2013-11-07
Practice set and Solutions 1
Financial Markets and Institutions – Risk Management
What to do with this practice set?
Practice sets are handed out to help students master the material of the course and prepare for the final exam.
These sets contain worked-out problems in corporate finance. These sets are not graded, and there is no need to
hand-in the solutions. Students are strongly encouraged to solve them, discuss the solutions with other course
participants, and use the teacher's (e-mail) to discuss any problems they might encounter. Questions in the final
exam will/might/perhaps resemble some of the problems given here.
Chapter 1
1.
What are five risks common to financial institutions?
2.
Identify and explain the two functions FIs perform that would enable the smooth flow of funds
from household savers to corporate users.
3.
Explain how financial institutions act as delegated monitors. What secondary benefits often
accrue to the entire financial system because of this monitoring process?
4.
What are five general areas of FI specialness that are caused by providing various services to
sectors of the economy?
5.
What are agency costs? How do FIs solve the information and related agency costs when
household savers invest directly in securities issued by corporations?
6.
How do financial institutions help individual savers diversify their portfolio risks? Which type
of financial institution is best able to achieve this goal?
7.
What are two of the most important payment services provided by financial institutions? To
what extent do these services efficiently provide benefits to the economy?
8.
Why are FIs among the most regulated sectors in the world? When is net regulatory burden
positive?
Chapter 3
1.
What is the primary function of an insurance company? How does this function
compare with the primary function of a depository institution?
2.
What is the adverse selection problem? How does adverse selection affect the profitable
management of an insurance company?
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Chapter 4
1.
Explain how securities firms differ from investment banks. In what ways are they financial
intermediaries?
2. What are the key activity areas for securities firms? How does each activity area assist in the
generation of profits and what are the major risks for each area?
3.
What is the difference between an IPO and a secondary issue?
Chapter 5
1.
What is a mutual fund? In what sense is it a financial institution?
2.
What are money market mutual funds? In what assets do these funds typically invest? What
factors have caused the strong growth in this type of fund since the late 1970s?
3.
What are long-term mutual funds? In what assets do these funds usually invest? What factors
caused the strong growth in this type of fund from 1992 through 2007?
4.
What is a hedge fund and how is it different from a mutual fund?
5.
What are the different categories of hedge funds?
6.
What are the economic reasons for the existence of mutual funds; that is, what benefits
do mutual funds provide for investors? Why do individuals rather than corporations hold
most mutual funds?
Chapter 6
1.
What is the primary function of finance companies? How do finance companies differ from
commercial banks?
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Solutions
Chapter 1:
1) Default or credit risk of assets, interest rate risk caused by maturity mismatches between assets
and liabilities, liability withdrawal or liquidity risk, underwriting risk, and operating cost risks.
2)
Is serve as conduits between users and savers of funds by providing a brokerage function and
by engaging in an asset transformation function. The brokerage function can benefit both
savers and users of funds and can vary according to the firm. FIs may provide only transaction
services, such as discount brokerages, or they also may offer advisory services which help
reduce information costs, such as full-line firms like Merrill Lynch. The asset transformation
function is accomplished by issuing their own securities, such as deposits and insurance
policies that are more attractive to household savers, and using the proceeds to purchase the
primary securities of corporations. Thus, FIs take on the costs associated with the purchase of
securities.
3) By putting excess funds into financial institutions, individual investors give to the FIs the
responsibility of deciding who should receive the money and of ensuring that the money is
utilized properly by the borrower. In this sense, depositors have delegated the FI to act as a
monitor on their behalf. Further, the FI can collect information more efficiently than
individual investors. The FI can utilize this information to create new products, such as
commercial loans, that continually update the information pool. This more frequent
monitoring process sends important informational signals to other participants in the market, a
process that reduces information imperfection and asymmetry between the ultimate providers
and users of funds in the economy.
