Name _____________________
Student ID _____________________
Final Exam
Economics 333
Money and Banking
December 18, 2008
The exam is scheduled for 3 hours from 8:30-11:30. Write all answers on this exam
paper. Do not hand in your blue books.
Multiple Choice (2 points each)
1. The price of a 1 year discount bond with a face value of 100 has a price of 90. We
also see the price of a 2 year discount bond is greater than 90. Assuming that
expectations theory of the term structure is true, we can say
a. The yield on 1 year bonds is greater than the yield on two year bonds and
the market expects the 1 year interest rate to be negative next year.
b. The yield on 1 year bonds is greater than the yield on two year bonds and
we need more information to tell if the market expects the 1 year interest
rate to be negative next year.
c. We need more information on whether the yield on 1 year bonds is greater
than the yield on two year bonds and the market expects the 1 year interest
rate to be negative next year.
d. We need more information on whether the yield on 1 year bonds is greater
than the yield on two year bonds and we need more information to tell if
the market expects the 1 year interest rate to be negative next year.
________________
2. The bond traders of the US Federal reserve may engage in an open market sale of
government bonds as
a. dynamic transactions to reduce the interest rate or defensive transactions
in response to an increase in the demand for reserves
b. dynamic transactions to reduce the interest rate or defensive transactions
in response to a decrease in the demand for reserves
c. dynamic transactions to increase the interest rate or defensive transactions
in response to an increase in the demand for reserves
d. dynamic transactions to increase the interest rate or defensive transactions
in response to a decrease in the demand for reserves
________________
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3. Purchasers of bonds become much more thrifty and decide to increase their
savings. At the same time, the government budget deficit increases. We can say,
a. The price of government bonds will clearly decrease while the change in
the quantity of bonds will be ambiguous.
b. The price of government bonds will clearly increase while the change in
the quantity of bonds will be ambiguous.
c. The quantity of government bonds will clearly decrease while the change
in the price of bonds will be ambiguous.
d. The quantity of government bonds will clearly increase while the change
in the price of bonds will be ambiguous.
________________
4. Which of the following is not a part of M2 in Hong Kong?
a. Time deposits at commercial banks with maturities greater than 1 year
b. Checking deposits at commercial banks
c. Exchange Fund Bills held by banks
d. Currency in Circulation
________________
5. The currency-to-deposit ratio will rise when
a. the fear of bank runs declines.
b. the expected return on deposits rises.
c. the anonymity premium declines.
d. the level of underground activity increases.
________________
6. Which of the following statements (choose one) is a true description of a
difference between the operation of the Hong Kong central bank and the operation
of the Federal Reserves:
a. A major asset of the Federal Reserve is US government bonds; a major
asset of the HKMA is Hong Kong government bonds.
b. A major liability of the Federal Reserve is US government bonds; a major
asset of the HKMA is Hong Kong government bonds.
c. A major asset of the Federal Reserve is US government bonds; a major
liability of the HKMA is Hong Kong government bonds.
d. A major liability of the Federal Reserve is US government bonds; a major
liability of the Hong HKMA is Hong Kong government bonds.
________________
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7. Which of the following is NOT a strategy for building an independent central
bank?
a. Long terms of office for central bank decision makers
b. Decision making by committee.
c. Monetary policy decisions not subject to review by Finance ministry.
d. Central bank keeps revenue from check clearing.
________________
8. Which of the following is NOT a way that monetary policy has changed in the
USA this year?
a. The Federal Reserve has begun purchasing mortgage backed securities.
b. The Federal Reserve has reduced the spread between the discount window
rate and the funds rate.
c. The Federal Reserve has increased the required reserve ratio for bank
holding companies.
d. The Federal Reserve has begun paying interest on reserves.
________________
9. Which of the following is not a way that competition in the Hong Kong banking
sector was limited in the past?
a. Mainland Chinese banks were not allowed to operate in Hong Kong
b. The deposit interested rate was regulated by a cartel.
c. Foreign bank branch networks were limited in size
d. There was a thirty year moratorium on issuing new banking licenses.
________________
10. Which of the following is NOT an example of adverse selection?
a. A family with a home ten feet from a large river buys flood insurance.
b. A company uses the proceeds of a new stock sale to build an unnecessarily
luxurious new headquarters.
c. A terminal cancer patient buys life insurance.
d. A company in serious financial trouble offers to pay you 30% on a loan.
________________
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Short Answer
11. (2 points) Name 4 parts of the monetary liabilities of the Hong Kong Monetary
Authority. Classify them as either currency (C) or reserves (R).
Monetary Liabilities
Classification
1
2
3
4
12. (3 points) The central bank observes that the price of gold has been rising rapidly.
The central bank decides that it would like to sell $100 worth of its reserves of
gold to a bank in the local banking system. However, the central bank does not
want to change the money supply but will instead sterilize the gold market
intervention with an open market operation that will keep the monetary base
constant. Use the following T-account of the Central Bank’s balance sheets to
describe the transactions. Include the gold market sale and the open market
operation in your T-account.
4
13. (5 points) A bank with no excess reserves faces a 10% reserve requirement. A
depositor withdraws some $100 cash from their checking account. The reserve
requirement implies that the bank must replenish its reserves. How much in
reserves does the bank need to acquire?
The bank believes the decline in deposits is temporary so the bank does not want
to call in any loans. Using T-accounts, describe two strategies for replacing these
reserves.
Strategy A
Strategy B
5
14. (3 points) You find that today, the yield to maturity on Exchange Fund discount
notes with a maturity of 5 years is 4% (it5 = .04) and the yield on Exchange Fund
discount bills with a maturity of 1 year is 2% (it1 = .02). Use the expectations
theory of the term structure to solve for the market’s expectation of the yield on 4
year bonds that will prevail next year.
