Financial Markets and Institutions Exam March 22, 2021 Exam: Code: E_EBE3_FMI Examinator: Dr. E. Karmaziene Co-reader: Dr. J. Wrampelmeyer Date: March 22, 2021 Time: 18:45-21:30 Duration: 2:45 Calculator allowed: Yes Graphical calculator allowed: No Language: English Remarks. 25 multiple choice questions and 4 open questions. Answer the multiple choice (mc) questions. Only one answer is correct (a, b, c or d). Numbers are written in English format with decimal points, and commas separating thousands (e.g. 1,234,567.89). You cannot use scrap paper. You cannot return to the previous question or exercise. Credit score: he maximum score for the mc questions is 25 points. The maximum score for the open questions is 45 points. 70 credits count for a 10. Exercise 1. Multiple-choice questions, 25 x 1 point =25 points Yellow highlights indicate material that was not covered this year. 1. Critics of the current system of central bank independence contend that • The current system is undemocratic. • Voters have too much say about monetary policy. • The president has too much control over monetary policy on a day-to-day basis. • The Board of Governors is held responsible for policy missteps. 2. The central bank which is generally regarded as the most independent in the world because its charter cannot be changed by legislation is the • European Central Bank. • Bank of England. • Bank of Canada. • Bank of Japan. 3. An increase in the expected rate of inflation ___ the expected (real) return for bonds, causing the demand curve to shift to the ___. • lowers, left • lowers, right • increases, left • increases, right 4. What is quantitative easing? • An unconventional monetary policy, in which a central bank purchases longerterm securities from the open market in order to increase the money supply and encourage lending and investment. • Actions undertaken to control money supply and achieve macroeconomic goals promoting sustainable economic growth • Tying down the price level to achieve price stability • Changes in relative prices that cannot be implemented without cutting the nominal price of some goods. 5. Which strategy does NOT help to achieve long-term price stability? • Varying unemployment • Monetary targeting • Inflation targeting • Implicit Nominal Anchor 6. According to the ___ an easing of monetary policy is more likely to affect investment by ___ firms than other firms. • bank lending channel, smaller • bank lending channel, larger • wealth channel, smaller • wealth channel, larger 7. A ________ pays out cash flows from a collection of assets in different tranches, with the highest-rated tranch paying out first, while lower ones paid out less if there are losses on the underlying assets. • collateralized debt obligation • adjustable-rate mortgage • negotiable CD • discount bond 8. If mortgage brokers do not make a strong effort to evaluate whether the borrower can pay off a loan, this creates a • severe adverse selection problem. • decline in mortgage applications. • call to deregulate the industry. • decrease in the demand for houses. 9. The growth of the subprime mortgage market led to • increased demand for houses and helped fuel the boom in housing prices. • a decline in the housing industry because of higher default risk. • a decrease in home ownership as investors chose other assets over housing. • decreased demand for houses as the less credit-worthy borrowers could not obtain residential mortgages. 10. What is the European sovereign debt crisis? • The case when several European countries were unable to repay or refinance their government debt or to bail out banks without the assistance of third parties. • The case when interest rate on bank debt fell to negative. • The case when failing US banks negatively affected the health of banks in Central Europe • The case when German and French savers lent too much to the borrowers in the periphery of Europe 11. For modern banks, when house prices rise, the marked-to-market asset value ___ immediately which makes it ___ to obtain wholesale funding. • Increases, easier • Increases, more difficult • Decreases, easier • Decreases, more difficult 12. Which of the following statements are TRUE? • A bank's balance sheet shows that total assets equal total liabilities plus equity capital. • A bank's assets are its sources of funds. • A bank's liabilities are its uses of funds. • A bank's balance sheet indicates whether or not the bank is profitable. 13. When $1 million is deposited at a bank, the required reserve ratio is 20 percent, and the bank chooses not to hold any excess reserves but makes loans instead, then, in the bank's final balance sheet • the liabilities of the bank increase by $1,000,000. • the assets at the bank increase by $800,000. • • the liabilities of the bank increase by $800,000. reserves increase by $160,000. 14. If the First National Bank has a gap equal to a negative $30 million, then a 5 percentage point increase in interest rates will cause profits to • decline by $1.5 million. • increase by $15 million. • increase by $1.5 million. • decline by $15 million. 15. The process of transforming otherwise illiquid financial assets into marketable capital market instruments is known as • securitization. • internationalization. • arbitrage. • program trading. 16. A stockholder's ownership of a company's stock gives her the right to • vote and be the residual claimant of all cash flows. • vote and be the primary claimant of all cash flows. • manage and assume responsibility for all liabilities. • vote and assume responsibility for all liabilities. 17. Using the one-period valuation model, assuming a year-end dividend of $0.11, an expected sales price of $110, and a required rate of return of 10%, the current price of the stock would be • $100.10. • $110.11. • $121.12. • $100.11 18. If it is • • • • a forecast made using all available information is NOT perfectly accurate, then still a rational expectation. not a rational expectation. an adaptive expectation. a second-best expectation. 