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Capital Markets Midterm Questions and Solutions Essay

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2 percent for each question 1. Liquidity… is the ease with which an asset can be exchanged for money 2. The concept of adverse selection helps to explain… why the financial system is heavily regulated 3. The Fed can influence the fed fund interest rate by selling T-bills, which ____reserves, thereby ____the federal fund rate. removes, raising 4. Standard Repos… are very low risk loans 5. A 4-year bond pays an annual coupon of 3.5%. If the interest rate equals 2.75% per year, how much do you have to pay to buy the equivalent of a $1,000,000 bond face value? $10 0280 000 6.

Unanticipated deflation implies a… a decline in net worth, as price levels fall while debt burden remains unchanged. 7. What is the annualized discount rate on a Treasury bill that you purchase for $9,900 and that will mature in 91 days for $10,000? 3.96% 8. Moral hazard is a problem arising from… only A and B of the above 9. A discount loan by the Fed to a bank causes a(n) ____ in reserves in the banking system and a(n) ____ in the monetary base.

increase; increase 10. The standard definition of the shadow banking systemt includes… money market funds, hedge funds, and pools of securitized assets

Comprehensive Questions (30 percent)

6 percent for each question 1) The financial system is important because it channels funds, reduces asymmetric information problems, provides an efficient payment system, and helps to manage risk. Explain the remaining functions that the financial system performs.

Besides these functions, the financial system provides ways for invididuals to pool their resources. For instance, some investment projects generate a positive NPV, but require a large initial down payment. Dividing ownership into many individual shares provides an efficient way to pool individual resources in order to finance these investment projects. The financial system also provides liquidity to market participants. This is important because corporations and individuals do not have the same time-horizon.

Therefore, it would be very difficult for corporations to get long-term sources of funding without these liquidity services. Finally, the financial system provides important information to financial investors, corporate managers, and political leaders. This information is critical to improve the decision-making process. For instance, managers may use the information observed in the financial system to compute the NPV of investment projects. 2) One of your friend tells you: “The main function of the financial system is to channel funds from lenders to borrowers. This function can be performed interchangeably by capital markets or financial institutions.” Do you agree? Why?

It is true that both capital markets and financial institutions are useful in channeling funds from lenders to borrowers. However, they differ in a fundamental way. Contrary to capital markets, financial institutions are extremely good at dealing with asymmetric information problems. This is due to the private nature of their activities. By avoiding free-riding, banks can bare the substantial costs of screening and monitoring borrowers. Therefore, corporations for which asymmetric information problems are substantial (e.g., small corporations), rely heavily on banks’ funding. If banks cut lending, as it was the case during the recent crisis, these companies do not have the option of receiving funding from capital makets, and must reduce their activities. Therefore, some of the functions performed by banks cannot be performed interchangeably by capital markets.

3) What is Quantitative Easing and how does it differ from the standard tool used by the Fed to expand the monetary base? What was the stated purpose of Quantitative Easing?

Quantitative Easing refers to the central bank’s policy of buying long-term securities, specifically mortgage-backed securities and 10—year Treasury bonds. This is different from the standard approach used by the Fed. Traditionally, the Fed expands the monetary base by implementing an open-market purchase of T-bills. The stated purpose of Quantitative Easing was to decrease the yield of these long-term securities. From the viewpoint of borrowers, this decrease would help them get lower refinancing conditions, thus easing pressure in these markets.

From the viewpoint of lenders, this decrease in yield may render these securities less attractive. Therefore, lenders may be willing to start buying risky assets again, thus improving economic conditions. 4) One student argues: “If more customers want to borrow funds at the prevailing interest rate, a financial institution can easily increase its profits by raising interest rates on its loan.” Is this statement true, false, uncertain? Explain your answer.

The situation faced by the bank is the following: it has limited resources and sees a lot of clients willing to borrow money, creating excess demand. The statement above is uncertain. A priori, we might believe that if the bank increases the interest rate, it is able to eliminate this excess demand and generate additional profits (there would be an increase in both the profit per loan and the quantity of loans). However, this reasoning assumes that the credit quality of the borrowers stays constant. This may not be true because raising the interest rate also increases adverse selection. To illustrate, consider the used-car market. If buyers observe an increase in the number of people interested in selling their cars, they may want to offer a lower price. But a lower price gives incentive to the sellers of good cars to leave the market, leaving only sellers of lemons.

As a result, the average quality of the cars purchased by buyers will decrease. A large part of the excess demand observed by the bank is driven by poor credit firms. After increasing the interest rate, the bank observes that these firms still agree to borrow, i.e., their poor credit quality should be charged an even higher interest rate. On the contrary, this higer interest rate may discourage good firms from borrowing from this bank because the loan becomes too expensive. As a result, the relative importance of bad firms over good ones increases, leading to a decrease in the average firm quality. This decrease in quality may lead to higher default rates and to a decrease in the bank’s profit.

5) What is meant by a flight to safety/liquidity? When does it occur? How can it trigger these negative spirals on the value of the banks’ balance sheet? A flight to safety/liquidity commonly describes the behaviour of investors when they attempt to sell the risky/illiquid assets they hold in their portfolio and move towards safe/liquid assets. This flight typically occurs in times of crisis when the investors’ willingness to take risks decreases significantly. Since banks mostly hold risky and illiquid assets, these flights to safety have a strong impact on their asset value. As their capital gets curtailed, their risk profile increases, making investors and depositors more worried about the potential losses they may incur.

