ANSWERS TO "DO YOU UNDERSTAND" TEXT QUESTIONS
CHAPTER 1
1.
What is the role of the financial system and why is it important to the economy?
Solution: The financial system facilitates the flow of saving to investment via direct and indirect
financing relationships formed in financial markets with the frequent help of financial institutions.
Without it, financing relationships would arise only when preferences of SSUs and DSUs match as to
amount, maturity, and risk. DSUs would not always obtain timely financing for attractive projects and
SSUs would under-utilize savings. The “production possibilities frontier” of society would be smaller.
2.
What is a financial claim? How can a financial claim be an asset and a liability at the same time?
Solution: A financial claim (or “security” or “financial instrument”) is one’s claim against another’s
wealth. To its holder, it is a financial asset; to its issuer, a liability or obligation. It may be debt
(contractually promising repayment with interest on a certain schedule) or equity (part ownership rewarded
by participation in profits). DSUs issue claims in return for funds; SSUs exchange funds for claims.
3.
What are some problems with direct finance that make indirect finance more attractive?
Solution: Direct financing requires a more or less exact match between the characteristics of the financial
claims DSUs wish to sell and those the SSUs want to buy. Direct financing can thus involve a costly
search and negotiation process, often complicated by information asymmetries concerning ultimate credit
risk of the DSU. Intermediaries transform direct claims sold by DSUs and make them more attractive to
SSUs, helping DSUs find financing and SSUs find appropriate investments.
4.
Explain what is meant by the term financial intermediation.
Solution: Financial intermediation is the process by which financial institutions mediate unmatched
preferences of DSUs and SSUs. Financial intermediaries buy financial claims with one set of
characteristics from DSUs, then issue their own liabilities with different characteristics to SSUs. Thus,
financial intermediaries “transform” claims to make them more attractive to both DSUs and SSUs.
5.
What are investment banks and what role do they play in the financial system?
Solution: Investment banks are financial institutions which “underwrite” new primary market issues of
securities to the investing public: They purchase new securities from a business or government and resell
them to other financial institutions and wealthy individuals. By purchasing the securities at a discount or
reselling them at a premium, investment banks earn an “underwriting spread”. It is common for
investment banking firms to function also as brokers, dealers, and financial advisors.
1.
Why is denomination divisibility an important intermediation service to the typical household?
Solution: Typical households do not have enough cash to invest in direct credit markets, where
minimum transactions are often $1 million. Financial intermediaries facilitate indirect investment by
households by offering financial claims with smaller denominations. Otherwise, households would have
1
to accumulate large sums of money before investing. During the time this would take, the household
would earn no interest income—a substantial opportunity cost, and a disincentive to save and invest.
2.
What are the three sources of comparative advantage that financial institutions enjoy?
Solution: (1) Economies of scale —large volumes of similar transactions; (2) transaction cost control—
finding and negotiating direct investments less expensively; and (3) risk management expertise—bridging
the “information gap” about DSUs’ creditworthiness.
3.
What would be the implications for investment in physical assets such as oil refineries or longdistance telephone cable if financial intermediaries were not willing to invest money for long
periods of time?
Solution: Suppose such a project costs $300 million and returns $30 million per year in cash flow. A 10%
return seems attractive, but would enough direct investors be willing to commit to such a long payback?
Such projects would have to be financed out of savings of the firms’ owners, many of whom would then
be under-diversified and demand a higher return, assuming they were willing to commit in the first place.
Valuable projects could be delayed indefinitely, curtailing economic growth and social progress.
4.
Why are economies of scale important to the viability and profitability of financial intermediaries?
Solution: Economies of scale give financial intermediaries a cost advantage. If their average cost
decreases as the size of the transaction increases, financial intermediaries can profitably engage in
denomination intermediation while remaining adequately diversified.
1.
Why do casualty insurance companies devote a greater percentage of their investments to liquid
U.S. government securities than do life insurance companies?
Solution: Because casualty losses are less predictable than deaths, a casualty insurer cannot predict future
claims as systematically as a life insurer. Thus the timing of cash outflows at casualty insurance
companies is less certain, and a casualty insurer must keep more of its assets liquid, ready to pay claims.
U.S. Government securities have a more active secondary market and lower risk profile than other
securities. They can be converted to cash quickly with less chance of loss.
2.
What are credit unions and how do they differ from commercial banks?
Solution: Credit unions are not-for-profit, tax-exempt, mutual associations of small savers; banks are
shareholder-owned, for-profit, taxpaying corporations. Credit union members share some meaningful
"common bond"; banks serve the general public. Credit unions traditionally make small consumer loans;
banks have diversified portfolios of commercial, consumer, and real estate loans.
3.
Why have mutual funds grown so fast compared to commercial banks?
Solution: As capital market (especially stock market) returns have risen in the last 20 years, money
traditionally deposited in banks for safety has moved to mutual funds. For many years, banks could not
offer capital market opportunities to ordinary individuals. The securities industry, which could not issue
deposits and did not want to be regulated like banks, attracted more of the public’s savings.
2
4.
For a consumer, what is the difference between holding a checking account at a commercial bank
and holding a money market mutual fund?
Solution: The major difference is deposit insurance. The checking account is insured by the government;
the MMMF is not insured by anyone. Consequently the MMMF should pay a higher return. Providing
liquidity, higher return, and only slightly higher risk, MMMFs have attracted billions away from banks
over the last 20 years. Although uninsured, they invest their shareholders’ money in the some of the safest,
most liquid instruments available in the financial system—Treasury bills, commercial paper, etc.
CHAPTER 2
1.
What were the objectives of the National Banking Acts and what problems existed in the U.S.
banking system before those acts were passed in the 1860s?
Solution: For much of the 19th century there was no systematic regulation of banking or overall control of
the size or quality of the money supply. Banks, state-chartered but otherwise largely unsupervised, were
free not only to engage in unsound lending practices but to fund themselves by issuing banknotes—IOUs
against themselves—without restraint. Consequent and frequent bank failures weakened public faith in
banks and the money supply, and exacerbated downturns in the normal business cycle. The National
Banking and Currency Acts (1862-64) created a new class of federally chartered banks, called “National
Banks”. These banks could issue banknotes, but they had to have them printed at the U.S. Treasury in
standard form and denominations to reduce counterfeits. National bank notes also had to be backed above
face value with U.S. government bonds, thus “enlisting” national banks to help finance the Civil War and
assuring redemption of any national bank note at face value, even if the bank failed. To encourage
circulation of national bank notes, the federal government also taxed state banknotes practically out of
existence. Beyond this first systematic effort at a reliable, standardized national currency, the Acts also
represented the first systematic federal regulation of banking: They required that national banks have
adequate capital to absorb losses before opening, hold adequate reserves, be examined regularly by the
Office of the Comptroller of the Currency, and avoid such unsound lending practices as financing risky
ventures or making loans too large relative to their capital.
2.
What were the problems posed by the National Banking Acts?
Solution: The currency was inelastic after bond issuance to finance the war ended, but before there was
political consensus for an alternate way of backing it (gold, silver, etc). The tax on state banknotes
increased the popularity of demand deposits which, despite the lack of deposit insurance and the difficulty
of clearing checks at face value, became a main source of funding for bank lending. Although required to
hold reserves, banks could “pyramid” reserves by counting deposits at other banks, so multiple
contractions in reserves occurred when cash was drained from banks during planting and cultivation
seasons or banking panics. There was no lender of last resort to provide banks with additional reserves
when they needed them, and thus no way to moderate wide swings in the business cycle.
3.
Why was the Fed initially established?
Solution: To provide an elastic currency, be a lender of last resort, improve bank supervision, and provide
for a more efficient payments system.
4.
How did the Federal Reserve System try to solve problems from the National Banking Act period?
Solution: The Fed could act as a “lender of last resort” to member banks needing extra liquidity. The Fed
3
could legally create, circulate, and de-circulate currency to keep the money supply elastic in relation to the
economy. The Fed provided free check clearing services to member banks and required that checks cleared
through it clear at par, converting the payment system from a hindrance to a handmaiden of commerce.
The Fed included all national banks as member banks and required all member banks, state or national, to
be examined regularly to ensure that they were sound and maintained adequate reserves.
5.
Why is the Fed chairman called the second most powerful person in the country?
Solution: The Chairman sets the agendas and runs the meetings of the Board of Governors and FOMC,
and thus can have a major effect on monetary policy. As the public face and voice of the Fed, the
Chairman can literally move financial markets with a few well-chosen—or ill-chosen—words.
CHAPTER 3
1.
What is likely to happen to the monetary base if (a) the Treasury department sends out
Social Security checks payable from its account at the Fed, (b) the Fed buys more government securities,
(c) banks in general borrow less from the Fed’s discount window and repay their past borrowings?
Solution: (a) the MB will increase as the Treasury checks clear the Fed providing increased bank
reserves; (b) the MB will increase as the Fed buys securities, increasing the bank reserve deposit account in
the Fed; (c) the repayment of Fed borrowings will reduce the bank reserve component of the MB.
2.
What is likely to happen to the Fed Funds Rate under the previous question’s scenarios?
Solution: Any action which increases bank reserves increases the supply of loanable funds and should
decrease the FFR. Any transaction which decreases bank reserves should decrease the FFR.
3.
What is likely to happen to the Fed Funds rate if the Fed increases the reserve
requirement? Explain.
Solution: An increase in reserve requirements on a given level of deposits will immediately convert more
total reserves into required reserves or create a reserve deficiency if total reserves on hand are not adequate
to comply. Either way, the reallocation of resources to comply with the higher reserve requirement will
pull loanable funds out of the system, pressuring the FFR upward.
4.
Why do the financial markets pay so much attention to the Fed Funds rate given that the
Fed can’t really control that interest rate in the long run?
Solution: In the short run open market operations can influence the fed funds rate, money market rates,
and indexed rates in lending agreements. The FFR is a “benchmark” rate in the financial system, usually
representing the lowest available cost of loanable funds to a depository institution.
1.
Describe the likely consequences for GDP growth when the FOMC directs the trading
desk at the New York Fed to sell Treasury securities.
Solution: Assuming the sale is of “monetary policy” magnitude and not “technical” magnitude, selling
securities reduces reserves and thus pressures interest rates upward, serving the slow the economy.
2.
What defensive actions do you suppose the Fed takes during periods of time when cash
holdings by the public increases? In other words, how does the Fed offset these cash drains?
Solution: The Fed seeks to control the total monetary base, not the individual components, so when the
4
public cash holdings increase, decreasing bank reserves, the Fed would purchase Treasury securities, (open
market operations) increasing reserves and offsetting the public’s increased cash holdings.
3. As a college student that will be entering the workforce soon, if not already, which of the
objectives of monetary policy would you like the Fed to focus on in the coming years?
Solution: As you near graduation, full employment is likely to be your main concern in the short term, but
you should also care about the long-term purchasing power of your earnings.
CHAPTER 4
1. Explain why the interest rate depends on the rate of return business firms expect to earn on real
investment projects.
Solution: The expected return on investment projects sets an upper limit on the interest rate firms are
willing to pay on borrowed funds. Unless a project earns more than the firm’s cost of capital (i.e., the
interest rate), it will be rejected.
2. How does a consumer’s time preference for consumption affect the level of savings and consumption?
How does the interest rate affect the consumer’s decision to spend or save?
Solution: If a consumer has a stronger preference for current consumption relative to future consumption,
she will save less and consume more at a given interest rate. If the interest rate decreases, the opportunity
cost of current consumption decreases and the consumer will spend more today. If the interest rate
increases, saving becomes relatively more attractive than consumption.
3. How do you think an increase in personal tax rates would affect the supply of loanable funds, holding
other things equal? Why? How would the equilibrium interest rate be affected?
Solution: Higher tax rates decrease disposable income, reducing maximum potential saving. Less saving
decreases the supply of loanable funds. Holding demand for loanable funds constant, a reduced supply puts
upward pressure on the interest rate.
1. If you believe that the real rate of interest is 4 percent and the expected inflation rate is 3 percent, what
is the nominal interest rate?
Solution: i = r + Pe = 4% + 3% = 7%. The correct compounding calculation is (1.04)(1.03) - 1 = 7.12%.
2. If actual inflation turns out to be less than expected inflation, would you rather have been a borrower or
a lender? Why?
Solution: You would rather have been lender. When inflation is less than expected, the nominal interest rate
overcompensates lenders. Thus, lower-than-anticipated inflation transfers wealth from borrowers to lenders.
3. During what period in the last 30 years were realized real rates of return negative? What causes
negative realized real rates of return?
5
Solution: Realized real rates were negative during much of the 1970s. Economists do not have a firm
explanation why market participants persistently underestimated inflation over this period.
4. Explain why interest rates move with changes in inflation.
Solution: Interest rates change in response to changes in inflation because inflation is a primary
component of nominal interest rates. Short-term rates respond more to monthly changes in inflation than
long-term rates because the inflation component of a contract rate is for the rate of inflation expected
across the life of the contract and accordingly, a monthly change has a larger effect on expectations across
a short-term contract than a long-term contract.
CHAPTER 5
1.
Why is a dollar today worth more to most people than a dollar received at a future date?
Solution: Investing means deferring consumption. Deferred consumption has an opportunity cost. In the
absence of risk, the minimum return must at least compensate the investor for this opportunity cost. Thus
a future dollar should be discounted by at least this rate, and a present dollar invested for at least this rate.
2.
If you were to invest $100 in a savings account offering 6% interest compounded quarterly, how
much money would be in the account after three years?
Solution: ($100)(1+(.06/4))12 = $119.56
3.
Your rich uncle promises you $10,000 when you graduate from college. What is the value of this
gift if you plan to graduate in 5 years and interest rates are 10%?
Solution:
PV 
$10,000
 $6209.21
1.105
1.
When a bond’s coupon rate is less than the prevailing market rate on interest on similar bonds, will
the bond sell at par, a discount, or a premium? Explain.
Solution: The bond will sell at a discount because buyers in the secondary market will bid the price down
until the bond yields the market rate.
2.
Under what conditions will the realized yield on a bond equal the promised yield?
Solution: If the investor receives all cash flows as promised by the issuer and reinvests them at the bond’s
promised yield (the yield to maturity at the time of its purchase), the realized yield will equal the promised
yield. If the issuer defaults on payments of coupon interest or principal, if the investor consumes the
6
coupon payments rather than reinvesting them, or if the market interest rate at which the coupon payments
can be reinvested deviates from the promised yield, the realized yield will not necessarily equal the
promised yield.
3.
Using the trial-and-error method, find the yield to maturity of a bond with 5 years to maturity, par
value of $1,000, and a coupon rate of 8% (annual payments). The bond currently sells at 98.5% of par
value.
Solution: The price of the bond is $985 = 0.985($1,000). Set up the known information in the bond
pricing formula and try different interest rates until the right side equals the left side:
5 $80
$1,000
$985  

