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Questions and Answers of Money Banking Financial Markets

What is the significance of current yield on a coupon bond? Explain with an example.
Suppose that Ed Scahill owns a farm in a small town. In exchange for allowing a road to pass through his farmland, the town has agreed to pay Ed and future owners of the land $135 per year in
Briefly explain what you understand by yield to maturity.
Explain the importance of yield to maturity for investors.
An article in the New York Times discussing mortgage-backed bonds observed: “When demand for the bonds rises, which translates into lower interest rates on them, banks can offer homeowners lower
In recent years, both Coca-Cola and Walt Disney have issued bonds with 100-year maturities. Why would any investor buy a bond with such a long maturity, given that the investor is unlikely to still
Suppose that on January 1, 2013, you purchased a coupon bond with the following characteristics:Face value: $1,000 Coupon rate: 8 3/8 Current yield: 7.5%Maturity date: 2015 If the bond is selling for
Suppose that on January 1, 2013, the price of a one-year Treasury bill is $970.87. Investors expect that the inflation rate will be 2% during 2013, but at the end of the year, the inflation rate
An article in the New York Times notes that “rising bond yields can … signal the threat of inflation.”Briefly explain why, if investors expect inflation to be higher, the yields on bonds will
What is meant by diversification? Why do investors need to have diversified portfolios?
An article in the Wall Street Journal observed that “investment pros” recommend that “individual investors spread their bets, pointing out those who bet the house on hot performers often end up
An article in the Economist magazine observes:“It is in the nature of black-swan-like events that they are near-impossible to predict.” What are black swan events? Why are they nearly impossible
An article in the Wall Street Journal reported the advice that a financial planner offered to a young single male who had most of his savings invested in seven stocks: “Even if he doesn’t plan to
Writing in the Wall Street Journal, economists Jeremy Siegel and Jeremy Schwartz made the following prediction: “We believe that when investors awake from their depressed state, they will realize
What are the main implications of the Fisher effect for bond markets?
In 2012, Spain had what the Wall Street Journal described as a “towering budget deficit.” When the Spanish government had difficulty selling bonds to investors, the European Central Bank
In 2012, an article in the Economist magazine recommended to investors that if economic growth and inflation remained low in the United States, the investors should buy bonds. But if inflation
An article in the New York Times in 2012 observed:Older Americans and other savers are just unintended casualties of policies aimed at other economic targets, particularly the policy making it easier
What do you understand by the term “world real interest rate”? How is it determined?
An article in the Economist magazine in 2012 observed:“America can now borrow from the bond market at a cheaper rate than at any time in the history of the republic.” Use the loanable funds model
What is default risk? Is it different from default risk premium?
List the different ways in which rating agencies measure the creditworthiness of a bond.
According to an article in the New York Times, in 2012, “everyone has piled into” the junk bond market. The article also observed,“The average yields on these bonds have dropped to 6.6 percent,
In 2012, Anheuser-Busch In Bev NV, maker of Budweiser and other beers, sold debt of varying maturities. According to an article in the Wall Street Journal:The three-year notes priced with a risk
According to an article in the New York Times, “It was the near universal agreement that potential conflicts were embedded in the [bond] ratings model.” What is the bond ratings model? What
Some economists have argued that one important role of rating agencies is to keep the managers of firms that issue bonds from using the funds raised in ways that would not be in the best interestsof
Suppose a candidate who runs on a platform of “soak the rich” wins the 2016 presidential election.After being elected, he or she persuades Congress to raise the top marginal tax rate on the
By 2012, actions by the Federal Reserve and other central banks had driven shortterm interest rates close to zero. One portfolio manager was quoted as saying: “The market has heard … central
State whether each of the following statements is true or false. Provide a proof if the statement is true or a counterexample if the statement is false.(a) If \(\widetilde{X}\) is a fair game with
This exercise explores the properties of two recently proposed riskiness indices: the Aumann and Serrano (AS 2008) index and the Foster and Hart (FH 2009) index.A decision maker is characterized by
In racetrack betting, a \(\$ 1\) bet placed at odds of 5:1 pays \(\$ 6\) if you win, and \(\$ 0\) if you lose. The odds ratio in this example is 5 . A gambler who believes that he has inside
Consider an investor who chooses a portfolio to maximize his expected utility of wealth next period, where the utility function is power (CRRA) with coefficient of relative risk aversion \(\gamma\).