15. (4 points) The price of a two year discount US$, Treasury bond with a face value
of 100 is 95. The price of a two year discount New Zealand dollar government
bond with a face value of 100 is 90. The current spot exchange rate is 1.72 NZ$
per US dollar. Assume that covered interest parity is true. What is the price of a
two year forward contract to sell New Zealand dollars in exchange for US
dollars?
16. (4 points) The price of a two year discount US$, Treasury bond with a face value
of 100 is 95. The price of an inflation protected security with a notional face value
of 100 has a price of 101. Assume that buyers of bonds pay no inflation risk
premium. Calculate a measure of the ex ante real interest rate and the expected
inflation rate over the next two years.
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17. (3 points) What is the price of a coupon bond that has annual coupon payments of $90, a
face value of $1000, a yield to maturity of 10%, and a maturity of two years?
18. (3 points) Currency outstanding equals $500 million, checkable deposits equal $2
billion, reserves equal $200 million, and the required reserve ratio is 0.075.
Calculate the M1 multiplier and excess reserves.
19. (3 points) A bond portfolio contains 3 discount bonds with face values of 100.
One has a maturity of the 1 year, another has a maturity of two years, and the
third has a maturity of three years. Each bond has a yield of 10%. Calculate the
present value of the portfolio and the duration of the portfolio.
7
20. (3 points) A historical database shows that the average growth rate of dividends is
5.1% per year. The average interest rate i is 5.8%. The average level of dividends
Dividendst
to prices
is 2.1%. Assuming an interest rate and dividend growth
Equity Pricest
rate at these levels, what is the average equity premium?
21. (2 points) You are an assistant of the finance minister of South Africa. Currently,
South African monetary policy is set in terms of an intermediate target that targets
a certain quantity of M2. Your minister advocates switching to an inflation target.
Describe two advantages of an inflation target.
A.
B.
22. (2 points) Because of past currency instability, many customers of a bank in
Indonesia would like to hold their deposits in US dollars. Name two strategies for
the bank to manage exchange rate risk.
A.
B.
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23. (3 points) Describe a CMO and a CDO.
24. (3 points) An important principle of managing credit risk is diversification. Name
two sound strategies for making profitable loans that might clash with
diversification? How might a bank overcome this clash?
A.
B.
25. (2 points) Describe the key restriction that the banking regulator puts on the
management of liquidity by banks in Hong Kong. Describe the key restriction that
the banking regulator puts on the management of capital by banks in Hong Kong.
a. Liquidity Requirement
b. Capitalization Requirement
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26. (7 points) Do a peer analysis of two banks, bank A and bank B using the
following balance sheets.
Balance Sheet
Bank A
Bank B
Cash
Government Bills
Gross Loans
Loan Loss Reserves
5
20
75
3
10
30
60
5
Debt to Other Banks
Savings Deposits
20
60
40
40
A. Compare the capitalization of Bank A and Bank B. Which bank has a safer equity
multiplier?
B. Compare the credit risk of the bank. Offer two measures along which Bank A has
greater credit risk
C. Compare the liquidity of the two banks. Offer one measure along which Bank A has
more liquidity risk and another measure along which Bank B has more liquidity risk.
10
27. (4 points) Attached are the consolidated balance sheets and profit and loss
accounts of a local bank, DBS (Hong Kong). Calculate the ROA, ROE and the
equity multiplier for this bank. Calculate the fraction of operating income that
comes from interest income.
2007
ROA
ROE
EM
Fraction of
Operating Income from Interest
28. (3 points) A duration analysis suggests that the duration of the banks liabilities is
dL = .5 and the duration of the banks assets is dA = 2.5. Suppose that interest rates
at the time the balance sheets were constructed were 2%. Now, they are 1%.
Calculate the change in net worth, ΔNW that would be caused by such a change
in interest rates. .
11
29. (4 points) There are two types of bonds which we might call creampuffs and
lemons. The fraction of the bonds that are lemons is p and the fraction of the
bonds that are creampuffs is (1-p). Investors would knowingly buy a lemon if the
price was 1000 or less and would buy a sure creampuff if the price was 2000 or
less. Sellers of lemon bonds are willing to sell them as long as they can get a price
of 500 while they would demand a price of 1600 for a creampuff. Assume that
bond buyers are bad bargainers, so bonds always sell at the maximum price that
buyers are willing to pay. Assume that sellers know the type of the bond they are
selling, but buyers only know the fraction p but are unable to distinguish lemons
from creampuffs beyond that. What is the maximum level of p at which adverse
selection would not destroy the market for creampuffs?
12
30. (4 points) An entrepreneur wants to borrow money at a 10% interest rate to start a
fashion business which has $10,000 in start-up costs. He has access to two
business plans. One is safe and will generate $12,000 with 100% probability. The
other is risky and will generate $5,000 or $15,000 each with equal probability.
The lender demands that the entrepreneur put up some collateral. The income of
the entrepreneur will be the negative of the amount of collateral, if they default on
the debt. What is the minimum amount of collateral the lender should demand to
induce the entrepreneur to undertake the safe plan?
13
31. (5 points) Both Korea and Hong Kong have faced a negative business cycle
demand shock. Korea operates a monetary policy that operates according to the
Taylor principle. Draw a graph that illustrates the different response of Korea and
Hong Kong to such a shock. Give a brief explanation of the differences.
π
Potential GDP
π
GDP
14
32. (4 points) The US Federal Reserve just announced a plan to increase purchases of
mortgage back securities. Demonstrate the impact of this on the US Fed Funds
rate with a graph of the market for reserves.
iFF
Reserves
33. (4 points) The US cuts its interest rate. Draw a picture of how this might affect the
Australian forex market and spot rate.
S
Forex
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