t
(1  i )5
t 1 (1  i )
The yield to maturity is 8.38%.
4.
An investor purchases a $1,000 par value bond with five years to maturity at $985. The bond pays
$80 of interest annually. The investor plans to hold the bond for 2 years and expects to sell it at the end of
the holding period for 94% of its face value. What is this investor’s expected yield? Use the trial-anderror method.
Solution: The current price is $985. The investor expects to sell it after two years for $940 =
0.94($1,000). Set up the known information in the bond pricing formula, and try different interest rates
until the right hand side equals the left hand side:
2
$80
$1020

t
(1  i)2
t 1 (1  i )
985  
The expected yield is 5.90 percent.
1.
Consider a 4-year bond selling at par with a 7% annual coupon. Suppose yields on similar bonds
increase by 50 basis points. Use duration (Equation 5.8) to estimate the percent change in the bond price.
Check your answer by calculating the new bond price.
Solution: 4 year, 7% annual coupon bond selling at par. Duration = 3624.32/1000 = 3.62. Per equation
5.8, (-3.62)(0.005/1.07)(100) = -1.69%. The increase in interest rates would actually decrease the bond’s
price by 1.67 % to $983.25, assuming a par value of $1000.
2.
Define price risk and reinvestment risk. Explain how the two risks offset each other.
Solution: Price risk is the variability of the market price of the bond caused by its inverse movement with
interest rates, while reinvestment risk is the variability in return caused by varying reinvestment rates as
payments are received. As interest rates fall, bond prices rise but reinvestment yields decline. As interest
rates rise, bond prices fall but reinvestment yields increase.
7
3.
What is the duration of a bond portfolio made up of two bonds: 37 percent of a bond with
duration of 7.7 years and 63 percent of a bond with duration of 16.4 years?
Solution: The portfolio duration is the weighted-average duration of the component bonds:
4.
7.7(.37) + 16.4(.63) = 13.18 years
How can duration be used as a way to rank bonds on their interest rate risk?
Solution: Duration is a measure of price variability, given a change in interest rates. The price risk varies
directly with the duration of the bond.
5.
To eliminate interest rate risk, should you match the maturity or the duration of your bond
investment to your holding period? Explain.
Solution: Duration matching is a technique that eliminates interest rate risk. Duration matching matches the
duration of the bond to the investor’s holding period. When a bond’s duration matches the holding period, the
bond’s price risk directly offsets the bond’s reinvestment rate risk, thus eliminating interest rate risk.
CHAPTER 6
1.
If you know interest rates are going to rise in the future, would you rather own a long- or a shortterm bond? Explain.
Solution: According to the second bond theorem, long-term bonds exhibit more price volatility than shortterm bonds. If rates are rising, the first bond theorem tells us that bond prices will fall. Thus, it is better to
hold short-term bonds when rates are rising because their prices will fall more slowly than those of longterm bonds.
2.
Suppose the spot rate on four-year bonds is 11 percent and the spot rate on five-year bonds is 12
percent. What forward rate is implied on a one-year bond delivered four years from now?
Solution: Use:
(1  t R n )n
1
(1  t R n - 1 )n - 1
t  n - 1 f1

(1.12)5
1.76
1
1
4
1.52
(1.11)
= 0.1579 = 15.79 %.
3.
What bond portfolio adjustments would investors make if interest rates are expected to decline in
the future? How do these adjustments cause the yield curve to change?
Solution: Profit maximizing investors will shift their holdings from short-term to long-term bonds. Selling
pressure drives down the prices of short-term bonds, but drives the yield up. Buying pressure increases the
prices of long-term bonds, but drives the yield down. If short-term rates are increasing while long-term
rates are decreasing, we would see the yield curve flatten or perhaps become downward-sloping.
4.
How does the existence of a liquidity premium affect the shape of the yield curve?
Solution: The liquidity premium puts an upward bias in the slope of the yield curve that causes yield
curves to tend toward an upward slope.
8
5.
Why, under the market segmentation theory, do investors not shift their holdings into the securities
with the highest returns? Under the preferred-habitat theory, what is necessary for investors to shift
their holdings away from their preferred maturities?
Solution: Financial institutions that face regulatory capital requirements may desire to hold only those
securities whose durations match their holding periods. Such a strategy minimizes their interest rate risk
and protects their capital position. Therefore, these participants may restrict themselves to a particular
maturity segment. Under the preferred habitat theory an adequate risk premium is required for investors to
shift away from their preferred maturities.
1.
Suppose the yield on a 30-year corporate bond rated Aaa is 8.86 percent and the yield on a 30-year
Treasury bond is 8.27 percent. What is the default risk premium? Would you expect a higher or
lower default risk premium on an A-rated bond?
Solution: Use: DRP = i - irf = 8.86% - 8.27% = 0.59% or 59 basis points.
2.
How does the yield spread between Treasury bonds and risky corporate bonds vary over the
business cycle? Can you provide a logical explanation for the cyclical behavior of the spread?
Solution: As the economy expands the spread contracts and as the economy slows down the spread
widens. One possible explanation is that investors become more risk averse during recessions. This causes
them to sell their Baa bonds and substitute Aaa bonds in their portfolios. The selling pressure drives down
the price of Baa bonds and drives up their yields. At the same time, buying pressure on Aaa bonds drives
their prices up and yields down. Thus, the spread widens during recessions. As the economy improves,
investors may be more willing to hold the riskier bonds. Thus the buying and selling behavior shifts the
other way, causing the spread to narrow in expansions.
3.
What factors do rating agencies consider when assigning bond ratings?
Solution: The most important factors are (1) the firm’s expected cash flow; (2) the amount of the firm’s
fixed contractual cash payments, such as interest and principal payments or lease payments; (3) the length of
time the firm has been profitable; and (4) the variability of the firm’s earnings.
4.
At what marginal tax rate would you be indifferent between an A-rated, ten-year corporate bond
offering a yield of 10 percent and an A-rated, ten-year municipal bond offering a yield of 6
percent? Why does the municipal bond offer a lower rate if it has the same bond rating and
maturity as the corporate bond?
Solution: The market indifference tax rate is (1 - Muni rate)/(Corp rate) or 1 - 0.06/0.10 = 40%.
1.
Which securities tend to have higher yields, those that are more marketable or those that are less
marketable? Why?
Solution: Less marketable securities have higher yields because of the additional premium associated with
infrequently traded securities.
2.
At what stage of the business cycle would you expect issuers to call in bonds? At what stage of the
business cycle would you expect the call interest premium to be the highest? Explain.
9
Solution: Issuers find it profitable to call bonds and refund with new bonds when interest rates are low.
This tends to happen during economic recession. A callable bond issued at the top of the business cycle
tends to carry a higher call interest premium. This is when interest rates tend to be at a cyclical peak.
Investors, therefore, rationally anticipate the falling interest rates to come and the increased likelihood of
issuers calling bonds. To compensate for the increased call risk, investors require a higher call interest
premium.
3. Why do you think investors are willing to accept lower yields on putable bonds? Explain.
Solution: The put option protects investors from unanticipated events that increase the bond’s risk. Thus,
putable bonds are less risky and therefore tend to carry lower yields.
4.
Holding the price of the firm’s stock constant, would you be more likely to convert bonds into
stock when interest rates are rising or falling? Explain.
Solution: If the stock price is held constant, when interest rates rise, the price of the firm’s bonds will
fall relative to the value of the stock. Obviously, it is advantageous to convert the bonds to stock in
such an environment.
CHAPTER 7
1.
Given the economic role of the money market, explain the importance of the typical characteristics
of money market securities.
Solution: Money market securities are liquid, short-term, high quality debt securities issued by high
quality borrowers and are used to store liquidity by investors around the world.
2.
Using the information in Exhibit 7.4, calculate the price of a 13-week T-bill and express it as a
percentage of face value.
Solution: At the 1.75% awarded competitive bidders, the price (% of face) of a 13-week
T-bill on a discount basis is: (See eq. 7.3)
n
91