19. The efficient markets hypothesis implies that prices in the stock market • are unpredictable. • follow a definite pattern. • are more likely to go up than down. • always undervalue the true assets of a corporation. 20. Nonfinancial businesses in Germany, Japan, and Canada raise most of their funds • from bank loans. • by issuing stock. • by issuing bonds. • from nonbank loans. 21. If a bank has $200,000 of checkable deposits, a required reserve ratio of 20 percent, and it holds $80,000 in reserves, then the maximum deposit outflow it can sustain without altering its balance sheet is • $50,000. • $40,000. • $30,000. • $25,000. 22. The "lemons problem" exists because of • asymmetric information. • transactions costs. • economies of scale. • rational expectations. 23. What is asset transformation? • The process of transforming individual risky assets into safer assets • Packaging stocks into exchange traded funds • Increasing bond’s maturity • Issuing A and B class shares 24. To pay for college, you have just taken out a $1,000 government loan that makes you pay $126 per year for 25 years. However, you don't have to start making these payments until you graduate from college two years from now. Why is the yield to maturity necessarily less than 12% (this is the yield to maturity on a normal $1,000 fixed-payment loan in which you pay $126 per year for 25 years)? • This is the case because the first payment due begins at a future date. • This is the case because the loan has a government guarantee. • This is the case because market interest rates are less than 12%. • This is the case because of the known effects of inflation. 25. Which corporate bonds’ feature increases its interest rate? • Call provision • Restrictive covenants • Financial guarantees • Collateral Exercise 2. The information asymmetry exercise. 7 + 2 = 9 points Your friend Anna wants to open a surf shop for this summer only. Her revenue is dependent on the tourist flow. If COVID-19 restrictions are lifted and cross-country tourism rises again, her profit after the summer will be 30,000 EUR. Otherwise, her gain will be 5,000 EUR. Currently, the Health ministry suggests that the probability of each state is 50% a) You agree to invest 10,000 EUR in Anna’s business. Anna thinks that after the summer, the used rental boards are worthless. But you know that you can liquidate them for 5,000 EUR. To maximize your income, would you choose to disclose this information: 1. Before you sign the share purchase contract? 2. Immediately after you sign this contract. 3. Do not disclose this information? Please provide calculations backing up your decision? 7 points. b) How is information asymmetry related to section a of this exercise? 2 points. Exercise 3. The bank balance sheet exercise. 2+6+4+4=16 points Suppose your local bank holds 100 million EUR in assets, which are composed of the following: Required reserves: $10 million Excess reserves: $ 5 million Mortgage loans: $20 million Corporate bonds: $15 million Stocks: $25 million Commodities: $25 million a) The required reserve ratio is 10%. Assume that the depositor has just withdrawn the maximum deposit that this bank could withstand without making further adjustments. What is the amount of this deposit? 2 points. b) After the deposit withdrawal in part a, a sound customer comes in asking for a loan, should you turn the customer down? Why or why not? What options are available that will enable you to provide the funds your customer needs? 6 points. c) What are the two main benefits of capital? Explain. 4 points. d) A bank fears that future clients are becoming riskier. The bank now needs to decide how to react to this additional potential credit risk when issuing a loan: The two options that it considers are (i) charging higher interest rates and (ii) limiting the size of loans (credit rationing). What are the relative benefits and drawbacks of both approaches? 4 points. Exercise 4. The financial crisis exercise. 3+2+6=11 points a) What are credit spreads and why do they rise significantly during a financial crisis? 3 points. b) What is the real interest rate? 2 points. c) When the economy reaches the zero lower bound interest rates, discuss how nonconventional monetary policies – providing liquidity to credit markets, purchasing private assets, setting forward guidance – affect real interest rates and credit spreads? 6 points. Exercise 5. The Economist exercise. 2+2+5=9 points a) What is Akerlof’s “lemons” problem? 2 points. b) How do credit rating agencies help to solve the “lemons” problem? 2 points. c) Please discuss the conflict-of-interest problem that credit rating agencies have using the information of the following article. 5 points. Credit-rating agencies are back under the spotlight This time is different from the financial crisis—sort of May 9, 2020 In a working paper, Edward Altman of New York University finds what he calls “an over-rating problem” just above junk. Based on analysis of a batch of metrics including leverage, liquidity and sales, he concludes that over one-third of corporate debt that was on the bottom investment-grade rung going into the pandemic should have been at least one grade lower. In other words, it was junk in all but name. This bears on the most pressing question facing rating agencies today: what to do about the more than $3trn of corporate debt rated triple-B, on the precipice above junk. In 2010, 45% of all investment-grade debt was in this bottom tier; now it is just shy of 60%. The OECD study found that downgrades from triple-B to junk are rarer than those elsewhere on the ratings spectrum, suggesting that agencies may be reluctant to force borrowers across that Rubicon. An alternative explanation is that firms make particularly strenuous efforts to avoid such a demotion, to socalled “fallen angel” status, aware that it can mean a sudden spike in borrowing costs.