Consider a set of \(N\) risky assets and, for parts (a)-(c), no riskless asset.(a) Prove that for any minimum-variance portfolio \(p\), except the global minimumvariance portfolio, the expected
Assume that the Sharpe-Lintner CAPM holds, so the mean-variance efficient frontier consists of combinations of Treasury bills and the market portfolio. Nonetheless, some households make the mistake
Consider a frictionless one-period economy with multiple risky assets and a riskfree asset with return \(R_{f}\). Let \(R_{p}\) denote the return to the risky portfolio of an agent who trades off the
Consider a static frictionless economy with a riskless asset in zero net supply with return \(R_{f}\), and \(n\) risky assets with jointly normal returns \(R_{i}, i=1 \ldots n\). Suppose the risky
(a) Consider a cross-sectional regression of stock returns onto a constant (normalized to unity). Show that the regression coefficient is the return on a portfolio. What portfolio?(b) Suppose that,
In this exercise, you are asked to explore some classic issues from the empirical literature on stock market returns. The data for this question can be found in an Excel spreadsheet on the textbook
The martingale method for portfolio choice, introduced in section 4.1.5, uses the SDF framework to characterize the optimal state-contingent payoffs that agents can attain through financial markets,
Suppose that a set of assets are correctly priced by a stochastic discount factor \(M\). An economist uses a false asset pricing model in which the stochastic discount factor is a random variable \(Y
Hansen and Richard (1987) show that an arbitrary gross return \(1+R_{i}\) can be decomposed aswhere \(R^{*}, Z^{*}\), and \(\varepsilon_{i}\) are random variables and \(w_{i}\) is a scalar. This
This exercise asks you to complete the GMM derivation in section 4.4 .3 of the standard asymptotic time-series test statistic (3.45). Use of the Kronecker product will be particularly useful. The
Consider an economy where the dividends on the aggregate stock market are expected to grow at a constant rate:where \(\eta_{t+1}\) has mean zero and variance \(\sigma^{2}\).The stochastic discount
In this exercise we study empirically whether the out-of-sample stock market return predictability of well-known valuation ratios can be improved by imposing simple theoretical restrictions on the
In this problem we derive and explore the theoretical and empirical implications of a lower bound on the forward-looking expected equity premium, derived by Martin (2017). The lower bound is the
In this problem we explore what information about the underlying economy we can recover from Arrow-Debreu state prices. \({ }^{10}\) Assume the existence of a representative agent with time separable
Long-run risk models offer a solution to the main asset pricing puzzles by assuming that there exists a representative agent with Epstein-Zin preferences with moderately high risk aversion and a high
Consider an infinite-horizon representative-agent economy. The representative agent has Epstein-Zin utility. Consumption, expected future consumption, and returns on all assets are jointly
A representative agent in an endowment economy has power utility with time discount factor \(\delta\) and coefficient of relative risk aversion \(\gamma\). The \(\log\) of the endowment, \(c_{t}\),
Consider a stochastic growth model with fixed labor supply and labor-augmenting technological shocks. Output \(Y_{t}\) isfor technology \(A_{t}\) and capital stock \(K_{t}\).Capital is accumulated
The first three principal components of the yield curve are empirically known to account for almost all of the cross-sectional variation in bond yields. These principal components approximately
Consider the following model for the log stochastic discount factor, \(m_{t+1}\) :where \(\xi_{t+1}\) is randomly drawn from one of two distributions. With probability \(\pi\), state 1 occurs at time
Consider the following two-factor essentially affine term structure model,where \(\varepsilon_{t+1}\) and \(\eta_{t+1}\) are independent standard normal variables. Assume \(\sigma_{x}, \sigma_{z
Lustig, Stathopoulos, and Verdelhan (2016) investigate the profitability of carry-trade strategies with long-maturity bonds. One such strategy involves going long (short) longmaturity government
In Problem 4.1 we showed that the martingale method for portfolio choice can be applied to static incomplete market settings under the special assumption of quadratic utility. Cochrane (2014) extends
This problem asks you to use the GMM framework, presented in section 4.4, to analyze the two-beta asset pricing model of Campbell and Vuolteenaho (CV 2004). The data for this question can be found in
Let Y1,Y2,…Y1,Y2,… be independent and identically distributed (iid) non-negative random variables with mean one. For tt greater than or equal to one, define Xt=Y1Y2⋯YtXt=Y1Y2⋯Yt. (a) Show
Consider the risky term structure model of Lettau and Wachter (LW 2007), given by equations (9.53)-(9.56). The model is closely related to the class of essentially affine term structure models with
Consider a simplified model of mortgage choice with three dates, 0,1 , and 2. At date 0 , a household buys a house of value \(M\) and finances it with a mortgage of equal value (so the loan-to-value
In a market for an individual stock, a fraction \(\mu\) of investors are subject to the disposition effect while the remaining investors are rational. The number of shares demanded by the rational
This question asks you to analyze a simple model that formalizes the case for consumer financial regulation. The model assumes that a fraction \(b\) of consumers are "behavioral" agents who make
Consider an economy with two dates \(t=1,2\) and a continuum of consumers. Each consumer receives a random endowment at date 2 and consumes only then. At date 1 , securities are traded but no
Consider a model with two dates \(t=1,2\) and two agents. Agents receive income and consume only at date 2. Agent 1 has income \(x_{1}=c+v+\varepsilon\), while agent 2 has income
In this exercise we will explore the welfare implications of the distributive pecuniary externalities discussed in section 11.1.3 in an international setting where countries are subject to "sudden
Consider the risksharing problem of two infinitely lived agents, who receive random shares of a fixed endowment \(e\). Each period there are two states of the economy. In state 1 , agent 1 receives
A large literature, briefly discussed in section 11.4.1, examines the conditions under which agents with incorrect beliefs about fundamentals will be driven out of the market by rational agents in
Consider a static model in which a continuum of agents of unit mass with exponential (CARA) utility and coefficient of absolute risk aversion \(A\) invest their wealth in two risky assets (stocks)
Consider an extension of the Kyle (1985) model with two periods of trading. The fundamental value of an asset is \(v\), which is distributed normally with prior mean \(\mu_{0}\) and variance
Consider the setting of section 12.3 .4 but now allow for multiple risky assets \(j=1, \ldots, J\). The speculators' budget constraint and margin constraint are now given by \(W_{t}=W_{t-1}+\)
Explain how the output gap and the inflation gap in the Taylor Rule are calculated.