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4) First, FIs collect and process information more efficiently than individual savers. Second, FIs
provide secondary claims to household savers which often have better liquidity characteristics
than primary securities such as equities and bonds. Third, by diversifying the asset base FIs
provide secondary securities with lower price-risk conditions than primary securities. Fourth,
FIs provide economies of scale in transaction costs because assets are purchased in larger
amounts. Finally, FIs provide maturity intermediation to the economy which allows the
introduction of additional types of investment contracts, such as mortgage loans, that are
financed with short-term deposits.
5) Agency costs occur when owners or managers take actions that are not in the best interests of
the equity investor or lender. These costs typically result from the failure to adequately
monitor the activities of the borrower. If no other lender performs these tasks, the lender is
subject to agency costs as the firm may not satisfy the covenants in the lending agreement.
Because the FI invests the funds of many small savers, the FI has a greater incentive to collect
information and monitor the activities of the borrower.
6) Money placed in any financial institution will result in a claim on a more diversified portfolio.
Banks lend money to many different types of corporate, consumer, and government
customers. Insurance companies have investments in many different types of assets.
Investments in a mutual fund may generate the greatest diversification benefit because of the
fund’s investment in a wide array of stocks and fixed income securities.
7) …
8)
I
FIs are required to enhance the efficient operation of the economy. Successful financial
institutions provide sources of financing that fund economic growth opportunities that
ultimately raise the overall level of economic activity. Moreover, successful financial
institutions provide transaction services to the economy that facilitate trade and wealth
accumulation.
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Conversely, distressed FIs create negative externalities for the entire economy. That is, the
adverse impact of an FI failure is greater than just the loss to shareholders and other private
claimants on the FI's assets. For example, the local market suffers if an FI fails and other FIs
also may be thrown into financial distress by a contagion effect. Therefore, since some of the
costs of the failure of an FI are generally borne by society at large, the government intervenes
in the management of these institutions to protect society's interests. This intervention takes
the form of regulation.
However, the need for regulation to minimize social costs may impose private costs to the FIs
that would not exist without regulation. This additional private cost is defined as a net
regulatory burden. Examples include the cost of holding excess capital and/or excess reserves
and the extra costs of providing information. Although they may be socially beneficial, these
costs add to private operating costs. To the extent that these additional costs help to avoid
negative externalities and to ensure the smooth and efficient operation of the economy, the net
regulatory burden is positive.
Chapter 3:
1) The primary function of an insurance company is to provide protection from adverse events.
Insurance companies accept premium payments in exchange for compensation in the event
that certain specified, but undesirable, events occur.
The primary function of depository institutions is to provide financial intermediation for
individual and corporate savers. By accepting deposits and making loans, depository
institutions allow savers with predominantly small, short-term financial assets to benefit from
investments in larger, longer-term assets. These long-term assets typically yield a higher rate
of return than short-term assets.
2) The adverse selection problem occurs because customers who are most in need of insurance
are most likely to acquire insurance. However, the premium structure for various types of
insurance typically is based on an average population proportionately representing all
categories of risk. Thus, the existence of a proportionately larger share of high-risk customers
may cause the premium revenue received by the insurance provider to underestimate the
revenue needed to cover the insured liabilities and to provide a reasonable profit for the
insurance company.
Chapter 4:
1) Securities firms specialize primarily in the purchase, sale, and brokerage of securities, while
investment banks primarily engage in originating, underwriting, and distributing issues of
securities. In more recent years, investment banks have undertaken increased corporate
finance activities such as advising on mergers, acquisitions, and corporate restructuring. In
both cases, these firms act as financial intermediaries in that they bring together economic
units who need money with those units who wish to invest money.
Both segments have undergone substantial structural changes in recent years. Some of the
most recent consolidations include the acquisition of Bears Stearns by J.P. Morgan Chase, the
bankruptcy of Lehman Brothers and the acquisition of Merrill Lynch by Bank of America.
Indeed, as discussed later in the chapter, the investment banking industry has seen the failure
or acquisition of all but two of its major firms (Goldman Sachs and Morgan Stanley) and these
two firms converted to commercial bank holding companies in 2008.
