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Questions and Answers of Banking

What risks might financial institutions face by funding long-run loans such as mortgages to borrowers (often at fixed interest rates) with short-term deposits from savers?
If higher leverage is associated with greater risk, explain why the process of deleveraging (reducing leverage) can be destabilizing.
You wish to buy an annuity that makes monthly payments for as long as you live. Describe what happens to the purchase price of the annuity as (a) Your age at the time of purchase goes up, (b) The
The design and function of financial instruments, markets, and institutions aretied to the importance of information. Describe the role played by information in each of these three pieces of the
Suppose you need to take out a personal loan with a bank. Explain how you could be affected by problems in the interbank lending market such as those seen during the 2007-2009 financial crisis.
Advances in technology have facilitated the widespread use of credit scoring by financial institutions in making their lending decisions. Credit scoring can be defined broadly as the use of
For each pair of instruments below, use the criteria for valuing a financial instrument to choose the one with the highest value.a. A U.S. Treasury bill that pays $1,000 in six months or a
Joe and Mike purchase identical houses for $200,000. Joe makes a down payment of $40,000 while Mike only puts down $10,000; for each individual, the down payment is the total of his net worth.
What would you expect to happen to investment and growth in the economy if the U.S. government decided to abolish the Securities and Exchange Commission?
Use Core Principle 3 from Chapter to suggest some ways in which the problems associated with the shadow banking sector during the 2007-2009 financial crisis might be mitigated in the future.
As the manager of a financial institution, what steps could you take to reduce the risks referred to in Problem 21?
Probably the most famous stock index in the financial markets is the Dow Jones Industrial Average. Plot this index (FRED code: DJIA) over the period from 1960 to the present.
Plot the percent change from a year ago of the Dow Jones Industrial Average (FRED code: DJIA). Discuss the behavior of changes in the average before, during, and after recession periods, which are
Do changes in stock values affect the wealth of households? Beginning in 1960, plot on a quarterly basis the percent change from a year ago of the Dow Jones Industrial Average (FRED code: DJIA) and
The Dow Jones Industrial Average is an index of the prices of only 30 stocks. Consider a much broader measure of the stock market -- the market value of equities (FRED code: MVEONWMVBSNNCB)– which
Compute the future value of $100 at an 8 percent interest rate 5, 10, and 15 years into the future. What would the future value be over these time horizons if the interest rate were 5 percent?
Compute the present value of a $100 investment made 6months, 5 years, and 10years from now at 4 percent interest.
Assuming that the current interest rate is 3 percent, compute the present value of a five-year, 5 percent coupon bond with a face value of $1,000. What happens when the interest rate goes to 4
Given a choice of two investments, would you choose one that pays a total return of 30 percent over five years or one that pays 0.5 percent per month for five years?
Consider two scenarios. In the first, the nominal interest rate is 6 percent and the expected rate of inflation is 4 percent. In the second, the nominal interest rate is 5 percent and the expected
Most businesses replace their computers every two to three years. Assume that a computer costs $2,000 and that it fully depreciates in 3 years, at which point it has no resale value and is
Some friends of yours have just had a child. Thinking ahead, and realizing the power of compound interest, they are considering investing for their child’s college education, which will begin in
Use the Fisher equation to explain in detail what a borrower is compensating a lender for when he pays her a nominal rate of interest.
Which would be most affected in the event of an interest rate increase– the price of a five-year coupon bond that paid coupons only in years 3, 4, and 5 or the price of a five-year coupon bond that
Under what circumstances might you be willing to pay more than $1,000 for a coupon bond that matures in three years, has a coupon rate of 10 percent, and a face value of $1,000?
Approximately how long would it take for an investment of $100 to reach $800 if you earned 5 percent? What if the interest rate were 10 percent? How long would it take an investment of $200 to
Rather than spending $100 today on paint today, you decide to save the money until next year, at which point you will use it to paint your room. If a can of paint costs $10 today, how many cans will
Recently, some lucky person won the lottery. The lottery winnings were reported to be $85.5 million. In reality, the winner got a choice of $2.85 million per year for 30 years or $46 million
You are considering going to graduate school for a one-year master’s program. You have done some research and believe that the master’s degree will add $5,000 per year to your salary for the
Assuming the chances of being paid back are the same, would a nominal interest rate of 10 percent always be more attractive to a lender than a nominal rate of 5 percent? Explain.
Suppose two parties agree that the expected inflation rate for the next year is 3 percent. Based on this, they enter into a loan agreement where the nominal interest rate to be charged is 7 percent.
You decide you would like to retire at age 65, and expect to live until you are 85 (assume there is no chance you will die younger or live longer). You figure that you can live nicely on $50,000 per
You are considering buying a new house, and have found that a $100,000, 30-year fixed-rate mortgage is available with an interest rate of 7 percent. This mortgage requires 360 monthly payments of
If the current interest rate increases, what would you expect to happen to bond prices? Explain.