P0  P f   yd 
 P f   100  (0.0175) *
* 100  99.558
360
360




3.
Refer to Exhibit 7.6. On May 14, 2004, what is the price of the T-bill maturing on September 9,
2004? Calculate the price two ways, using both the asked yield and the bid yield. Assume a face
value of $10,000.
n


P0  P f   yd 
 Pf 
360


Solution: The price of the T-bill, discount basis is:


The ask price is: 100  ( 0.0106) *
115

* 100  99.6614  $10,000  $9,966.14
360

10


The bid price is: 100  ( 0.0107 ) *
115

* 100  99.6582  $10,000  $9,965.82
360

11
4.
Assuming a face value of $10,000, what is the price of a T-bill with 161 days to maturity if its
bond equivalent yield is 1.99 percent?
Solution: The price of the T-bill, discount basis is:
n
161




P0  P f   yd 
 P f   100  ( 0.0199) *
* 100  99.11003
360
360




99.11003

 $10,000  $9,911.00
100
5.
Why is the bond equivalent yield of a T-bill higher than the yield calculated on a discount basis?
Solution: The bond equivalent yield uses a 365 day year versus a 360-day year. Any periodic yield
multiplied by a smaller fraction, 161/365 versus 161/360, will have a higher yield. See solution in #4
above.
1.
Why do issues of securities by U.S. government agencies tend to have higher interest rates than
similar issues of debt by the U.S. Treasury?
Solution: The U.S. government agencies have the explicit guarantee of Congress, but lack the
marketability, and thus liquidity, of U.S. Treasuries of equivalent term. Sponsored-agencies do not have
the explicit guarantee of Congress, nor the liquidity/marketability of U.S. Treasuries. See Federal Reserve
Bulletin, Table A30.
2.
Why would you never observe a U.S. Treasury bill paying the same quoted rate of interest as a
negotiable CD with the same maturity?
Solution: First, the negotiable CD has a small amount of default risk—as even an insured CD is
guaranteed only up to $100,000 by government insurance and many negotiable CDs are much larger than
that. Second, because of the mathematics involved in computing discount interest rates, the T-bill discount
rate understates the true rate of return paid by the T-bill, while the CD does not have the same problem.
3.
Why is a “repo” like a secured loan?
Solution: The borrower of the money “sells” a government security to the lender along with an agreement
to repurchase it at a future time at a predetermined higher price that is based on the “repo rate.” Thus the
lender of the money owns the security until the money is paid back with interest, so the security serves as
“collateral” for the loan.
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4.
How and why do banker’s acceptances frequently arise in international trade transactions?
Solution: Often when people trade across borders, they trust the guarantee of an international bank more
than they trust an importer’s agreement to pay them in the future. Thus, exporters often ask importers to
obtain a “letter of credit” from a well-known bank that will agree to pay the importer’s obligation. When
the exporter complies with all terms of the transaction, the bank “accepts” the obligation to make payment
to complete the transaction if the importer does not. Because the bank’s credit is good, the banker’s
acceptance can be sold easily in the money markets and when it comes due; the bank will pay, if necessary,
if the importer does not.
CHAPTER 8
1.
Why do businesses use the capital markets?
Solution: Businesses use the capital market to finance long-term investments and to provide a "market
value" evaluation of company performance. The use of long-term securities allows issuers to be certain of
the cost of funds for the life of the investment and reduces refinancing problems
2.
What is the difference between a T-bill, T-note, and T-bond?
Solution: There are two major factors that differentiate T-bill, T-notes, and T-bonds: term and interest
payments and denomination. T-bills are offered at varied maturities up to one year and are zero-coupon or
discount securities at a minimum denomination of $10,000. T-notes, five and ten-year maturities, are
coupon securities with $1000 denominations. T-bonds, with maturities greater than 10 years, are $1000
face value, coupon securities.
3.
What is a strip? Explain how they are created?
Solution: A Separate Trading of Registered Interest and Principal (STRIPS) are zero-coupon claims on
a either the interest (every six months) or principal of a standard T-note or bond, fulfilled the investing
public's demand for zero-coupon securities.
4.
Explain how strips can be used to immunize portfolios against interest rate risk?
Solution: STRIPS are zero-coupon bonds and a portfolio of STRIPS will have its portfolio duration equal
to the maturity of the portfolio. If a bond is held to its duration, the realized YTM equals the expected
YTM, eliminating reinvestment and price risk.
1.
Explain why sinking funds on corporate bond issues play the same role as the serial structure
found on municipal bond issues.
Solution: Sinking funds, an old term dating back to the days when companies accumulated funds to pay
off bonds at maturity, today effectively pay off bonds periodically (called or purchased in market). Serial
bonds are bonds issued with varying maturities, so that part of the bond issues matures every year,
beginning in a certain year.
2.
When buying bonds, explain why investors should always make a tax-exempt and taxable
comparison? What are the ground rules for making the comparison?
Solution: Everything else the same the investor is seeking the higher after-tax return. Calculate the after13
tax return of the corporate or the pre-tax equivalent rate on the municipal bond, using the investor's
marginal tax rate.
3.
Why are commercial banks large investors in municipal bonds and property and casualty insurance
companies are not?
Solution: Until the Tax Reform Acts in the 1980's commercial banks were major investors in munis.
Households are the major investor in munis today with mutual funds second and property/casualty
insurance companies third. P/C companies have high tax exposure and seek tax sheltering via preferred
stock and muni bonds. Life insurance companies, with considerable tax shelters coming from whole life
policies, invest in taxable corporate bonds.
4.
How do the secondary markets differ between municipal bonds and corporate bonds?
Solution: The secondary market for municipals is a dealer market and is quite thin, as are many corporate
bond issues. There are more large-issues of corporate bonds, some listed on exchanges, which trade more
frequently in dealer markets.
5.
Explain how and why the junk bond market had an impact on commercial bank lending?
Solution: Prior to the development of the junk bond market, low credit quality firms depended on bank
loans for their funds. Banks would only offer short-term or variable rate medium-term loans regardless of
the borrowers’ need, thus passing on any interest rate risk to the borrower. These firms had no alternative
until the junk bond market developed and allowed these low quality firms to replace bank loans with
marketable debt with longer maturities that matched their cash flow needs.
1.
Why are asset-backed securities becoming increasingly important in the capital markets?
Solution: Many of them are tailored to provide characteristics, such as products with financial
guarantees, predictable cash flows, or floating rate characteristics, that some buyers of capital market
securities value highly, and thus are willing to pay a premium price to obtain. This is especially true
in the mortgage market where the credit enhancements reduce default risk to investors of
the mortgage-backed securities. Since those tailored products are highly desirable, more of them are
being created.
2.
Why are financial guarantees becoming increasingly important in the financial markets both
domestically and internationally?
Solution: People need only to ascertain the creditworthiness of the guarantor and not the creditworthiness
of each underlying asset. Furthermore, the interest cost saving from the improved credit-enhanced credit
rating exceeds the cost of the guarantee. Financial guarantees are increasingly important in international
markets as the credit-worthiness of the guarantor is often easier to assess than the creditworthiness of the
borrower. Also, because collection activities across borders are problematic, it often will be easier to
collect from a guarantor that has a financial reputation to protect than from a defaulting borrower in
another country. Because of the reduction in default risk, guaranteed securities are more marketable than
non-guaranteed securities and enable issuers to pay lower yields.
14
3.
What types of credit enhancement can be obtained to make asset-backed securities more desirable?
Solution: Financial guarantees such as bond insurance, standby letters of credit, the use of cash collateral
accounts, the use of subordinated tranches that enhance senior tranches by bearing the default risk, and the
set-aside of profits and servicing fee accruals to protect buyers of tranches against future losses.
4.
Why are financial markets regulated, and who is the principal U.S. regulator?
Solution: Financial markets are regulated so people will retain confidence in them and continue to supply
money to them. The SEC which was established in 1933 after the Great Depression, is the
principal regulator at the federal level. There are regulators also at the state level in every state who
focus on consumer protection issues. In addition there are self-regulatory bodies like the National
Association of Securities Dealers (NASD) which were established to protect the integrity of the
markets and the industries involved.
CHAPTER 9
1.
If you had a 6 percent, $100,000, 15-year mortgage, and you paid it as scheduled, how much
interest would you pay in the first month of the sixth year on that mortgage? How much principal
would you pay?
Solution: $351.44 in interest would be due on the 15-year mortgage, so the balance of the $843.86
total monthly payment, or $492.42 , would be used to pay down the principal due.
2.
What would your principal and interest payments be if the mortgage were a 30-year mortgage at 9
percent? (Hint: See Exhibit 9.1 and carry the calculations forward in a spreadsheet.)
Solution: Interest on the 30-year mortgage would be $$711.08 and the remainder of the payment, or $93.54,
would be repayment of principal. These can be calculated by first calculating 0.75 percent interest (9
percent interest on an annual basis is 0.75 percent per month) on the balance due after the fifth year’s 12th
month, and then subtracting that amount from the monthly payment.
3.
If you had a mortgage with an initial rate of 2 percent that adjusted its rate once a year to equal the
one-year Treasury bill rate plus 2.75 percent, with a cap on rate increases of 2 percent per year and
5 percent rate increase cap over the life of the mortgage, what rate would you pay in the second
year of the mortgage if the one-year Treasury bill rate was 1.5 percent when the new rate was
calculated?
Solution: 4 percent. Due to the 2 percent cap on annual rate increases, the rate could not exceed 4
percent even though 1.5 percent plus 2.75 percent would imply a rate of 4.25 percent if the mortgage rate
increases were not capped.
4.
In the mortgage described above, what is the maximum rate you could be charged if the Treasury
bill rates rose to 10 percent and stayed there?
Solution: 7 percent, which equals the initial 2 percent rate plus the 5 percent lifetime cap.
1.
If you owned a $100,000 security interest in a pass-through mortgage pool that contained
$200,000,000 in mortgages and received $20,000,000 in interest payments and $2,000,000 in
15
principal payments in its first year, how much principal and interest would you receive (if there
were no mortgage servicing costs) that year?
Solution: You own a 1/2,000 interest in the pool so you receive 1/2,000 of the interest—or $10,000 in
interest—plus 1/2,000 of the principal, or $1,000 in principal, since you receive principal and interest on a
“pro rata” basis according to your ownership interest in the pool.
2.
If your security interest in the mortgage pool described above were a PO, or principal only,
security, rather than a regular pass-through security, how much would you have received after the
first year?
Solution: $1,000, or a 1/2,000 “pro rata” share of the total principal payments.
3.
Why are securitized mortgage-backed securities often more attractive to investors than passthrough securities on the same pool of mortgages would be?
Solution: On some tranches, payments may be more certain or predictable than payments on the mortgage