Because these lenders give money on a short-term basis, they can quickly go to the bank and ask for their money back. Then, banks have to scramble for liquidity and sell their risky/illiquid assets. When many banks try to sell simultaneously, the price of these assets will go further down. For instance, suppose that in normal times, the bank would have to sell 15% of its assets to reimburse lenders. As many institutions sell simultaneously, the bank has to sell more than 15%. Observing these additional losses, investors and depositors may want to further reduce the amount they are willing to lend, aggravating the liquidity issues face by banks. Overall, these effects reinforce each other, creating a spiraling effect.

Understanding Interest Rates (30 percent)

15 percent for question 1, 10 for question 2, and 5 for question 3 1) In February 2010, a column in the Wall Street Journal warns: “Be wary of long-term bonds… The risk of higher expected inflation is in due course. Longer-term bonds are the most at risk.” Using the supply and demand analysis studied in class, plot a graph that clearly explains the effect of an increase in expected inflation on the bond price. Why are longer-term bonds more at risk? Explain whether your analysis would be different if you were to examine the impact on the price of TIPS.

Since the coupon rate paid by US government bonds is fixed in nominal terms, news of higher expected inflation leads to a decrease in the real rate of return offered by these bonds. As a result, the demand curve moves to the left as investors want to invest their money in securities with better return prospects. In addition, the supply curve moves to the right as corporations can borrow at lower costs in real terms. Because of these two shifts, we observe a large excess supply of bonds at the initial interest level. This excess supply will lead to a decrease in the bond price and a increase in the interest rate until the new equilibrium is reached. This effect, called the Fisher effect, is shown in the graph below:

The effect is likely to be stronger for long-term bonds because investors are stuck with fixed nominal payments for a long-time period. As a result, the only way to be compensated for higher inflation during many years is to buy the bond at a sufficiently low price today. Intuitively, we can capture this price sensitivity using duration, as we know that the duration of a long-term bond is above that of a short-term bond. The analysis would be completely different for TIPS because their coupon payments adjust for changes in inflation. As a result, any news of future inflation simply means that the future coupon payments in nominal terms will be higher. As a result, the price is not sensitive to changes in expected inflation.

2) In the Financial Times in February 2011, Professor Siegel from the Wharton School talks about the decline in the real yield of TIPS: “Recently, the yields on these bonds have collapsed to levels that would have been uninimaginable just a few years ago. Last October, the real yield on the US 10-year TIPS plunged to 36 basis points.” Professor Siegel argues that an important factor driving this result is the increase in inflation risk. Why do US investors currently perceive that inflation risk is higher than usual? Explain why this increase in inflation risk can lead to (i) an increase in the demand for TIPS relative to bonds; and (ii) a decrease in the TIPS interest rate.

There are two sources of concerns regarding future inflation. First, the central bank has greatly expanded its monetary base during the recent financial crisis—at the end of 2009, its value was close to $2 trillion. For the moment, banks are not aggressively lending, implying that the growth rate of the monetary base is somewhat disconnected from that of the money supply. But failure from the Fed to reduce the monetary base as lending activity resumes may lead to higher inflation. Second, the fiscal position of the US government has deteriorated substantially over the past few years, leading to a downgrade of the credit rating attached to its bonds. If the future growth rate in the economy is not sufficiently high and if the US government is not able to reduce deficits, it may have no option but inflate the debt away.

This will of course lead to higher inflation. Overall, these two issues create important uncertainty about the future path of inflation. Contrary to bonds, TIPS are protected against inflation. If there is higher inflation risk, bonds become riskier relative to TIPS. Using our supply and demand framework, the demand for bonds moves to the left, while the demand for TIPS moves to the right. At the initial price, there is an excess demand for TIPS, driving the TIPS price up and its interest rate down, consistent with Professor Siegel’s arguments. 3) Professor Siegel also argues that: “As economic growth recovers and real rates rise, the price of TIPS will fall.” Can you find a simple explanation of this statement based on our supply and demand framework?

Economic growth means that the business cycle is in an expanding phase. In this case, we can rely on the relation between business cycle expansions and the interest rate seen in class. First, the demand curve for bonds move to the right because of the wealth effect, as people have more money to invest in the capital market (bonds, stocks,…). On the supply side, business cycle expansions are related to an increase in the firms’ expected profitability. As a result, the supply curve moves to the right. Based on empirical evidence, the move of the supply curve tends to be more important than the one observed for the demand. At the initial level of interest rate, there is an excess supply, leading to an decrease in bond price, and an increase in the interest rate. This is consistent with the yield reaction discussed by Professor Siegel.

Bond Market (20 percent)

5 percent for each question Consider the following bonds: Annual interest rate Maturity Annual coupon Price Duration Bond X 5% 8 years 3% 87.1 7.2 Bond Y 8% 3 years 3% 87.1 ?

1) One of your friends tells you: “the fact that the price of these two bonds is the same is not consistent with theory.” Without making any computation, explain whether you agree with your friend.

Your friend is not right. These two bonds are both quoted below par value, because their respective yield to maturity is lower than the coupon rate. If these two bonds had the same maturity, the price of bond Y should be lower than the price of bond X because investors require a higher interest rate to hold bond Y. However, the maturity of bond Y is lower.

Although the annual differential between the interest rate and the coupon rate is higher for bond Y, this differential has to be given during 3 years only. For bond X, the annual differential between the interest rate and the coupon rate is lower, but it has to be given during 8 years. In our case, these two effects (different ratings and different maturities) offset each other and the two prices are exactly the same. The information shown in the table is therefore perfectly consistent with theory. 2) Compute the duration of bond Y and compare it with that of bond X. Is the difference consistent with theory?

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