Your firm has the opportunity to buy a perpetual motion machine to use in your business. The machine costs $1,000,000 and will increase your profits by $75,000 per year. What is the internal rate of
How does inflation affect nominal interest rates? a. Plot the three-month U.S. Treasury bill rate (FRED code: TB3MS) from 1960 to the present. What long-run pattern do you observe? What may have
In Data Exploration Problem 1, you saw the impact of inflation in the U.S. on short-term U.S. Treasury bill rates. Now examine similar data for Brazil. a. Plot the Brazilian Treasury bill rate (FRED
The expected real interest rate is the rate which people use in making decisions about the future. It is the difference between the nominal interest rate and the expected inflation rate, not the
Plot the expected real interest rate since 1979 by subtracting the Michigan survey inflation measure (FRED code: MICH) from the three-month Treasury bill rate (FRED code: TB3MS). Plot as a second
Consider a game in which a coin will be flipped three times. For each heads you will be paid $100. Assume that the coin comes up heads with probability ⅔. a. Construct a table of the possibilities
You are the founder of IGRO, an Internet firm that delivers groceries.a. Give an example of an idiosyncratic risk and a systematic risk your company faces.b. As founder of the company, you own a
Assume that the economy can experience high growth, normal growth, or recession. Under these conditions, you expect the following stock market returns for the coming year:a. Compute the expected
Car insurance companies sell a large number of policies. Explain how this practice minimizes their risk.
Explain how liquidity problems can be an important source of systemic risk in the financial system.
For each of the following events, explain whether it represents systematic risk or idiosyncratic risk and explain why. a. Your favorite restaurant is closed by the county health department.b. The
You are planning for retirement and must decide whether to purchase only your employer’s stock for your 401(k) or, instead, to buy a mutual fund that holds shares in the 500 largest companies in
For each of the following actions, identify whether the method of risk assessment motivating your action is due to the value at risk or the standard deviation of an underlying probability
Which of the following investments in the following table would be most attractive to a risk-averse investor? How would your answer differ if the investor were described as risk-neutral?
Consider an investment that pays off $800 or $1,400 per $1,000 invested with equal probability. Suppose you have $1,000 but are willing to borrow to increase your expected return. What would happen
Why is it important to be able to quantify risk?
Mortgages increase the risk faced by homeowners.a. Explain how.b. What happens to the homeowner’s risk as the down payment on the house rises from 10 percent to 50 percent.
Give an example of systematic risk for the U.S. economy and how you might reduce your exposure to such a risk.
Looking again at the investment described in question 15, what is the maximum leverage ratio you could have and still have enough to repay the loan in the event the bad outcome occurred?
Consider two possible investments whose payoffs are completely independent of one another. Both investments have the same expected value and standard deviation. If you have $1,000 to invest,
Suppose, as in Problem 17, that there were ten independent investments available rather than just two. Would it matter if you spread your $1,000 across these 10 investments rather than two?
You are considering three investments, each with the same expected value and each with two possible payoffs. The investments are sold only in increments of $500. You have $1,000 to invest and so you
In which of the following cases would you be more likely to decide whether to take on the risk involved by looking at a measure of the value at risk? (LO2)a) You are unemployed and are considering
You have the option to invest in either country A or country B but not both. You carry out some research and conclude that the two countries are similar in every way except that the returns on
Plot the percentage change from a year earlier of the value of the S&P 500 stock index (FRED code: SP500). Visually, has the risk of the S&P 500 index changed over time?
Another way to understand stock market risk is to examine how investors expect risk to evolve in the near future. The DJIA volatility index (FRED code: VXDCLS) is one such measure. Plot the level of
For the period since 1986, plot on one graph the 30-year conventional mortgage rate (FRED code: MORTG) and the one-year adjustable mortgage rate (FRED code: MORTGAGE1US). Explain their systematic
Plot the difference since 1979 between the Moody’s Baa bond index (FRED code:BAA) and the U.S. Treasury 10-year bond yield (FRED code:GS10). Comment on the trend and variability of this “credit
You are an officer of a commercial bank and wish to sell a car loan that the bank owns as an asset to another bank. Using equation A5 in the Appendix to Chapter 4, compute the price you expect to
Your financial adviser recommends buying a 10-year bond with a face value of $1,000 and an annual coupon of $80. The current interest rate is 7 percent. What might you expect to pay for the bond
Consider a coupon bond with a $1,000 face value and a coupon payment equal to 5 percent of the face value per year.a. If there is one year to maturity, find the yield to maturity if the price of
Which of these $100 face value one-year bonds will have the highest yield to maturity and why?a. A 6 percent coupon bond selling for $85.b. A 7 percent coupon bond selling for $100.c. An 8 percent
You are considering purchasing a consol that promises annual payments of $4.a. If the current interest rate is 5 percent, what is the price of the consol?b. You are concerned that the interest rate
Suppose you purchase a 3-year, 5-percent coupon bond at par and hold it for two years. During that time, the interest rate falls to 4 percent. Calculate your annual holding period return.