pool as a whole. Conversely, on other tranches, payments may be less certain but promised rates of return
are higher. Alternatively, payments on some tranches may be credit-enhanced to reduce their risk; while on
other tranches, greater risk is compensated for with higher promised rates of return. In addition, some
mortgage pools may be structured so that people who pay high taxes on interest receive only principal
repayments, or vice versa. Finally, payments on fixed-interest mortgages may be restructured so some
tranches receive variables rates of interest while others receive interest returns that vary inversely with market
interest rates. Both types of securities may appeal to different types of investors. Thus, by restructuring
payments flow from pools of mortgages, various tranches can be derived that have greater appeal to buyers
than the original pool of mortgages and thus can be sold for a higher combined value in the nation’s capital
markets.
4.
Why is government or private insurance important to the mortgage markets?
Solution: Buyers of mortgages need only check the creditworthiness of the insurer of the mortgages and
need not go to the trouble and expense of checking the credit of each individual mortgage borrower in the
pool of mortgages that back the mortgage-backed securities or the individual mortgages they are buying.
CHAPTER 10
1.
What characteristics of an asset determine the type of secondary market in which it is most likely
to trade?
Solution: New issues of securities are sold in the primary market. Any subsequent transaction in the
security takes place in the secondary market. In the money market all securities are dealer traded debt
securities; while the capital market is divided between debt (bonds and mortgage-related) and equity
markets.
2.
What are the four types of secondary markets?
Solution: The four types are (1) direct search, (2) brokered, (3) dealer, and (4) auction markets.
3.
Explain the differences between the OTC market, NASDAQ, and a stock exchange.
16
Solution: The major difference is that most stock exchanges are auction markets, whereas the OTC
market or NASDAQ is more like dealer markets. NASDAQ stands for the National Association of
Securities Dealers Automated Quotation system and it provides continuous bid/ask information.
NASDAQ is an electronic pink sheet.
4.
What are the functions of market makers and specialists? How do they differ?
Solution: The more fungible an asset (the more each asset is like other assets. For example, houses are not
fungible, each is different. Share of IBM common stock are completely fungible, each is equivalent.), the
more likely it is to trade in a dealer market or on an exchange. The more frequently an asset trades, the
more likely it is to trade in a dealer market or on an exchange.
1.
Describe the general approach to valuing a share of stock.
Solution: First, identify the timing and the size of the cash flows. Second, decide upon the appropriate
discount rate to use in the present value calculation. Finally, apply the discount rate to the cash flows in
each period to obtain present values and sum the present values to obtain the price of the security.
2.
What cash flows are relevant to the value of stock?
Solution: Dividends and capital gains are the sources of income from holding a stock.
3.
Describe what happens to the total risk of a portfolio as the number of securities is increased.
Solution: As the number of securities increases, the diversification effect reduces the standard deviation
of portfolio return, a measure of the portfolio’s total risk. Total risk can be reduced, however, only to the
level of systematic risk, which cannot be diversified away because it is caused by general market
movements that tend to affect all stocks similarly.
4.
Suppose a firm’s stock has a beta of 1.2. What will probably happen to the value of the stock if the
market decreases by 20 percent?
Solution: The value of the stock will probably decline by (1.2)20% = 24%. A positive beta means that the
stock is positively correlated with the market. Because the beta is greater than 1.0, the stock will tend to
have wider swings than the market, but in the same direction.
17
CHAPTER 11
1.
Explain the major differences between futures contracts and forward contracts.
Solution:
FORWARD MARKET
FUTURES MARKET
The forward market is unstructured and trades over
the counter.
Numerous dealers match individual buyers and
sellers and/or trade for their own accounts.
No maintenance margin is required.
Futures transactions are conducted on an organized
exchange
Contracts are made between buyers or sellers and
the exchange.
Margin requirements are imposed to ensure no one
will default when prices move adversely.
Very few contracts are settled by delivery.
The futures market is useful when it is necessary to
hedge price risk over a period of time.
Marked to market daily.
All elements of the contract are standardized (Only
price is variable).
Trades on exchanges, and are very liquid.
Clearing house guarantees delivery and payment.
Low default risk.
Most forward contracts are settled by delivery.
The forward market is useful when a set amount of
currency is needed on a specific date.
No marking to market
All elements of the contract are negotiated.
Highly illiquid because of customized features.
Default potential is quite high.
2.
What is the economic role of the margin account on a futures exchange?
Solution: The margin account protects futures market participants from default resulting from adverse
price movements. As contracts are marked to market daily, increases in value are added to the margin
account and decreases in value are subtracted. The exchange maintains these accounts so participants
needn’t worry about default risk.
3.
What determines the size of the margin requirement for a particular futures contract?
Solution: The size of the margin requirement is determined by the price volatility of the underlying asset.
4.
What is the difference between hedging and speculating?
Solution: In the context of a futures transaction, a hedger will hold a position in the spot market opposite
to that in the futures market. For example, a shipping firm that is short in the spot fuel oil market could
hedge the price risk by going long in oil futures. Hedgers are primarily trying to reduce price risk.
Speculators, on the other hand, will be long or short a futures contract without holding an offsetting
position in the spot market. They are in effect accepting price risk in hopes of making money on price
movements.
1.
Suppose you own a portfolio of stocks currently worth $100,000. The portfolio has a beta of 1.2.
Describe in detail the futures transaction you would undertake to hedge the value of your portfolio.
Which futures contract would you use? How many contracts would you buy or sell?
Solution: The investor should sell S&P 500 futures contracts short. Because the futures contract is
assumed to have a beta of 1.0, you would have to sell contracts worth 20 percent more than the value of
your portfolio to create the hedge.
18
2.
Suppose your desired holding period is five years, but you find yourself with a bond portfolio
having a duration of seven years. Describe the futures transaction you would undertake to hedge
the value of your portfolio at the end of five years. What futures contract would you use? Would
you buy or sell these futures contracts to shorten the duration of your bond portfolio?
Solution: Since you are long in bonds, you should hedge the position by selling short futures contracts on
similar bonds. You should pick the futures contract whose underlying bond most closely resembles the
bonds in your portfolio with respect to maturity and default risk. This will minimize your basis risk.
3.
Why does cross-hedging lead to basis risk?
Solution: Basis risk exists because the value of an item being hedged may not always keep the same price
relationship to contracts purchased or sold in the futures market. Cross-hedging involves hedging with a
futures contract whose characteristics do not match those of the hedger’s risk exposure. Since the price
movements of the hedged commodity are likely to be less than perfectly correlated with those of the futures
contract in a cross-hedge, basis risk results.
1.
What are some considerations in the decision to use futures or options for hedging?
Solution: Gains and losses in futures contracts are virtually without limit. For that reason, some hedgers
prefer options. Options give a one-sided type of price protection that is not available from futures.
However, premiums on options may be high, and the value of options decays over time. The buyer of
protection must decide whether the insurance value provided by the option is worth the price.
2.
Explain the relationship between the time to expiration for a call option and the value of the
option.
Solution: European options can only be exercised at maturity. American options can be exercised any
time before maturity.
3.
Explain the relationship between the price variance of an asset and the value of an option written
on that asset.
Solution: The more price variability a stock has, the greater the chance that the buyer can exercise the
option for either a larger profit or a larger loss. However, the buyer will never exercise the option and take
a loss. Thus, options with greater price variance tend to be more valuable.
4.
If you hold some shares of stock and would like to protect yourself from a price decline, without
giving up a lot of upside potential, should you purchase call options or put options? Explain.
Solution: You should purchase put options. When the value of the stock goes below the exercise price,
the payoff from the put at maturity increases. This increased payoff offsets losses from holding the stock.
19
CHAPTER 12
1.
Why should purchasing power parity exist? Why might it not hold?
Solution: (a) Because of the law of one price, the same good or equivalent goods should cost the same
amount except for transportation cost differences if the goods are in different places. Thus, exchange rates
between currencies should be such that equivalent sets of goods should cost approximately the same in
different countries after converting their prices from one currency to the other. (b) Short-term, long-term, or
politically motivated capital flows can cause exchange rates to diverge as funds flow from one country to
another. Furthermore, tariffs, quotas, export and import fees, and other non-tariff barriers may prevent
goods from being transferred from one market to another without incurring substantial costs that require
that they be sold at a higher price. As a result, prices for similar goods in different markets may never be
equalized.
2
What can cause a country to have a deficit in its current account balance of payments?
Solution: A deficit on its balance of trade in goods and services that results from importing more goods
and services from abroad than it exports, a deficit on its investment income balance caused by paying more
interest and dividends to foreigners than it receives from abroad, or a deficit caused by net flows of
unilateral transfers abroad in the form of gifts, aid, and other unilateral transfer payments.
3.
Is it always true that when a country has a deficit in its trade balance, the value of its currency will
decline? Explain.
Solution: Two types of funds flow impact foreign exchange rates: trade flows and capital flows. If as in
the U.S. for many years, there is a deficit in the trade and current account, foreign investors may demand
the glut of dollars supplied from trade for the purchase of dollar denominated U.S. securities. For many
years in the U.S. growing trade deficits and a strengthening dollar existed.
4.
What types of capital flows exist between countries and what can motivate each type of flow?
Solution: Capital flows may be made in the form of direct investment (purchase of a plant), direct
financial investment (purchase of stock in a company), or from inter-governmental capital flows.
5.
Why must the balance of payments always balance?
Solution: Just as "purchase" of assets (balance sheet) must be matched by "payments" of cash or an IOU,
so the balance of payments accounts must theoretically balance.
1.
What could a government do to support the value of its currency in the foreign exchange market?
Solution: It could buy its currency by selling some of its stock of reserve currencies or gold, or it could
borrow currencies from foreign countries and use the borrowed currencies to buy its domestic currency in