2) The seven major activity areas of security firms are:
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a) Investing: Securities firms act as agents for individuals with funds to invest by
establishing and managing mutual funds and by managing pension funds. The
securities firms generate fees that affect directly the revenue stream of the
companies.
b) Investment Banking: Investment banks specialize in underwriting and distributing
both debt and equity issues in the corporate market. New issues can be placed either
privately or publicly and can represent either a first issued (IPO) or a secondary
issue. Secondary issues of seasoned firms typically will generate lower fees than an
IPO. In a private offering the investment bank receives a fee for acting as the agent
in the transaction. In best-efforts public offerings, the firm acts as the agent and
receives a fee based on the success of the offering. The firm serves as a principal by
actually takes ownership of the securities in a firm commitment underwriting. Thus,
the risk of loss is higher. Finally, the firm may perform similar functions in the
government markets and the asset-backed derivative markets. In all cases, the
investment bank receives fees related to the difficulty and risk in placing the issue.
c) Market Making: Security firms assist in the market-making function by acting as
brokers to assist customers in the purchase or sale of an asset. In this capacity the
firms are providing agency transactions for a fee. Security firms also take inventory
positions in assets in an effort to profit on the price movements of the securities.
These principal positions can be profitable if prices increase, but they can also create
downside risk in volatile markets.
d) Trading: Trading activities can be conducted on behalf of a customer or the firm.
The activities usually involve position trading, pure arbitrage, risk arbitrage, and
program trading. Position trading involves the purchase of large blocks of stock to
facilitate the smooth functioning of the market. Pure arbitrage involves the purchase
and simultaneous sale of an asset in different markets because of different prices in
the two markets. Risk arbitrage involves establishing positions prior to some
anticipated information release or event. Program trading involves positioning with
the aid of computers and futures contracts to benefit from small market movements.
In each case, the potential risk involves the movements of the asset prices, and the
benefits are aided by the lack of most transaction costs and the immediate
information that is available to investment banks.
e) Cash Management: Cash management accounts are checking accounts that earn
interest and may be covered by FDIC insurance. The accounts have been beneficial
in providing full-service financial products to customers, especially at the retail
level.
f) Mergers and Acquisitions: Most investment banks provide advice to corporate
clients who are involved in mergers and acquisitions. This activity has been
extremely beneficial from a fee standpoint during the 1990s and 2000s.
g) Back-Office and Other Service Functions: Security firms offer clearing and
settlement services, research and information services, and other brokerage services
on a fee basis.
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3)
An IPO is the first time issue of a company’s securities, whereas a secondary
offering is a new issue of a security that is already offered.
Chapter 5:
1) A mutual fund represents a pool of financial resources obtained from individuals and
companies, which is invested in the money and capital markets. This process represents
another method for economic savers to channel funds to companies and government units that
need extra funds.
2) Money market mutual funds (MMMFs) invest in assets that have maturities of less than one
year. These assets primarily are Treasury bills, negotiable certificates of deposit, repurchase
agreements, and commercial paper. The growth in MMMFs since the late 1970s initially
occurred because of rising interest rates in the money markets, while Regulation Q restricted
interest rates on accounts in depository institutions. Many investors moved their short-term
savings from the depository institutions to the MMMFs as the spread in the earnings rate
reached double digits. A result of this activity was to introduce many investors to the capital
markets for the first time.
At the end of 2008, the share of long-term funds plunged to 59.1 percent of all funds, while
money market funds increased to 40.9 percent. Part of the move to money market funds was
the fact that during the worst of the financial crisis, the U.S. Treasury extended government
insurance to all money market mutual fund accounts on a temporary basis. As financial
markets tumbled in 2008, money market mutual funds moved investments out of corporate
and foreign bonds (12.4 percent of the total in 2007 and 5.0 percent in 2009) into safer
securities such as U.S. government securities (13.6 percent of the total investments in 2007
and 31.6 percent in 2009).
