Money, Banking, and Financial Markets (Econ 353)
Midterm Examination III
July 25, 2005
Name__________________________________ Univ. Id #______________________
Note: Each multiple-choice question is worth 4 points. Problems 21, 22, carry 10 points
each.
1) Regular bank examinations and restrictions on asset holdings help to indirectly reduce
the _____ problem because, given fewer opportunities to take on risk, risk-prone
entrepreneurs will be discouraged from entering the banking industry.
A) moral hazard
B) post-contractual opportunism.
C) ex post shirking
D) adverse selection
2) Advocates of Fed independence fear that subjecting the Fed to direct presidential or
congressional control would
A) impart an inflationary bias to monetary policy.
B) force monetary authorities to sacrifice the long-run objective of price stability.
C) make the so-called political business cycle less pronounced.
D) both A and B of the above.
3) The theory of bureaucratic behavior when applied to the Fed helps to explain why the
Fed
A) resists so vigorously congressional attempts to limit the central bank's autonomy.
B) is so secretive about the conduct of future monetary policy.
C) sought less control over banks in the 1980s.
D) all of the above.
E) only A and B of the above.
4) The rapid growth of the commercial paper market since 1970 is due to
A) government regulation.
B) the fact that commercial paper has no default risk.
C) improved information technology making it easier to screen credit risks.
D) FDIC insurance for commercial paper.
E) all of the above.
5) When compared to banks with _____ net worth, banks with _____ net worth have
fewer incentives to engage in activities that ensure profitability.
A) high; low
B) low; high
C) low; low
D) high; high
6) In figure above, with a expiration price of 120, the best return is obtained by
A) selling futures.
B) buying a put option.
C) buying futures.
D) buying a call option.
E) none of the above.
7) Hedging risk for a long position is accomplished by
A) taking another long position.
B) taking additional long and short positions in equal amounts.
C) taking a short position.
D) taking a neutral position.
E) none of the above.
8) When you deposit $50 in currency at Old National Bank,
A) its liabilities increase by $50.
B) its assets increase by less than $50 because of reserve requirements.
C) its reserves increase by less than $50 because of reserve requirements.
D) only A and B of the above occur.
9) One way of describing the solution that high net worth provides to the moral hazard
problem is to say that it
A) collateralizes the debt contract.
B) state verifies the debt contract.
C) makes the debt contract incentive compatible.
D) does none of the above.
10) Although the Federal Open Market Committee does not have formal authority to set
_____ and the _____, it does possess the authority in practice.
A) margin requirements; discount rate
B) reserve requirements; discount rate
C) margin requirements; federal funds rate
D) reserve requirements; federal funds rate
11) A bank failure is less likely to occur when
A) a bank suffers large deposit outflows.
B) a bank holds less U.S. government securities.
C) a bank holds more excess reserves.
D) a bank has more bank capital.
12) A contract that requires the investor to sell securities on a future date is called a
A) micro hedge.
B) short contract.
C) long contract.
D) hedge.
13) Because of the adverse selection problem,
A) lenders may make a disproportionate amount of loans to bad credit risks.
B) lenders are reluctant to make loans that are not secured by collateral.
C) lenders may refuse loans to individuals with low net worth.
D) all of the above.
14) The advantage of futures contracts relative to forward contracts is that futures
contracts
A) are standardized, making it easier to match parties, thereby increasing liquidity.
B) specify that more than one bond is eligible for delivery, making it harder for someone
to corner the market and squeeze traders.
C) cannot be traded prior to the delivery date, thereby increasing market liquidity.
D) all of the above.
E) both A and B of the above.
15) Most major financial crises in the United States have begun with
A) a sharp decline in interest rates.
B) a sharp decline in bond values.
C) a sharp stock market decline.
D) all of the above.
16) The main motive behind the forces that have shaped the development of the current
regulatory system has been the
A) desire to foster a highly competitive banking system.
B) desire to create an interstate banking system.
C) desire to ensure a sound banking system.
D) desire to prevent monopolistic practices.
17) If Second National Bank has more rate-sensitive liabilities then rate-sensitive assets,
it can reduce interest rate risk with a swap that requires Second National to
A) both receive and pay fixed rate.
B) both receive and pay floating rate.
C) pay fixed rate while receiving floating rate.
D) receive fixed rate while paying floating rate.
18) Social Security is a
A) federally insured private pension plan.
B) government sponsored private pension plan.
C) fully funded pension plan.
D) "pay-as-you-go" system.
19) If a bank has $10 million of deposits, a required reserve ratio of 10 percent, and it
holds $2 million in reserves, then it will not have enough reserves to support a deposit
outflow of
A) $1.1 million.
B) $1 million.
C) $1.2 million.
D) either A or B of the above.
20) (Bonus Question) One of the crucial assumptions of the Herd Behavior Model is:
A) signals coming from observing other individuals’ behavior always precedes the
reception of own signal
B) own signal and signals coming from observing other individuals’ behavior is of the
same quality
C) the quality of own signal is always higher than the quality of signals coming from
observing other individuals’ behavior
D) signals coming from observing other individuals’ behavior and the own signal are
always received at the same time
21. Suppose that two types of firms, H-type and L-type, are issuing new stocks. You
know that the stock of L-type firms is worth $50/stock whereas those of H-type firms are
worth $120/stock. You have to invest your money in buying stocks. Unfortunately, you
have no way to find out which one is L-type or H-type. However, you know that, overall,
the proportion of L-type firms is 10% whereas that of H-type firms is 90%.
a. (5 points) If both firms were selling their stocks in the market, what price you
would be willing to pay for each share without knowing the quality of the firm?