the exchange markets. Such interventions might only have a temporary effect, however, unless it addressed
its major problems by reducing its money supply to raise interest rates to attract foreign capital inflows and
restrain domestic inflation.
20
2. How can a firm reduce its risk by engaging in forward currency transactions? Why are losses on such
transactions often more apparent than real?
Solution: It can reduce its risk that foreign currency values change adversely prior to the time it must
make payments in or receive a foreign currency by prearranging the exchange rate for that currency into or
out of its domestic currency. Thus, a firm that expects to receive British pounds in the future may sell the
pounds forward at a prearranged price, such as $1.58 per pound, in order to assure itself that the dollar
revenues it receives will guarantee a profit on the transaction. If the British pound were currently trading at
$1.60 per pound, some might say that it would lose on the forward transaction. However, the forward
exchange rate will be lower than the spot rate primarily because British interest rates are higher than
domestic rates—usually because expected inflation is greater in Britain than in the United States. If
inflation is high, the pound will be losing purchasing power over time—thus, pounds received in the future
will be worth less than pounds received now. Consequently, it is only logical that the future receipt of
pounds should be worth less than current pound holdings— and that difference is reflected in the
difference in the spot and forward exchange rates.
3. When a country has high inflation, why is it risky for a foreigner to invest in that country?
Solution: Because, over time, sustained inflation will cause the value of that country’s currency to
decline. Unless it is possible to earn returns that are higher than the possible loss in value caused by
currency devaluations, investments in that country may not earn positive net returns after accounting for
currency exchange losses. Furthermore, countries that experience balance of payments problems often
impose capital controls so people cannot take their funds out of the country easily just because they fear the
currency will be devalued. Thus, it may be easier to invest in the rapidly inflating country than to repatriate
the principal invested or earnings on the investment.
4.
Why might consumer groups support government policies that maintain a “strong” U.S. dollar?
Solution: A "strong" dollar buys more foreign consumer goods (clothing) and services (travel abroad)
than a "weak" dollar, but at the same time encourages the exportation of manufacturing jobs out of the
country. Those consumers that are working want a strong dollar.
5.
If the US has a high rate of inflation, what will likely happen to the value of the dollar? Why?
Solution: A rate of inflation higher than that of trading partners should, everything else the same, produce
a glut of dollars on the forex market and the dollar should depreciate. With higher inflation,
foreign prices are cheaper, creating a trade and service deficit, and depreciating the dollar on forex
markets.
21
CHAPTER 13
1. Approximately how many banks operate in the U.S.? Discuss trends in the number of banks versus the
number of banking offices. What do these trends tell us about the future structure of the banking industry?
Solution: There are currently about 7,800 banks in the U.S. More than three times as many
operated in the 1920s. The collapse of the financial system during the early 1930s reduced the number of
banks to about 15,000. The number of banks continued to decline gradually until the 1960s, primarily
because of mergers rather than failures. After 1960, the number of banks increased slightly, stabilizing at
around 15,000 until the late 1980s. Then, in the late 1980s and early 1990s the number of banks declined
as a result of failures and mergers. Since the early 1980s, however, the number of total banking offices
(branches plus main offices) has been increasing despite the decrease in the number of banks. The reason
is the increase in the number of branches. Even as the number of banks has decreased, geographic
restrictions have relaxed in the past 20 years, resulting in more branches per bank. Although the number
of banks has declined in recent years, the number of banking offices has grown dramatically because of a
sharp increase in branching. In 1941, there were 3,564 branch offices. By 2003, there were almost 75,000
banking offices, of which about 67,000 were branch offices. As regulatory restrictions further relax, we
will see further consolidation in the industry, which means fewer banks, but probably more branches.
2. The interest rate on borrowed funds is usually higher than the interest rate on small time deposits. Given
that, why do large banks continue to rely more heavily on borrowed funds as a source of funds?
Solution: The demand for loans at the largest institutions has outpaced the institutions’ ability to
fund those loans with deposits. In addition, borrowed funds are a more flexible source of funds in that the
funds can be raised quickly and retired quickly without catering to the preferences of depositors.
3. What are the major sources of bank funds? How do these differ between large and small banks?
Solution: The most important source of funds is deposits, which are more important for small
banks than large banks. Large banks get more of their funds directly from the money markets (borrowed
funds) in the form of Fed Funds purchased and repurchase agreements.
4. How does the proportion of capital for a typical bank compare with that of a typical industrial firm? Do
you believe banks have adequate capital? Why or why not?
Solution: In general banks seem thinly capitalized (highly leveraged) compared to industrial
firms. A typical bank is financed with less than 10% capital and even less for large banks. Most industrial
firms are financed with 40% to 60% capital. Because most banks are prudently managed and all banks are
highly regulated, their capital is probably adequate. Industrial firms do not have their primary operating
debts insured by the government, nor is their liquidity guaranteed by the central bank.
5. Why do you think that small banks are financed by a higher proportion of capital than large banks?
Solution: Large banks have direct access to the money markets, so equity is less important to
them as a source of funds. Small banks tend to be managed more conservatively.
1. Why do you think small banks have a higher proportion of assets in investments than do large banks?
Solution: Small banks rely more on investments for liquidity. Large banks are more able to “buy”
liquidity directly in the money market. Small banks thus tend to have more assets invested in Treasuries,
which are safe and highly liquid.
22
2. Describe a typical Fed Funds transaction. Why do you think small banks sell more Fed Funds as a
proportion of total assets than large banks?
Solution: A Fed Funds transaction is an unsecured loan of excess reserves from one bank to
another, usually “overnight”. In general, small banks carry more excess reserves. Large banks carry fewer
excess reserves because they have direct access to the money markets.
3. How does loan portfolio composition differ between large and small banks? Can you provide an
explanation?
Solution: Large banks have a much higher proportion of commercial loans, which they compete
for in a national market. Smaller banks tend to operate in more local markets and have more of a retail
emphasis. Smaller banks tend to have a higher proportion of agriculture and real estate loans than large
banks, which have more of a wholesale emphasis. The loan portfolio of a small bank will be, to a large
extent, a function of the local economy in which it operates. Small banks are also likely to be more
conservatively managed, affecting their choices about what kinds of risk to underwrite, and under what
conditions. Large banks may more willingly originate riskier assets with the intention of securitizing them.
4. What factors go into setting the loan interest rate? Explain how each factor affects the rate.
Solution: The prime rate, the Fed Funds rate, Treasury rate, or LIBOR may serve as a bank’s base
rate. It accounts for the bank’s expenses and a fair return to the bank’s shareholders, before adjusting for
any special risk. Banks add or subtract from the base to price for a borrower’s default risk and borrowing
alternatives. An adjustment for the term of the loan may also be added. If the yield curve slopes upward,
for example, banks would add a term premium to the base.
5. What customer characteristics do banks typically consider in evaluating consumer loan applications?
How does each of these factors influence the decision of the bank to grant credit?
Solution: Banks typically use the five Cs: character (willingness to pay), capacity (cash flow),
capital (wealth or net worth), collateral (security), and conditions (economic conditions). Character,
capacity, capital, and collateral all have a positive influence. A customer’s sensitivity to poor economic
conditions is a negative influence. Collateral is generally not a primary justification for credit. Rather, a
credit decision justified in terms of the other four C’s is then be reinforced by adequate collateral.
1. What are the main factors a bank must consider when setting the interest rate to offer on deposits?
Solution: There are two major factors. First, the bank must offer a high enough interest rate to
attract and retain deposits. If deposit rates are too high, however, they squeeze the spread between the
average return on assets and the average cost of liabilities. Second, to meet competition, banks not only
have to lower rates charged on loans, but also have to increase rates on deposits. Bank managers should
recognize that market forces ultimately determine deposit rates.
2. List and describe the major fee-based services offered by commercial banks.
Solution: The major fee-based services are correspondent banking, trust services, investment
products, and insurance products. Correspondent banking is the sale of banking services to other banks
or nonbank financial institutions. Trust operations involve the bank’s acting in a fiduciary capacity for
an individual or a legal entity. Trust typically involves holding and managing assets for the benefit of a
23
third party. The investment and insurance products sold by banks involve the sale of brokerage services,
mutual funds, or annuities through affiliated nonbank companies.
3. Discuss the uses of standby letters of credit (SLCs). What benefits do SLCs offer to a bank’s
commercial customers?
Solution: In an SLC transaction, the bank acts as a third party in a commercial transaction
between the bank’s customer and a beneficiary, substituting the bank’s creditworthiness for that of its
customer. Thus, if the bank’s customer fails to meet the terms and conditions of the commercial contract,
the bank guarantees the performance of the contract as stipulated by the terms of the SLC.
4. What are the major reasons that banks sell loans?
Solution: First, to earn fee income for originating and servicing sold loans. Second, a bank may
have a comparative advantage in booking certain types of loans and can use funds from loan sales to fund
additional similar loans. Third, loan sales permit banks to diversify across a different set of loans than
they originate and service. Finally, banks may sell loans to avoid burdensome regulatory taxes such as
federal deposit insurance premiums, foregone interest from holding required reserves, and mandatory
capital requirements.
5. What are the major benefits to banks of securitization?
Solution: First, by selling rather than holding loans, banks reduce the amount of assets and
liabilities, thereby reducing reserve requirements, capital requirements, and deposit insurance premiums.
Second, securitization provides a source of funding loans that is less expensive than other sources. Finally,
banks generate origination and loan servicing fees in the securitization process.
CHAPTER 14
1. Explain how liquidity risk can lead to a bank’s failure.
Solution: If a bank has insufficient funds to meet its depositor’s withdrawals, it must close. Banks
fail if they cannot meet their legal obligations to depositors or creditors.
2. What defines a bank’s insolvency? What characteristic of a bank’s balance sheet makes it vulnerable to
insolvency?
Solution: Banks are thinly capitalized. Therefore, a slight depreciation in the value of the bank’s
assets, many of which embody credit risk or interest rate risk, could cause the value of liabilities to exceed