3) Long-term mutual funds primarily invest in assets that have maturities of more than one year.
The most common assets include long-term fixed-income bonds, common stock, and preferred
stocks. Some money market assets are included for liquidity purposes. The growth in these
funds in the 1990s and 2000s reflected the dramatic increase in equity returns, the reduction in
transaction costs, and the recognition of diversification benefits achievable through mutual
funds.
The financial crisis and the collapse in stock and other security prices produced a sharp drop
in mutual fund activity. At the end of 2008, total assets fell to $9,601.1 billion and the number
of accounts to 264,499. Investor demand for certain types of mutual funds plummeted, driven
in large part by deteriorating financial market conditions. Stock market funds suffered
substantial outflows, while inflow to U.S. government money market funds reached record
highs. As the economy recovered in 2009, so did assets invested in mutual funds, growing to
$11,126.4 billion by the end of the year.
4) Hedge funds are a type of investment pool in that they solicit funds from (wealthy) individuals
and other investors (e.g., commercial banks) and invest these funds on their behalf. Hedge
funds are similar to mutual funds in that they both are pooled investment vehicles that accept
investors’ money and generally invest these funds on a collective basis. Hedge funds,
however, are not technically mutual funds in that they are not required to register with the
SEC. Thus, they are subject to virtually no regulator oversight and generally take significant
risk. Hedge funds are also not subject to the numerous regulations that apply to mutual funds
for the protection of individuals such as regulations requiring a certain degree of liquidity,
regulations requiring that mutual fund shares be redeemable at any time, regulations protecting
against conflicts of interest, regulations to assure fairness in the pricing of funds shares,
disclosure regulations, and regulations limiting the use of leverage. Further, hedge funds do
not have to disclose their activities to third parties. Thus, offer a high degree of privacy for
their investors. Hedge funds offered in the U.S. avoid regulations by limiting the number of
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investors to less than 100 individuals (below that required for SEC registration), who must be
deemed “accredited investors.” To be accredited, an investor must have a net worth of over $1
million or have an annual income of at least $200,000 ($300,000 if married). These stiff
financial requirements allow hedge funds to avoid regulation under the theory that individuals
with such wealth should be able to evaluate the risk and return on their investments.
According to the SEC, these types of investors should be expected to make more informed
decisions and take on higher levels of risk.
5) Most hedge funds are highly specialized, relying on the specific expertise of the fund
manager(s) to produce a profit. Hedge fund managers follow a variety of investment
strategies, some of which use leverage and derivatives, others use more conservative
strategies and involve little or no leverage. Generally, hedge funds are set up with
specific parameters so investors can forecast a risk-return profile. Figure 5-4 shows the
general categories of hedge funds by risk classification.
“More risk” funds are the most aggressive and may produce profits in many types of
market environments. Funds in this group are classified by objectives such as:
aggressive growth, emerging markets, macro, market timing, and short selling.
Aggressive growth funds invest in equities expected to experience acceleration in
growth of earnings per share. Generally, high price-to-earnings ratios, low or no
dividend companies are included. These funds hedge by shorting equities where
earnings disappointment is expected or by shorting stock indexes. Emerging market
funds invest in equity or debt securities of emerging markets which tend to have
higher inflation and volatile growth. Macro funds aim to profit form changes in global
economies, typically brought about by shifts in government policy which impact
interest rates. These funds include investments in equities, bonds, currencies and
commodities. They use leverage and derivatives to accentuate the impact of market
moves. Market timing funds allocate asset among different asset classes depending on
the manager’s view of the economic or market outlook. Thus, portfolio emphasis may
swing widely between assets classes. Unpredictability of market movements and the
difficulty of timing entry and exit from markets adds significant risk to this strategy.
Short selling funds sell securities in anticipation of being able to buy them back in the
future at a lower price based on the manager’s assessment of the overvaluation of the
securities or in anticipation of earnings disappointments.
