance

Screening to reduce adverse selection, insurance companies try to screen out

poor insurance risks from good ones. Effective information collection procedures are

therefore an important principle of insurance management.

Prevention of Fraud. Insurance companies also face moral hazard because an

insured person has an incentive to lie to the company and seek a claim even if the

claim is not valid. For example, a person who has not complied with the restrictive

provisions of an insurance contract may still submit a claim. Even worse, a person may

file claims for events that did not actually occur. Thus, an important management

principle for insurance companies is conducting investigations to prevent fraud so

that only policyholders with valid claims receive compensation.

40) Why will Social Security funding problems rise in the coming decades?

Identify and evaluate the proposals that have been suggested to ease or reverse

these problems. Topic: Chapter 21.6 Types of Pensions

The problem is that, millions of baby boomers are reaching their normal retirement

ages, meanwhile the workers that supporting each one of those retirees will fall. The

gov predict the cost will exceed the revenue, lead to reduced in the asset balances

Proposal to reserve the problem.

1. To raise the cap on the maximum amount that workers have to pay into the

fund in any given year.

2. To change concerns the minimum age when one can start receiving benefits.

This was changed in 1984 to gradually rise so that those born after 1960

cannot start receiving full benefits until they are age 67. Small changes to

the retirement age have a large impact on the Social Security fund balance.

3. To alter the way that cost-of-living adjustments to Social Security payments

are calculated. Currently the benefit payments are adjusted annually based on

the consumer price index (CPI). Economists argue that this overstates true

inflation because it ignores consumers’ switching to less expensive

alternatives. While admitting some validity to this, critics argue that the CPI

underestimates the increase in medical costs, which make up a large portion

of retirees’ budgets
41) Describe how insurance companies try to reduce adverse selection and moral

hazards. Topic: Chapter 21.2 Fundamentals of Insurance

Moral Hazard: A moral hazard exists when a person (or entity) intentionally takes
additional risk or exaggerates a loss because someone else (insurance company) is
going to bear the costs of those risks. A moral hazard generally exists after a policy
is put in force.

Measures that insurance companies take to reduce moral hazards include:

● Proper use of Deductibles and Copay's - making the first dollars the
responsibility of the insured, reduces the potential for abuse of
insurance.
● Use of Credit & Insurance Scores - A person's use of credit is an
indicator of their potential for moral hazard
● Penalize bad behavior - insurance companies prosecute fraud in
order to mitigate losses to moral hazards.

● Good claim metrics - Insurance companies monitor frequency and

relative severity of losses to determine where moral hazards have
existed.

Adverse Selection: Adverse selection is an undesired result because one party has
more information or a product advantage (client/prospect) than the other party
anticipates (insurance company). The client/prospects seizes the opportunity
because of the imbalance in information that they possess or the product advantage
which weighs in their favor. Adverse selection is condition that exists prior to a
policy being put in force.

Measures that insurance companies take to reduce adverse selection include:

● Proper Pricing - Adequately pricing insurance for the risks insured

 ● Risk Selection/Underwriting Rules - Features, benefits or

underwriting rules that attract above average risks

● Spread of Risk - Seek to obtain an optimum spread of independent

loss exposures by location, class, size and line of business

The risk of adverse selection and moral hazards are lower with insurance products

that are allowed adequate pricing and underwriting guidelines. Conversely those

products that are not granted that same level of authority can anticipate they will

attract risks that have greater exposure and need the coverage most.

Depending on the line of business, underwriting and pricing practices allowed, moral

hazards and adverse selection represent a manageable challenge - to - a cost of doing

business for insurance companies.

42) What niche in the financial system (jenis sistem kewangan) do venture capital

firms fill?

Topic: Chapter 22.5 Private Equity Investment

Venture capital funds are investment funds that manage the money of investors who
seek private equity stakes in startup and small- to medium-sized enterprises with strong
growth potential. These investments are generally characterized as high-risk/high-return
opportunities
Buyout is an investment transaction by which the ownership equity of a company, or a
majority share of the stock of the company is acquired. The acquiror thereby "buys out"
the present equity holders of the target company.
43) How do venture capital firms overcome the problem of information

asymmetries that accompany start-up firms? Topic: Chapter 22.5 Private Equity

Investment

Managers of these firms may engage in wasteful expenditures, such as leasing expensive office
space, since the manager may benefit disproportionately from them but does not bear their entire
cost. The difficulty outside investors have in tracking early-stage high-technology companies
leads to other types of costs.