the value of assets, the condition that defines insolvency. Given commercial banks’ low equity
capitalization, they can fail if they assume excessive risk.
3. Explain some simple strategies banks can follow to avoid insolvency or illiquidity. Why don’t more
banks adopt these strategies?
Solution: To avoid insolvency, banks could invest only in short-term, risk-free instruments, such
as Treasury bills. To avoid illiquidity, banks could invest only in the most liquid securities or hold more
cash. None of these strategies, however, is particularly profitable. Banks answer not only to depositors and
regulators with an interest in safety, but to shareholders with a required return. To earn higher returns,
banks must assume and manage credit risk and interest rate risk.
24
4. Why do banks try to minimize their holdings of primary reserves in the practice of asset management?
Solution: Primary reserves consist of the cash assets on a bank’s balance sheet: vault cash,
deposits at correspondent banks, and deposits at Federal Reserve Banks. None of these assets earn interest.
5. What asset accounts comprise secondary reserves? What role do these accounts serve in an asset
management strategy?
Solution: Secondary reserves consist of Treasury bills, Fed Funds sold, and short-term agency
securities. These securities are very marketable and therefore provide a good secondary source of liquidity.
1. Explain how bank capital protects a bank from failure.
Solution: Capital provides a “cushion” against losses. If these losses erode the bank’s capital
below regulatory minimums, regulators will intervene and may close the bank.
2. Why was bank capital increased in recent years?
Solution: Bank capital has increased because banks enjoyed high profitability for the most of the
1990s, because growing earnings from off-balance-sheet banking have added equity relative to assets, and
because risk-based regulatory minimums have been in effect since 1988.
3. Why do you think bankers prefer to use higher leverage than regulators would like them to?
Solution: Like any other firm, banks understand the role of leverage in increasing ROE. Bank
managers believe that long-term profit maximization can best be achieved if their banks are highly
leveraged. Regulators are more concerned about the risk of bank failures in general than the profits of an
individual bank. Their overriding concern is protecting the economy from widespread bank distress.
4. Explain why the credit risk associated with a loan portfolio is less than the sum of the credit risk
associated with each of the loans in the portfolio.
Solution: All the loans in the portfolio will not default at the same time, nor do they all represent
the same risk factors. Modern portfolio theory teaches us that diversification reduces portfolio risk.
5. Explain how loan brokerage, as discussed in Chapter 13, can be used to reduce concentration ratios.
Solution: Banks that specialize in loans of a certain type, to certain industries, or in certain
geographic regions can broker those loans in the secondary market. They can use the proceeds to acquire
loans by other institutions of a different type, to different industries or in different geographic regions.
1. What is meant by repricing? What happens to the cash flows of a bank whose liabilities reprice before
assets as interest rates increase?
Solution: An interest-bearing asset or liability “reprices” when its interest rate changes upon
rollover or refinancing. Short-term assets or liabilities reprice before long-term ones in that they roll over
more frequently in a given period. If liabilities reprice before assets and interest rates are rising, the cost
of the bank’s funds will increase faster than the rates it earns on its assets. This will decrease net income.
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2. If a bank’s liability costs increase faster than yields on assets as interest rates rise, does the bank have a
positive or negative maturity GAP? What kind of duration GAP would such a bank tend to have—positive
or negative? Explain.
Solution: The bank has a negative GAP because its rate sensitive liabilities are greater than its
rate sensitive assets. If liabilities reprice more frequently than the assets then the average duration of the
liabilities is less than the average duration of assets. The bank, therefore, has a positive duration GAP.
3. Should banks use maturity GAP or duration GAP to manage interest rate risk? What are the important
considerations in this decision?
Solution: Because it requires a great deal of computation on a continuing basis, only the largest
banks use duration GAP analysis. Most smaller banks settle for maturity GAP analysis because of its
simplicity. They should recognize, however, that their management of interest rate risk will be less precise
because maturity GAP ignores reinvestment risk on intermediate cash flows.
4. Explain how financial futures can be used by banks to reduce interest rate risk.
Solution: A bank with a negative maturity GAP or positive duration GAP should sell futures on
interest rates to reduce interest rate risk. As interest rates increase the bank’s cash flow (or value)
decreases. The short position in interest rate futures, however, increases in value when interest rates
increase, offsetting the loss in value experienced by the bank. Conversely, a bank exposed to a drop in
rates should take a long position in interest rate futures.
5. What trade-offs should banks consider when choosing between a cap or a collar to manage interest rate
risk?
Solution: Caps may be preferred because the downside is limited to loss of the option premium.
Caps, however, are likely to be expensive. Banks can offset the cost of a cap by simultaneously selling a
floor. The premium income from selling a floor reduces the cost of the cap, but exposes the bank to more
downside risk.
CHAPTER 15
1.
What are the reasons for growth in American banking overseas in recent decades?
Solution: There are at least three reasons for growth in American banking overseas. First, as large U.S.
corporations began expanding overseas in the 1960s, U.S. banks helped to finance that expansion. Second,
because of several federal programs designed to restrict the outflow of funds from the United States, many
U.S. banks opened overseas branches to tap international sources of funds that U.S. banks could then lend
overseas. And finally, domestic restrictions like regulation Q, which limited the interest rate that banks
could pay on some deposits, forced some U.S. banks to open foreign branches where they were free to pay
market rates of interest to attract depositors.
2.
What are the organizational forms banks use to deliver international banking services to their
overseas customer?
Solution: The organizational forms discussed in the text are: representative offices, shell branches,
correspondent banks, foreign branches, Edge Act corporations, foreign subsidiaries and affiliates, and
international banking facilities.
3.
Compare the U.S. philosophy of bank regulation to that of other countries.
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Solution: The U.S. philosophy has sought to maintain a separation of banking from other business
activities in order to promote soundness in banking and to prevent concentration of power. In other
countries, banks are allowed to engage in a wider range of business activities. In addition, until recently,
other countries have focused on regulating the domestic operations of banks while ignoring their overseas
activities.
1.
In what ways may an international loan differ from a domestic loan?
Solution: International loans differ from domestic loans in at least one of the following characteristics:
(1) funding, (2) syndication, (3) pricing, and (4) collateral. Most large international loans are funded in the
Eurocurrency market, are syndicated, are priced relative to LIBOR, and are unsecured (made without
specific collateral).
2.
What is the difference between currency risk and country risk?
Solution: Country risk refers to the risk that political developments in a country will increase the
likelihood that a borrower defaults or refuses to service its debt obligations. Currency risk, on the other
hand, refers to the risk that the currency in which the loan is made declines in value between the time the
loan is made and the time it is repaid.
3.
Compare the strategies of pooling risk and diversification as methods of reducing the risks of
international lending.
Solution: Pooling risk is a process where several lenders fund a loan such that no single lender bears all
the risk associated with the loan. Diversification, on the other hand, refers to a lender making loans in
several countries, for example, so that in the event a borrower defaults, earnings from loans in other
countries minimize the effect of the loan loss on the bank’s total earnings.
CHAPTER 16
1. Why are bank failures considered to be so undesirable that the government should try to prevent them?
Solution: Unlike other business failures, bank failures reduce the money supply and disrupt the
financing of a variety of other business activities. Bank failures also tend to be contagious if liquidity is
not promptly and decisively injected to restore the confidence of the depositing public.
2. What has the U.S. trend in bank failures been since 1920?
Solution: In the 1920s small unit bank failures were relatively common in economically
distressed parts of the country. The nationwide failure rate skyrocketed from 1929 to 1933 as the Great
Depression unfolded and asset values collapsed. After the advent of deposit insurance in 1934, bank
failures dropped sharply until the 1980s, when increased competition, moral hazard, and sharply rising
interest rates precipitated the most recent banking crisis in U.S. history. Bank failures declined sharply in
the 1990s after adoption of risk-based capital standards.
3. What is the difference between a “purchase and assumption” and a “payoff” method for liquidating a
failed bank?
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Solution: In purchase and assumption, another institution purchases the assets of the failed bank
and assumes its liabilities. There is no direct deposit insurance payout. In a payoff, the FDIC pays insured
depositors up to the limit, but any payment above the limit will be made in full only if the assets of the
failed bank can be sold at a high enough price to repay all uninsured depositors and creditors in full.
4. Why might it be unfair to small banks if all large bank liquidations were accomplished via purchase and
assumption rather than payoff transaction?
Solution: If only purchase and assumptions were used for large banks, large depositors would
prefer to place their money in such banks to keep all their funds safe, even if their deposits exceeded
$100,000. Large banks would thus have an unfair advantage in attracting large depositors. For that
reason, the FDIC has experimented with modified purchase and assumption policies to give uninsured
depositors an incentive to monitor the riskiness of large banks.
1. What is moral hazard and how does deposit insurance contribute to it on the part of both depositors and
bank management?
Solution: Moral hazard exists whenever a decision-maker is protected from the full consequences
of a bad decision—a problem inherent in insurance contracts. The insured faces temptation to pursue
riskier behavior, knowing that the insurance will cover losses. Deposit insurance makes depositors less
careful about depositing their funds in insured banks. It allows banks to take more risk without having to
compensate depositors by paying higher interest rates. Thus, unlike uninsured businesses, banks can often
increase profits by taking extra risks without commensurate increases in cost of funds.
2. How can bank capital and subordinated debt help protect deposit insurance funds against losses?
Solution: If a bank is liquidated, depositors will be paid before owners or subordinated creditors.
Thus, those items are analogous to a “deductible” on deposit insurance. Furthermore, nondeposit creditors
stand to lose if a bank fails, so they monitor its risk-taking and price their securities accordingly, thereby
alerting markets and regulators if anything is amiss.
3. What are the arguments for and against the regulators using a “too big to fail” policy?
Solution: The failure of a very large bank could destabilize the banking system, causing losses to
firms and banks doing business with the failed bank and risking widespread financial disruption and loss
