1. How do you think financial institutions help financial markets to work?
Financial institutions help to funnel money to the most successful businesses, which allows
them to grow faster and supply even more of the desirable goods and services. This is how
financial institutions greatly contribute to the efficient allocation of economic resources.
Financial institutions are what make financial markets work. Without them, financial markets
would not be able to move money from people who save to people or companies who need to
borrow. Financial institutions thus play a crucial role in improving the efficiency of the
economy.
2. “A robust financial market is one of the pillars of stable economic growth and financial
sustainability for the future” – Discuss
A robust financial market creates conditions for economic growth and financial sustainability
for the future by ensuring a constant (uninterrupted) flow of funds between savers and
borrowers based incredible information on the best possible uses of these funds. However, when
the information flow is not credible (i.e., lacks transparency), the system becomes susceptible to
crises, and proper channeling of funds is interrupted, thus stalling economic growth and
financial sustainability for the future.
3. How does the presence of asymmetric information in the direct selling market lead to
consumers not buying products?
"Asymmetric information" is a term that refers to when one party in a transaction is in
possession of more information than the other. In certain transactions, sellers can take
advantage of buyers because asymmetric information exists whereby the seller has more
knowledge of the good being sold than the buyer. The reverse can also be true. As a
consequence, the market will not achieve allocative efficiency, because one of the parties normally the consumer, pays a higher price for a product than they would have done if they had
perfect knowledge.
4. What is an adverse selection? How is it usually created in financial markets?
Adverse selection is the problem created by asymmetric information before the transaction
occurs. Adverse selection in financial markets occurs when the potential borrowers who are the
most likely to produce an undesirable (adverse) outcome – the bad credit risk – are the ones who
most actively seek out a loan and are thus more likely to be selected. Because adverse selection
makes it more likely that loans might be made to bad credit risks, lenders may decide not to
make any loans even though good credit risks exist in the marketplace. In fact, adverse selection
resembles the problem created by lemons (bad cars) in the quality of the cars. Potential buyers
of used cars are unable to assess the quality of the cars and for this reason will be ready to by
only a price that reflects the average quality of the cars in the market. The owners of cars, on
the contrary, know the quality of the cars they own, so if they are lemons they will be still
happy to sell at an average price, while if they are peaches (good cars) they know the price
undervalues the car and will be reluctant to buy. This produces an economic inefficiency in the
market.
5. Suppose you bought a land that costs $500,000 today. You will need to continue to pay tax
on the land, and the rate is 3% of your purchase. Calculate the PV of your payment, using a
10% discount rate. Assume that there are no changes in the land’s price and tax rate.
Yearly payment will be 500,000 * 3% = 15,000.
Present value of future payments is 15,000/0.10 = 150,000 (a perpetuity)
6. Suppose that you want to take out a loan at a bank that wants to charge you an annual real
interest rate equal to 5%. Assuming that the expected rate of inflation during the life of the
loan is 2%, what will be the nominal interest rate that the bank will charge you? If the real
inflation was 3% instead of the expected 2%, what was the actual real interest rate on the
loan?
FISHER :(Nominal interest rate=real interest rate+expected inflation)
Since the bank wants to charge an annual real interest rate of 5%, and the expected
rate of inflation is 2%, according to the Fisher formula, the nominal interest rate will be 5%
+ 2% = 7%; If the real inflation was 3%, and the nominal interest rate on the loans was 7%,
using the same formula, the real interest rate is 7% - 3% = 4%. Therefore, the bank received
4% rather than 5% on your loan.
7. In the aftermath of the global economic crisis that started to take hold in 2008, U.S.
government budget deficits increased dramatically, yet interest rates on U.S. Treasury debt
fell sharply and stayed low for quite some time. Does this make sense? Why or why not?
The supply effect of large deficits should lead to higher interest rates. The effects of the
economic crisis lead to significantly lower wealth and income, which depressed Treasury
bond demand, but also decreased corporate bond supply by even more because investment
opportunities collapsed. The larger leftward shift in the bond supply curve than the
rightward shift in the bond demand curve would then result in a rise in bond prices and a
fall in interest rates.
In addition, due to the severity of the global crisis, U.S. treasury debt became a safe haven
investment, reducing relative risk and increasing liquidity for U.S. treasury debt. This
significantly raised U.S. treasury bond demand, leading to higher bond prices and
significantly lower yields. In other words, the decrease in investment opportunities and risk
factors significantly offset the wealth effect on demand and the deficit effect on supply.
8. How would the demand curve for corporate bonds be affected if news about accounting
scandals in major corporations spread? What would be the effect on interest rates?
When news about accounting scandals in big corporations spread, people get worried about
the quality of the bonds they are either holding or considering to buy. We can expect then
that bonds are not as desirable assets as they were before (maybe because the ability of
corporations to honor their commitments was overstated). This negatively affects demand
for these bonds and shifts the demand curve to the left, raising interest rates and lowering
corporate bond's prices (for a given supply curve).
9. If the current interest rate on one-year bonds is 6%, you may expect an increase in interest
rates by 1% in the following year. Predict what interest rate would be suitable now for twoyear bonds. Explain your answer and state the theory that justifies it?
If the current interest rate on one-year bonds is 6%, and it is expected to rise by 1% in the
following year, it will become 7%. Accordingly, the current two-year bonds must have an
interest rate of (6% + 7%)/2 = 6.5%. This calculation is based on the expectation theory,
which states that interest rates with different maturities move together over time and longterm rates are the average of expected future short-term rates.
10. If the income tax exemption on municipal bonds were abolished, what would happen to the
interest rates on these bonds? What effect would it have on interest rates on U.S. Treasury
securities?
Abolishing the tax-exempt feature of municipal bonds would make them less desirable
relative to Treasury bonds. The resulting decline in the demand for municipal bonds and
increase in demand for Treasury bonds would raise the interest rates on municipal bonds,
while the interest rates on Treasury bonds would fall.
11. “The more collateral there is backing a loan, the less the lender has to worry about adverse
selection.” Is this statement true, false, or uncertain? Explain your answer.
True. When an individual has a lot of collateral on a loan, the more he will act in the lenders
favor because he has much at risk too.
12. How does the free-rider problem aggravate adverse selection and moral hazard problems in
finacial markets?
Adverse Selection - Stock Market; Purchasing information to better yourself on your
investment that a private company provides will cost a lot of money. That cost will be given
freely to many others that follow your lead.
Moral Hazard - Security Market; Spending time and money monitoring the business. Other
people will no and allow you to do all the monitoring, while they sit back and save that
monitoring money.
13. Provide one argument in favor of and one against the idea the Fed was responsible for the
housing price bubble of the mid-2000s.
There is an argument that the low fed funds rate, led to mortgage rates that stimulated housing
demand and issuance of subprime mortgages. An argument against would be because of new
mortgage products that lowered mortgage payments
14. Deregulation of the financial services industry in the United States and the United Kingdom
led to the global financial crisis of 2007. Discuss.
Deregulation in the financial industry was the primary cause of the 2008 financial crash. It
allowed speculation on derivatives backed by cheap, wantonly-issued mortgages, available to
even those with questionable creditworthiness.
The 2007-2009 financial crisis began years earlier with cheap credit and lax lending
standards that fueled a housing bubble.
When the bubble burst, financial institutions were left holding trillions of dollars worth of
near-worthless investments in subprime mortgages.
Millions of American homeowners found themselves owing more on their mortgages than
their homes were worth.
The Great Recession that followed cost many their jobs, their savings, or their homes.
The turnaround began in early 2009 after the passage of the infamous Wall Street bailout
kept the banks operating and slowly restarted the economy.