In a recent issue of the Wall Street Journal (or on www.wsj.com or an equivalent financial Website), locate the prices and yields on U.S. Treasury issues. For one bond selling above par and one
A 10-year zero-coupon bond has a yield of 6 percent. Through a series of unfortunate circumstances, expected inflation rises from 2 percent to 3 percent.a. Assuming the nominal yield rises in an
As you read the business news, you come across an advertisement for a bond mutual fund – a fund that pools the investments from a large number of people and then purchases bonds, giving the
You are sitting at the dinner table and your father is extolling the benefits of investing in bonds. He insists that as a conservative investor he will only make investments that are safe, and what
Consider a one-year, 10-percent coupon bond with a face value of $1,000 issued by a private corporation. The one-year risk-free rate is 10 percent. The corporation has hit on hard times, and the
If, after one year, the yield to maturity on a multi-year coupon bond that was issued at par is higher than the coupon rate, what happened to the price of the bond during that first year?
Use your knowledge of bond pricing to explain under what circumstances you would be willing to pay the same price for a consol that pays $5 a year forever and a 5-percent, 10-year coupon bond with a
You are about to purchaseyour first home and receive an advertisement regarding adjustable-rate mortgages (ARMs). The interest rate on the ARM is lower than that on a fixed rate mortgage. The
Use the model of supply and demand for bonds to illustrate and explain the impact of each of the following on the equilibrium quantity of bonds outstanding and on equilibrium bond prices and yields:
Suppose that a sustainable peace is reached around the world, reducing military spending by the U.S. Government. How would you expect this development to affect the U.S. bond market?
Use the model of supply and demand for bonds to determine the impact on bond prices and yields of expectations that the real estate market is going to weaken.
Suppose there is an increase in investors’ willingness to hold bonds at a given price. Use the model of the demand for and supply of bonds to show that the impact on the equilibrium bond price
Under what circumstances would purchase of a Treasury Inflation Protected Security (TIPS) from the U.S. government be virtually risk free?
In the wake of the financial crisis of 2007-2009, negative connotations often surrounded the term “mortgage-backed security”. What arguments could you make to convince someone that they may have
In a recent issue of the Wall Street Journal (or on www.wsj.com), locate the yields on government bonds for various countries. Find a country whose 10-year government bond yield was above that on
Graph investors’ long-term expected inflation rate since 2003 by subtracting from the 10-year U.S. Treasury bond yield (FRED code: GS10) the yield on 10-year Treasury Inflation Protected Securities
Compare long-run market expectations of inflation with a consumer survey measure of one-year-ahead inflation expectations. Starting with the graph from Data Exploration Problem 1, add as a second
How does the variability of annual inflation – an indicator of inflation risk – change over time? Graph the percent change from a year ago of the consumer price index (FRED code: CPIAUCSL)
Economists sometimes exclude food and energy prices from the “headline” consumer price index and use the resulting “core” price measure to assess inflation prospects. For the period since
Suppose that a major foreign government defaults on its debt. What, if anything, will happen to the position and slope of the U.S. yield curve?
What was the connection between house price movements, the growth in subprime mortgages, and securities backed by these mortgages—on the one hand—andon the other hand—the difficulties
Suppose that theinterest rate on one-year bonds is currently 4 percent and is expected to be 5 percent in one year and 6 percent in two years. Using the Expectations Hypothesis, compute the yield
According to the liquidity premium theory, if the yield on both one-and two-year bonds are the same, would you expect the one-year yield in one-year’s time to be higher, lower or the same? Explain
You have $1,000 to invest over an investment horizon of three years. The bond market offers various options. You can buy (i) a sequence of three one-year bonds; (ii) a three-year bond; or (iii) a
Suppose that the yield curve shows that the one-year bond yield is 3 percent, the two-year yield is 4 percent, and the three-year yield is 5 percent. Assume that the risk premium on the one-year bond
If, before the change in tax status, the yields on the bonds described in question 10 were below the Treasury yield of the same maturity, would you expect this spread to narrow, to disappear, or to
If regulations restricting institutional investors to investment grade bonds were lifted, what do you think would happen to the spreads between yields on investment grade and speculative grade bonds?
The misrating of mortgage-backed securities by rating agencies contributed to the financial crisis of 2007-2009. List some recommendations you would make to avoid such mistakes in the future.
You and a friend are reading The Wall Street Journal and notice that the Treasury yield curve is slightly upward sloping. Your friend comments that all looks well for the economy but you are
Given the data in the accompanying table, would you say that this economy is heading for a boom or for a recession? Explain yourchoice.
Consider a firm that issued a large quantity of commercial paper in the period leading to a financial crisis. a. How would you expect the credit rating of the commercial paper to evolve as the crisis
If inflation and interest rates become more volatile, what would you expect to see happen to the slope of the yield curve?

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