“Moderate risk” funds are more traditional funds, similar to mutual funds, with
only a portion of the portfolio being hedged. Funds in this group are classified
by objectives such as: distressed securities, fund of funds, opportunistic, multi
strategy, and special situations. Distressed securities funds buy equity, debt or
trade claims at deep discounts of companies in or facing bankruptcy or
reorganization. Profits opportunities come from the market’s lack of
understanding of the true value of these deep discount securities and from the
fact that the majority of institutional investor cannot own below investment
grade securities. Fund of funds mix hedge funds and other pooled investment
vehicles. This blending of different strategies and asset classes aims to provide a
more stable long term investment return than any of the individual funds.
Returns and risk can be controlled by the mix of underlying strategies and funds.
Capital preservation is generally an important consideration for these funds.
Opportunistic funds change their investment strategy as opportunities arise to
profit form events such as IPOs, sudden price changes resulting from a
disappointing earnings announcement, and hostile takeover bids. These funds
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may utilize several investing styles at any point in time. and are not restricted to
any particular investment approach or asset class. Multi strategy funds take a
diversified investment approach by implementing various strategies
simultaneously to realize short and long term gains. This style of investment
allows the manager to overweight or underweight different strategies to best
capitalize on current investment opportunities. Special situation funds invest in
event driven situations such as mergers, hostile takeovers, reoganizations, or
leveraged buyouts. These funds may undertake simultaneous purchases of stock
in companies being acquired, and the sale of stock in its bidder, hoping to profit
from the spread between the current market price an the final purchase price of
the company.
“Moderate risk” funds are more traditional funds, similar to mutual funds, with
only a portion of the portfolio being hedged. Funds in this group are classified
by objectives such as: income, market neutral – arbitrage, market neutral securities hedging, and value. Income funds invest with the primary focus on
yield or current income rather than solely on capital gains. These funds use
leverage to buy bonds and some fixed income derivatives, profiting from
principal appreciation and interest income. Market neutral – arbitrage funds
attempt to hedge market risk by taking offsetting positions, often in different
securities of the same issuer, e.g., long convertible bonds and short the firm’s
equity. Their focus is on obtaining returns with low or no correlation to both the
equity and bond markets. Market neutral - securities hedging funds invest
equally in long and short equity portfolios in particular market sectors. Market
risk is reduced but effective stock analysis is critical to obtaining a profit. These
funds use leverage to magnify their returns. They also sometimes use market
index futures to hedge systematic risk. Value funds invest in securities perceived
to be selling at deep discounts relative to their intrinsic values. Securities include
those that may be out of favor or underfollowed by analysts.
6) One major economic reason for the existence of mutual funds is the ability to
achieve diversification through risk pooling for small investors. By pooling
investments from a large number of small investors, fund managers are able to
hold well-diversified portfolios of assets. In addition, managers can obtain lower
transaction costs because of the volume of transactions, both in dollars and
numbers, and they benefit from research, information, and monitoring activities
at reduced costs.
Many small investors are able to gain benefits of the money and capital markets
by using mutual funds. Once an account is opened in a fund, a small amount of
money can be invested on a periodic basis. In many cases, the amount of the
investment would be insufficient for direct access to the money and capital
markets. On the other hand, corporations are more likely to be able to diversify
by holding a large bundle of individual securities and assets, and money and
capital markets are easily accessible by direct investment. Further, an argument
can be made that the goal of corporations should be to maximize shareholder
wealth, not to be diversified.
Chapter 6:
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1) The primary function of finance companies is to make loans to individuals and corporations.
Finance companies do not accept deposits, but borrow short- and long-term debt, such as
commercial paper and bonds, to finance the loans. The heavy reliance on borrowed money has
caused finance companies to generally hold more equity than commercial banks for the
purpose of signaling solvency to potential creditors. Finally, finance companies are less
regulated than commercial banks, in part because they do not rely on deposits as a source of
funds.
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