of confidence. However, it is unfair to protect depositors in large banks fully while protecting depositors
in small banks only partially. It also creates a serious moral hazard: Depositors in large banks will only
care whether such banks are “TBTF”, not whether they are taking too much risk.
1. In what way did the Financial Services Modernization Act of 1999 merely formalize the regulatory
interpretations of existing laws?
Solution: Over the years court and regulatory decisions had gradually but effectively eviscerated
the traditional Glass-Steagall regime of segregation of commercial banking from investment banking. The
FSMA formalized this practical reality. Congress is generally slow to repeal enabling legislation.
Markets, regulators, and the courts are often far ahead.
2. What was the justification for separating commercial banking from investment banking?
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Solution: The Banking Act of 1933 tried to reduce bank risk taking by separating commercial
banking from investment banking. Commercial banks would not be exposed to price-risk fluctuations in
the value of securities that they had underwritten but had not yet sold. Glass-Steagall also prevented
banks from acquiring equity securities for their own accounts and from acting as equity securities dealers.
The prohibition against owning equity securities not only prevented banks from carrying certain potentially
risky assets on their balance sheet, which could increase their risk of failure, but also lessened potential
conflicts that can arise when the ownership and creditor functions of banks are combined. Before passage
of the Banking Act, the integrated banking houses of the era abused their commercial banking powers to
grant cheap credit to buyers of the securities they were underwriting, capturing large underwriting profits
while shifting most of the risk to uninsured depositors.
3. Why do bankers probably have more favorable attitudes toward the Truth in Lending Act than the
Community Reinvestment Act?
Solution: The truth-in lending act may help bankers by showing that they charge relatively low
rates on consumer credit compared to retailers, finance companies, and other lenders. Truth-in-lending
regulations affect disclosures and recordkeeping, but not lending policy or resource allocation. The CRA,
on the other hand, may prevent banks from merging, branching, or obtaining other regulatory approvals
unless they can show they have allocated loanable funds to certain politically favored purposes or
constituencies, which may or may not meet their credit criteria.
4. What does it mean to say that the Federal Reserve is an “umbrella” regulator?
Solution: Under the Financial Services Modernization Act the Fed has overall responsibility for
financial holding companies, but cedes “functional” regulatory authority to regulators of each of a holding
company’s subsidiaries. For example, a holding company owning a national bank, a securities firm, and an
insurance company would have those subsidiaries regulated by, respectively, the OCC, the SEC, and the
state insurance regulators in each state where the insurance subsidiary was operating. This scheme will
require increased coordination of regulatory actions and information in the future, as reflected to some
extent in the existence and purpose of the Federal Financial Institutions Examination Council.
CHAPTER 17
1. When and why were the various types of thrift institutions started in the United States?
Solution: Thrifts trace their origins to the early-to-mid-19th century, when they originated as
associations or clubs in “mutual” (depositor-owned) form to pool savings and make loans among ordinary
individuals overlooked or disregarded by the financial establishment (particularly commercial banks).
2. Name the present federal regulators of savings institution institutions. Also, explain which ones no
longer exist and why.
Solution: The present deposit insurers are the FDIC-BIF and the FDIC-SAIF. The present
regulator of federally chartered savings associations is the OTS, while the FDIC regulates most federallyinsured and chartered savings banks. State regulators regulate state-chartered savings banks and
associations on a mostly OTS/FDIC model. The FHLBB and FLSIC were closed in 1989 because they
failed both to anticipate and to remediate the thrift crisis. The RTC was chartered in 1989 to dispose of
failed depository institutions, and disbanded in 1995 when its work was completed.
3. What are savings institutions’ most important assets and liabilities?
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Solution: Commensurate with the industry’s traditional “franchise”, its most important assets are
still 1–4 family home mortgage loans and its most important liabilities are still savings and time deposits.
Relative importance of other sources and uses of funds has, however, increased over the last 25 years.
4. What trends have recently occurred in savings associations’ capital adequacy, earnings, and numbers,
and why?
Solution: Capital adequacy has trended upward as weak thrifts have been liquidated or
consolidated with healthy ones and mutual form has largely given way to stock form. Interest rate spreads
have widened with low interest rates in the last decade or so. Loan losses have declined to nominal levels.
Overall earnings have thus improved. The number of charters has declined through merger, conversion to
bank charters, acquisitions of thrifts by banks, and disposition of failed institutions.
1. What are credit unions' most important assets and liabilities?
Solution: Credit unions’ most important assets are consumer loans (chiefly vehicle and
real estate), investment securities, and deposit holdings. Their most important liabilities are members’
share deposits, share-draft deposits, and certificates of deposit.
2. Why is the credit union common-bond requirement changing? How, and why is it changing?
Solution: The requirement that all members of a credit union should share some common bond
(occupational, associational, or residential) is being applied under a broader definition. For
example, a teachers’ credit union might also admit spouses and relatives of teachers, and
allow members to remain after they retire or change to some other occupation. C redit unions
are often small and a restrictive interpretation of their common bond would limit their potential
growth. They cannot attain economies of scale or offer sophisticated services to their members
unless they find a way to grow.
3. How does the common-bond requirement affect credit unions’ credit risk?
Solution: Common-bond requirements potentially limit diversification of the loan portfolio.
1. What types of finance companies exist and what does each do?
Solution: Consumer finance companies primarily make loans to consumers. Sales finance
companies primarily finance sales made by retail dealers by buying the credit contracts (“ dealer paper”)
generated by those sales. Captive finance companies are sales finance companies that were started to
finance the sales of their parent companies’ goods and services. Factors finance business firms by buying
and collecting their accounts receivable. Business finance companies finance business loan needs in
general. Leasing companies purchase equipment needed by their customers and lease it to their customers.
2. How do finance companies fund their operations?
Solution: Most have lines of credit at commercial banks, and larger finance companies issue
commercial paper to obtain short-term funding. They also issue long-term debt. Captive finance
companies can borrow (obtain “transfer credit”) from their corporate parents.
3. Why are good credit ratings important to finance companies?
Solution: They generally do not issue insured liabilities. Thus, in order to reduce funding costs to the
lowest possible level and to borrow loanable funds as needed, they must have the best ratings possible.
4. What regulations have caused finance companies to de-emphasize their unsecured personal lending?
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Solution: Consumer protection regulations have generally increased the cost of unsecured personal
lending. In particular, restrictions on collection practices and remedies have made it more difficult to
collect nonperforming or underperforming unsecured consumer loans. Proceedings under the Bankruptcy
Code also commonly involve the cancellation of unsecured debts. State interest rate ceilings have
sometimes made it difficult to make a profit on small consumer loans, which already embody just a narrow
margin of return over risk. Thus, finance companies have switched to making larger, better-secured loans,
such as second-mortgage home-equity lines.
CHAPTER 18
1. Define insurance. What are the requirements for privately insurable risks?
Solution: Insurance is a contract which transfers pure risk to a third party. Insurable risks are
fortuitous and random, but losses associated with them are determinable and measurable upon occurence.
Insurable risks are manageably distributed across time; they are not all likely at one time (i.e., not
catastrophic). Premiums must be high enough to cover losses but affordable enough so to attract
widespread purchase and build a risk pool.
2. What is meant by the term objective risk and why is it so important to insurers?
Solution: Objective risk is deviation of actual from expected. Expected losses are a starting point
for calculating premiums. If objective risk is small, premiums will cover losses; but if objective risk is
large, premiums may not cover losses and “underwriting loss” may occur. Repeated underwriting losses
can lead to insurer insolvency.
3. What are the various types of insurance organizations?
Solution: Stock, mutual, fraternal, reciprocal, and “Lloyd’s associations”.
4. What are the sources of regulation for the insurance industry and what areas are regulated?
Solution: The states regulate insurance in the US. The National Association of Insurance
Commissioners coordinates state regulatory activity. The purpose of insurance regulation is to assure
financial strength of insurers in order to protect against insolvencies, to protect consumers in drafting
insurance contracts, to assure reasonable rates, and to assure widespread availability of coverage.
5. How does securitization of risk increase insurance industry capacity?
Solution: Rather than simply relying on insurers and reinsurers to bear risk, securitization opens
the door for other capital market participants to share risk. Securitization is especially important in
addressing potentially catastrophic losses (earthquakes, hurricanes, etc.).
1. How do term life insurance and whole life insurance differ with respect to the duration of coverage and
savings accumulation?
Solution: Term life premiums cover losses, expenses and expected returns to capital, whereas
whole life premiums include the "cost" of term (noted above) plus an savings program designed to provide
a "cash value" living benefit to the insured/owner in case the "insurance" event does not occur. Whole life
policies and companies who promote them are likely to grow quickly and to great size, while "term"
specialists remain relatively small.
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2. Why was universal life insurance popular in the 1980s, but not in the 1990s? What made variable life
insurance popular in the 1990s?
Solution: Universal life insurance was a flexible species of "whole life", which includes two
separate financial services: life insurance and savings. Ambiguity about the cost of the insurance
component and the return on the savings component convinced most people to “buy term and invest the
difference”. Variable life, in which returns on the savings feature are tied to the company’s investment
performance, became popular when the equity markets were providing double-digit returns in the late
1990s.
3. Why are life insurance and life annuities often described as opposites?
Solution: Life insurance provides economic protection for early death; annuities provide
protection against late death—living beyond one’s assets.
4. What are the largest asset categories on a life insurance company balance sheet?
Solution: Corporate and foreign bonds, corporate equities, U.S. Government securities,
mortgages, and policy loans.
1. Property insurance is available for both direct and indirect losses. Differentiate between these two types
of losses.
Solution: Direct losses include fire, theft or other perils that impact the property of the insured