First, as opposed to bank loans or bond financing, venture capital firms hold an equity interest in
the firm. The firms are usually privately held, so the stock does not trade publicly. Equity interests
in privately held firms are very illiquid. As a result, venture capital investment horizons are long-
term. The partners do not expect to earn any return for a number of years, often as long as a
decade. In contrast, most investors in stocks are anxious to see annual returns through either
stock appreciation or dividend payouts. They are often unwilling to wait years to see if a new idea,
process, innovation, or invention will yield profits. Similarly, most investors in bonds are not going
to wait years for revenues to grow to a point where interest payments become available. Venture
capital financing thus fills an important niche left vacant by alternative sources of capital.

As a second method of addressing the asymmetric information problem, venture capital usually
comes with strings attached, the most noteworthy being that the partners in a venture capital firm
take seats on the board of directors of the financed firm. Venture capital firms are not passive
investors. They actively attempt to add value to the firm through advice, assistance, and business
contacts. Venture capitalists may bring together two firms that can complement each other’s
activities. Venture capital firms will apply their expertise to help the firm solve various financing
and growth-related problems. The venture capital partners on the board of directors will carefully
monitor expenditures and management to help safeguard the investment in the firm. One of the
most effective ways venture capitalists have of controlling managers is to disburse funds to the
company in stages only as the firm demonstrates progress toward its ultimate goal. If
development stalls or markets change, funds can be withheld to cut losses
44) Discuss the challenges regulators face in controlling the use of derivatives

by financial institutions. Topic: Chapter 24.A1 More on Hedging with Financial

Derivatives

(tak sure lh)

Recent events indicate that financial derivatives pose serious dangers to the financial system, but
some of these dangers have been overplayed. The biggest danger occurs in trading activities of
financial institutions, and this is particularly true for credit derivatives, as was illustrated by AIG’s
activities in the CDS market.

Regulators have been paying increased attention to this danger and are continuing to develop
new disclosure requirements and regulatory guidelines for how derivatives trading should be
done. Of particular concern is the need for financial institutions to disclose their exposure in
derivatives contracts, so that regulators can make sure that a large institution is not playing too
large a role in these markets and does not have too large an exposure to derivatives relative to
its capital, as was the case for AIG. Another concern is that derivatives, particularly credit
derivatives, need to have a better clearing mechanism so that the failure of one institution does
not bring down many others whose net derivatives positions are small, even though they have
many offsetting positions. Better clearing could be achieved either by having these derivatives
traded in an organized exchange like a futures market or by having one clearing organization net
out trades. Regulators such as the Federal Reserve Bank of New York have been active in making
proposals along these lines.

The credit risk exposure posed by interest-rate derivatives, by contrast, seems to be manageable
with standard methods of dealing with credit risk, both by managers of financial institutions and
by the institutions’ regulators.

45) Why would a crisis in the subprime mortgage market lead to declining prices

in the U.S. equity markets? Topic: Chapter 13.4 Errors in Valuation

The subprime financial crisis had a major negative impact on the economy, leading to a

downward revision of the growth prospects for U.S. companies, thus lowering the dividend

growth rate (g) in the Gordon model. The resulting increase in the denominator in Equation

P0 = D0 * (1 + g) / (ke - g) = D1/ (ke - g) would lead to a decline in P0 and hence a decline in stock

prices.

Increased uncertainty for the U.S. economy and the widening credit spreads resulting from

the subprime crisis would also raise the required return on investment in equity. A higher

ke(cost of equity = rate of return) also leads to an increase in the denominator in Equation

P0 = D0 * (1 + g) / (ke - g) = D1/ (ke - g) use for valuation of stock, a decline in P0, and a general fall in

stock prices. In the early stages of the financial crisis, the decline in growth prospects and

credit spreads were moderate and so, as the Gordon model predicts, the stock market

decline was also moderate. However, when the crisis entered a particularly virulent stage,

credit spreads shot through the roof, the economy tanked, and as the Gordon model

predicts, the stock market crashed

46) Discuss the pros and cons of a subprime market for residential mortgages

in the U.S. Topic: Chapter 14.8 What Is a Mortgage-Backed Security?

PROS:

It allows people with low credit scores a chance to own a home without going through

years of trying to establish a better credit history.

Subprime loans can help borrowers fix their credit scores, by using it to pay off

other debts and then working towards making timely payments on the mortgage.

CONS:
Closing costs and fees are generally higher with subprime loans; the lender tries to

get as much money up front as possible because of the increased risk and chances

of the borrower defaulting.

