All Questions Carry Equal Weight
Section A: Answer Four Questions
1.
(a) What is the interest rate on a perpetuity that has a price of £500 and an
annual interest payment of £25?
(b) If a security pays £110 next year and £121 the year after that, what is its
yield to maturity if it sells for £200?
(c) If the interest rate is 5%, what is the present value of a security that pays
you £1,050 next year and £1,102.50 two years from now? If this security sold
for £2,200, is the yield to maturity greater or less than 5%? Why?
(d) Using an appropriate diagram show what happens to the price of
government bonds and the interest rate when there is an increase in the budget
deficit. Clearly state additional assumptions you need to make.
(e) Using an appropriate diagram show what happens to risk premiums on
corporate bonds during recessions.
2.
(a) What is a yield curve? What does an inverted yield curve imply?
(b) What does the expectations theory predict today's interest rate on a fouryear bond is if the expected path of 1-year interest rates over the next four
years is 5 percent, 4 percent, 2 percent, and 1 percent?
(c) If 1-year interest rates for the next three years are expected to be 4, 2, and 3
percent, and the 3-year term premium is 1 percent, what is the 3-year bond
rate?
(d) Explain how the yield curve can be used to infer information about the
future state of the economy. When the yield curve is flat or downward-sloping,
is the economy more likely to enter a recession or an expansion?
(e) If a higher inflation is expected, what would you expect to happen to the
shape of the yield curve? Why?
3.
(a) What is asymmetric information? What kind of problems does it lead to?
(b) Why is indirect finance a more important source of business finance than
direct finance?
(c) Explain the principal-agent problem as it pertains to equity contracts.
(d) Explain how debt contracts mitigate but do not eliminate moral hazard.
(e) What three types of financial service activities have led to problems of
serious conflict of interest in financial markets in recent years?
4.
(a) When is a bank illiquid?
(b) When is a bank insolvent?
(c) Explain how illiquidity can turn into insolvency.
(d) Explain how bank capital helps prevent bank failures. What are the
implications of high bank capital for the return on equity?
(e) Explain how falling real estate prices contributed to a credit crunch in
2008.
5.
(a) What is a bank panic? How does it lead to contagion?
(b) Outline the frequent causes and the main consequences of a financial
crisis.
(c) What kinds of financial innovations led to the subprime financial crisis of
2007-2008 in the United States? What were the implications of these
innovations for other countries?
(d) Government bailouts of troubled financial institutions in the U.S., the
U.K. and many other countries came under severe criticism. Why?
(e) What two key factors trigger speculative attacks leading to currency crises
in emerging market countries?
6.
(a) Outline the main features of the Basel Capital Accord.
(b) What is regulatory arbitrage?
(c) To what extent is the problem of regulatory arbitrage addressed by Basel
II?
(d) Basel II is sometimes criticized as pro-cyclical. Explain why.
(e) Basel II is sometimes criticized as an agreement developed to further the
interests of the big banks in rich-countries. Do you agree?
Section B: Answer ONE Question
7.
Explain how asymmetric information can provide an economic rationale for
government intervention in the financial system. What forms does this
intervention usually take? To what extent does it give rise to other problems?
8.
To what extent do the ECB, the Bank of England and the Fed follow inflation
targeting? What are its advantages and disadvantages compared to monetary
targeting? What are the implications of your analysis for central bank
independence?