"directly." Indirect losses are losses contingent upon other losses, such as business interruption after a fire.
2. Why is the liability loss exposure more difficult to gauge than the property loss exposure?
Solution: The ultimate determination of liability exposure may be contingent, as to both timing
and amount, on factors more behavioral and less predictable than either the actual value of the loss or the
actual merits of the case. Such factors may include bias, corruption, or incompetence in the legal system,
the inclination or disinclination of a defendant to settle, or the personal reactions of jurors. Property losses,
by contrast, are determinable and measurable as of their occurrence.
3. What are major benefits of purchasing coverage through a multiple line policy as opposed to purchasing
the same coverage separately?
Solution: A multiple line policy covers several risks at once, costs less to produce, and simplifies
recordkeeping. Multiple line policies take advantage of the tendency of consumers who are low-risk to be
low-risk in every respect.
4. What are the major classes of asset holdings on a property and liability insurance company balance
sheet? How do the asset holdings of property and liability insurance companies differ from the holdings of
life and health insurance companies?
Solution: P/L companies do not have a "savings" or "accumulation" portion of their premiums, so
they are usually smaller than LICs. They have higher federal tax exposure than LICs so they are likely to
invest heavily in preferred stock and municipal bonds. Needing more liquidity than LICs, P/L companies
usually hold more marketable issues (large issues). P/L insurance covers replacement value, so investing
in equities as a hedge against inflation is likely. Bonds, equities and government securities are the largest
asset categories.
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1. How are Social Security old-age benefits funded? Are these benefits based on social adequacy or
individual equity?
Solution: Social Security is funded “pay as you go”. The federal government collects the
payroll tax, pays the benefits, and spends the excess on other parts of its budget. Benefits are based on
social adequacy, not individual equity. The minimum benefit over-rewards low contributors and the
maximum benefit under-rewards top contributors. Participation is mandatory and participants have no
property rights in their contributions. The premise is social insurance—a large population of elderly poor
would be a social problem affecting all of us, irrespective of who individually deserves what.
2. What are the tax advantages of qualified private pension plans?
Solution: Participants defer income tax on all contributions, and returns compound tax-deferred.
Withdrawals are taxed in retirement, when most beneficiaries are in a lower tax bracket.
3. Explain the difference between contributory and noncontributory pension plans. Differentiate between
defined benefit and defined contribution pension plans.
Solution: “Noncontributory plans” are funded with employer contributions only. “Contributory
plans” receive both employer and employee contributions. “Fully contributory plans” are funded with
employee contributions only. “Defined benefit plans” are a traditional industrial-era arrangement under
which an employer promises benefits set by some formula based on years of service and average pay. The
employer is fully responsible for delivering the promised benefits. “Defined contribution plans” are the
modern arrangement. Contributions defined as some percentage of salary are paid in by the employee
and/or employer. The employee decides how the contributions are invested.
4. ERISA and subsequent Acts regulate several features of qualified private pensions. What is meant by
portability, vesting, and fiduciary standards?
Solution: ERISA prescribes the requirements for portability and vesting of employer-provided
pensions. Portability assures that when an employee leaves an employer before retirement, the employee
may defer tax payment on a lump-sum distribution of the pension fund by depositing the fund into a taxqualified retirement account. Vesting provisions assure that after the employee has been participating in the
pension plan for a certain number of years, the balance in the fund belongs to the employee, even if the
employee leaves the employment of the employer providing the plan. Fiduciary standards are associated
with placing pension funds with responsible professionals (fiduciaries), usually outside the company or
labor union to reduce the chance of self-dealing and theft.
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CHAPTER 20
1.
What type of investment company is more likely to sell at a price that diverges the most or the least
from its net asset value—a mutual fund with a load, a no-load fund, or a closed-end fund? Explain
why each type of fund might or might not sell at a price that diverges from its net asset value.
Solution: A closed end fund may have a price that diverges the most from its net asset value. Discounts
from net asset value may reach 25% or more and premia often exceed 10%. No-load fund prices diverge
the least from net asset value as they sell for their net asset value, while load funds can have a price
premium of as much as 8.5%.
2.
What are the pros and cons on investments in mutual funds that try to match a general market
index?
Solution: PROS:
 Index funds have low operating costs so investment returns are not reduced by high
administrative charges. Index funds do, on average, about as well as the market as a whole
so investors in such funds will generally do as well as the market as a whole. If markets
were truly efficient, one would find it difficult or impossible to beat the market as a whole.
In addition, one should expect to get an average return from taking average risk, and that
is what an index fund provides. Due to high administrative costs and possibly inferior
investment choices, most mutual funds with discretionary management have performed
less well than index funds.
CONS:
 Index funds, in general, will never do substantially better than the market index to which
they are tied. Index funds generate average risk-return tradeoffs yet individuals may prefer
to take more or less risk. If everyone invested in the same index fund, there would be no
one left to evaluate the relative merits of various securities, so blind buying of securities
in the index might cause their risk-adjusted prices to rise relative to securities that were not
included in the index. I.e., if no one analyzed the relative merits of securities contained in
the index relative to securities outside the index, the market would not be efficient and
mis-pricings could occur. Thus, index fund buyers might later find that they had paid too
much for stocks contained in the index if no one did any securities analysis.
3.
What are the various types of fees and charges that may be levied by different mutual funds?
Solution: Front-end “load” charges are levied as an extra sales charge when a fund is purchased. Back end
loads may take the form of contingent deferred sales charges assessed as percentage fees levied on the
amount of money withdrawn from a fund. Contingent deferred sales charges often diminish in percentage
terms the longer that the money has been invested in the fund prior to withdrawal. Other back end loads
may take the form of “redemption fees” that are expressed as either fixed amounts or as fixed percentages
of the amount withdrawn from the fund. Additional sales charges may take the form of 12b-1 fees that are
levied each year as a percentage of the assets managed by the fund in order to generate income so the fund
management company can pay for marketing expenses and pay salesmen. In addition, each fund will levy
advisory or management fees, usually expressed as a percentage of the assets under management, each
year. Finally, some funds may levy “account maintenance fees” on small balance accounts, or “exchange
fees,” when a fund balance is transferred from one fund to another managed by the same fund management
company.
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4.
Why is it essential that potential investors thoroughly read the prospectus for any mutual fund they
are considering as an investment?
Solution: The prospectus will detail all the fees that a fund may charge and illustrate the impact the fees
are likely to have on the fund’s net returns. In addition, the prospectus will define the securities in which
the fund is permitted to invest and will explain the risks associated with investments in the fund. The
prospectus may also give recent information on the actual securities held by the fund, and the fund’s
returns.
1.
Why would an investor want to invest in a hedge fund?
Solution: Hedge funds give investors the opportunity to add securities with higher potential returns to
their portfolios. Venture capital funds and hedge funds also allow investors to diversify their portfolios.
2.
How are hedge funds different from closed-end funds and mutual funds?
Solution: The advantages of venture capital to an entrepreneur include access to financing for growing the
company and assistance from the venture capitalists in managing the company. The disadvantages of
venture capital include the high rates of return that venture capitalists expect from their investments and
the fact that the venture capitalists often demand control of the company.
3.
Why do hedge fund managers follow such specialized strategies?
Solution: Identifying profitable investment opportunities is difficult. Hedge fund managers must
specialize in particular investment strategies in order to develop the expertise required to be successful.
1.
Explain the economic and regulatory climate that gave rise to MMMFs.
Solution: In the inflationary 1970's the Fed effectively used Reg. Q to prevent small deposit bank
customers from "market" priced rates of return. MMMF's provided small denomination, limited checkwriting, relative safety, and higher market rates of return compared to banks.
2.
What are the competitive advantages and disadvantages that money market mutual funds have
relative to depository institutions?
Solution: Money market mutual funds have low administrative costs and are not constrained by rate
ceilings so they can pay rates nearly equal to the rates they earn on their money market investments. Also,
they can be part of fund management companies and brokerage firms where they can automatically sweep
funds in and out and use the funds to pay for stock purchases or debit card usage. However, they generally
do not have deposit insurance, and they cannot pay rates higher than they earn on short-term money market
investment securities.
3.
In general, why do people often invest in specialized funds like REITs? Why have REITs become
more popular during the 1990s, and why do you think they operate like closed-end funds? What
problem were FREITs invented to solve?
Solution: In general, people buy specialized funds because they want to own assets similar to the assets in
which the fund invests. Investors in REITs want to own real estate related assets and earn returns from
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their real estate ownership. In the 1990’s, REITs have appealed to people because they have generated
relatively high yields and have not had high failure rates. Furthermore, they provide passive real estate
related income that may be advantageous to some people depending upon their tax situation. REITs
operate like closed end funds because they cannot quickly liquidate their assets at good prices in order to
generate cash. FREITs were established because, like closed end funds, REITs often sold for less than their
net asset value and this would no longer be possible when the FREITs assets were liquidated and
distributed as cash to the fund’s shareholders.
4.
How have money market funds tried to cope with the fact that they do not have federal deposit
insurance?
Solution: Money market mutual funds have variously restricted their asset holdings to risk free
government securities, tried to obtain private deposit insurance (which was too expensive), and, in the past,
were established by financial institutions that acquired non-bank banks so they could offer deposit
insurance on their deposits. In addition, fund management companies have typically made up any losses
incurred by the funds so they would not “break the buck” and therefore could retain investors’ confidence
that they would not lose money if they invested in the fund.
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