Even though credit scores aren’t a determining factor for qualifying for the loan,

income is. Borrowers must show that they have sufficient income to finance the

monthly mortgage payments.

Advantages of Subprime Mortgages

Subprime mortgages come with wide scale benefits to both borrowers and

lenders. To begin with, the first major benefit that borrowers accrue from this type

of mortgage is its ease of approval. Subprime mortgages unlike conventional

mortgages do not need a lot of formalities to approve. In fact, companies which issue

subprime mortgages do not concentrate at all on formalities that are meant to depict

the credit rating of an individual. The ease of approval means that subprime

mortgages can be acquired within a shorter period in that the conventional

mortgages; this is suitable for borrowers who could have urgent need for money. In

addition; subprime mortgages provide a relief to people with low credit rating and

who may be denied mortgages from other financial institutions owing to low credit

rating. For a borrower to qualify for a subprime mortgage he or she does not have

to meet the credit threshold set by Fair Isaac and Company FICO, this ensures that

individuals can still have their financial needs met despite having low credit rating

(Demyanyk & Van Hemert 2011).

Another advantage of subprime mortgage is their high usefulness in debt

settlements for people in high debt. Such people are hindered from accessing

conventional mortgages by their debts; it would mean that if it were not for subprime

mortgages, such people would continue drowning in mortgage loans. Individuals can
access subprime mortgages to pay for their outstanding mortgage loans; after which

they can now focus on paying for the subprime loan; this way, such individuals are

able to increase their credit rating through time. Therefore, subprime mortgages

provide an opportunity to people with low credit rating to improve their credit

worthiness (Kregel 2008).

Subprime Mortgages also have outstanding benefits to financial institutions which

issue them. These types of mortgages are issued at very high interest rates in

comparison to conventional mortgages. The interest ceiling for subprime mortgages

is very high, and it allowable by the government. The high interest rates are meant

to relief the issue of the burden of risk that comes with issuing mortgages to

persons with low credit rating. This means that institutions which issue subprime

mortgages stand to gain more returns from the issue in comparison to institutions

which issue ordinary mortgages. The high interest rates ensured that returns from

borrowers who default the mortgages are covered. In addition, the mortgages are

issued in good faith and there are very limited chances of default. Therefore,

subprime mortgage issuers stand to benefit more from the mortgages in comparison

to conventional mortgage companies. For instance, before the bursting of the

housing bubble in 2008, organizations that specialized in subprime mortgages had

realized high levels of returns (Demyanyk & Van Hemert 2011).

Disadvantages of subprime mortgages

Despite the advantages that come with subprime mortgages they have various

disadvantages to borrowers and lenders. The major disadvantage of subprime

mortgages to borrowers is that they attract very high interest rates in comparison

to conventional mortgages. This means that borrowers of subprime mortgages will

end up paying more in comparison to if they took ordinary mortgages. Therefore,

subprime mortgages come with a higher financial burden to borrowers in comparison

to conventional mortgages. Another disadvantage of subprime mortgages is that they

could put borrowers in a debt trap. The mortgages enable borrowers to access credit

even when their credit rating is low; this could tempt the borrowers to borrow more

than they can pay which could lead them to bankruptcy and insolvency (Purnanandam

2011).

The major disadvantage of subprime mortgages to lenders is that the lenders

stand at a very high risk of losing the funds invested since they mortgages are issued

to persons of low credit rating. There is a very high chance of subprime mortgages

borrowers defaulting, hence the mortgages pose a high financial risks to issuers. The

second disadvantage of subprime mortgages to lenders is that few or no insurance

companies will be ready to underwrite such loans; this means that in a case of

borrowers defaulting, the issuers will have to bear all the financial loses realized

(Kregel 2008).

47) How can financial liberalizations lead to financial crises?

Topic : Chapter 8 Why Do Financial Crises Occur and Why Are They So Damaging

to the Economy?

Financial liberalization increases the likelihood of banking crisis and debt crisis in

both developing and developed countries. Regarding inflation crisis, financial

liberalization increases the likelihood of crisis in developed countries but reduces

the likelihood of crisis in developing countries. Financial liberalization decreases the

probability of currency crisis in developing countries and increases the probability

of stock market crash in developed countries. financial liberalization dimensions

that have major contribution in affecting each type of crises.

Financial liberalization often leads to financial crises. This link has usually been

attributed to moral hazard from promised bailouts, or to pressure from increased

competition.

48) What role does weak financial regulation and supervision play in causing

financial crises?

Topic : Chapter 8 Why Do Financial Crises Occur and Why Are They So Damaging to

the Economy?