Economists are searching for a “good” measurement of the money supply. What constitutes a good measurement of the money supply?
Private equity funds often earn high returns on their investments, in part because the interest that must be paid on debt issued by their portfolio firms can be used to reduce the amount of federal
Robyn is an entrepreneur, and she is looking for a private equity firm to make an equity investment in her firm. How can Robyn tell the difference between the dumb money and smart money that various
Why do general partners in private equity funds pay such a low rate of tax on the income they generate?
People who operate private equity funds can receive very high levels of compensation if the fund is able to sell its portfolio firms for a much higher price than what it paid for and invested in
“Waterfalls are pretty things in nature; it is water falling off a cliff. But how do they function in private equity?” asks your friend. How do you answer this question?
Sandy is confused about the terminology used in the private equity industry. How would you explain to her the differences between a limited partner and general partner in private equity?
During what time periods did the size of investment banks change?a. In the 1920s, as US consumer spending increased, investment banks grew in size to provide credit to American consumers.b. Shortly
Explain why so many people see a “revolving door” between the investment banking industry and the entities designed to regulate and oversee it.
Rodney does not understand how investment banks work. In the Abacus case, Rodney assumes Goldman Sachs would lose money since the value of assets in Abacus declined drastically. How would you explain
Your friend Cynthia works at an investment bank and tells you she is going on a “roadshow.” What will Cynthia be doing?a. Going to the government and asking for a taxpayer bailout of the
Explain how proprietary, or prop, trading, when done by investment banks, can result in the bank’s customers becoming the bank’s competition.
Which of the following are characteristics that make hedge funds different from open-ended mutual funds?a. Investors in hedge funds are limited to individuals with a high net worth and institutional
Explain how close-ended mutual funds are, at the same time, in some ways very similar to but in other ways very different from open-ended mutual funds.
Explain why ETFs seldom trade at a premium or discount relative to their NAV.
Doug sees that his mutual fund is charging him with a 12b-1 fee. He has no idea what this is. Which of the following would correctly summarize for Doug what he is being charged?a. A fee to purchase
Adrienne is a registered financial advisor. What role do mutual funds and mutual funds play in Adrienne’s career?
Jason is thinking about purchasing some mutual fund shares, but he is confused by the terminology. How would you explain to Jason the difference between a mutual fund with loads and a no-load mutual
Grace is disappointed with the relatively low rate of return she is earning on her government bond mutual fund. She sees another bond fund that invests in corporate securities offered by firms that
Bob lives in Texas, is 64 years old, and is close to retirement. What type of mutual funds might be best for Bob? Why?
Trudy, who lives in New York, is concerned that her investment portfolio suffers from the “home country bias.” Explain what Trudy is worried about and how might she use mutual funds to address
You read a story in the Financial Times reporting that mutual funds that invest primarily in equities are currently holding a high level of cash. Based on this, where do many analysts think stock
Bob is confused about how the pricing of the open-end mutual fund he owns is actually calculated. Bob sees that stock prices have increased, yet the market value of his mutual fund, as determined by
If the total market value of an open-end mutual fund is $2,500 and there are 100 shares outstanding at the end of trading on Monday, what would the NAV of the fund be?
Which of the following has resulted in questions being raised about the future of the Social Security public pension system?a. Demographic changes in the US populationb. Decreasing market interest
Carolyn has just purchased a homeowners’ insurance policy that will pay for damages to her house that occur only if flooding in her area takes place. What type of insurance did Carolyn purchase?a.
Charlotte is fully vested in her defined contribution pension plan where she works. What will happen if Charlotte decides to quit her job and go work for a different employer?
Stan has worked for the same firm for over 30 years and has a defined benefits pension. However, he is worried the pension fund where he works is underfunded. Explain to someone with no training in
Ben, who has health insurance provided through his employer, has an appointment with his physician for an annual exam. Ben pays a $25 co-pay at the doctor’s office. Ben tells Sheila it cost him $25
Credit default swaps often were issued by banks, yet many argue they were actually an insurance product and thus should have been issued only by regulated insurance companies. Explain this argument.

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