Now, if we know that the H-type firms would be willing to issue the stock for any
price equal or above $100, which firms will be selling their stocks and at what
price? (Show your work)
b. (5 points) Now suppose that the proportions change to 90% of L-type firms and
10% of H-type firms. Which firms would be selling their stocks now and at what
price? (Again, we assume that H-type firms require at least $100 for their stock)
(Show your work)
22. Here are the summary balance sheets of two banks A and B. The required reserve
ratio is 10%.
A
Assets
Liabilities
Reserves: $10 m
Deposits: $95m
Loans: $90m
Bank’s Capital: $5m
B
Assets
Treasury Bills $5 m
Reserves: $15 m
Loans: $90m
Liabilities
Discount Loans $10m
Deposits: $98m
Bank’s Capital: $2m
a. (5 points) Suppose both banks have similar loans in regard to their expected
returns and default risk. If, for each bank, $4 m loans become non-performing and
the borrowers default, the banks will have to write them off. The depositors at
which bank are facing high risk that the bank itself will default? Why? (Show
your work using the T-accounts)
b. (5 points) Suppose there is no default problem and both banks have equal net
profits of $1 m from interest on their loans. Calculate ROE, ROA and EM for
both banks and thoroughly EXPLAIN THE DIFFERENCES. (Show your work)
ANSWER KEY
1) D
2) E
3) E
4) C
5) A
6) C
7) C
8) A
9) C
10) B
11) D
12) B
13) D
14) E
15) C
16) C
17) C
18) D
19) C
20) B
21. Suppose that two types of firms, H-type and L-type, are issuing new stocks. You
know that the stock of L-type firms is worth $50/stock whereas those of H-type firms are
worth $120/stock. You have to invest your money in buying stocks. Unfortunately, you
have no way to find out which one is L-type or H-type. However, you know that, overall,
the proportion of L-type firms is 10% whereas that of H-type firms is 90%.
c. (5 points) If both firms were selling their stocks in the market, what price you
would be willing to pay for each share without knowing the quality of the firm?
Now, if we know that the H-type firms would be willing to issue the stock for any
price equal or above $100, which firms will be selling their stocks and at what
price? (Show your work)
d. (5 points) Now suppose that the proportions change to 90% of L-type firms and
10% of H-type firms. Which firms would be selling their stocks now and at what
price? (Again, we assume that H-type firms require at least $100 for their stock)
(Show your work)
Answer: a. With no knowledge about the quality of a firm an investor will be willing to pay
the expected price, i.e.
E(P) = Probability that it is a high quality stock * dollar value of high quality stock +
Probability that it is a low quality stock * dollar value of low quality stock, or
E(P) = 0.1*$50+0.9*$120 = $113
Hence, an investor will be willing to pay $113/share. Since this is higher than the $100
required by H-type firms, all firms will sell their shares and the price will be $113.
b) When the proportions are reversed the expected price will be:
E(P) = 0.9*$50+0.1*$120 = $57
When high quality firms don’t sell their stock at $57, investors know that only low quality
stocks are being sold in the market. Then the expected price of a share will be equal to the
dollar value of a low quality stock with probability one, i.e., equal to $50. Thus because of
the adverse selection problem only low quality stocks will be sold at a price of $50.
22. Here are the summary balance sheets of two banks A and B. The required reserve
ratio is 10%.
A
Assets
Liabilities
Reserves: $10 m
Deposits: $95m
Loans: $90m
Bank’s Capital: $5m
B
Assets
Treasury Bills $5 m
Reserves: $15 m
Loans: $90m
Liabilities
Discount Loans $10m
Deposits: $98m
Bank’s Capital: $2m
c. (5 points) Suppose both banks have similar loans in regard to their expected returns
and default risk. If, for each bank, $4 m loans become non-performing and the
borrowers default, the banks will have to write them off. The depositors at which
bank are facing high risk that the bank itself will default? Why? (Show your work
using the T-accounts)
d. (5 points) Suppose there is no default problem and both banks have equal net profits
of $1 m from interest on their loans. Calculate ROE, ROA and EM for both banks and
thoroughly EXPLAIN THE DIFFERENCES. (Show your work)
Answer: a. When the banks write off $4 m of loans that default, their new balance sheets
will be
A
Assets
Liabilities
Reserves: $10 m
Deposits: $95m
Loans: $86m
Bank’s Capital: $1m
B
Assets
Liabilities
Treasury Bills $5 m
Discount Loans $10m
Reserves: $15 m
Deposits: $98m
Loans: $86m
Bank’s Capital: -$2m
We can see that bank B has negative net worth (-$2m), is insolvent and will be liquidated by
Fed.
b. Bank A:
ROE (A) = net profit/total equity = 1/5 = 0.2 = 20%
ROA (A) = net profit/total assets = 1/100 = 0.01 = 1%
EM (A) = total assets / total equity = 100/5 = 20
Bank B:
ROE (B) = net profit/total equity = 1/2 = 0.5 = 50%
ROA (B) = net profit/total assets = 1/110 = 0.009 = 0.9%
EM (B) = total assets / total equity = 110/2 = 55
From the financial analysis of ROE, ROA and EM we see that the bank B has not just
larger assets but also significantly larger leverage (smaller capital). As a result, bank B
has lower return on assets (for the same profit of $1m) but has higher return on equity
(and also higher risk).