Money, Banking, and Financial Markets (Econ 353): Section 1
Midterm Examination III
April 12, 2005
Name_______________________________________ Univ. Id #______________________
Note: Each multiple-choice question is worth 4 points. Problems 19, 20, and 21 carry 11, 10,
and 11 points, respectively.
1) Which of the following will tend to cause domestic currency to appreciate?
A) an increase in foreign interest rates.
B) a decrease in the expected future exchange rate
C) an increase in the domestic interest rate.
D) an equal change in domestic and foreign interest rates.
2) A borrower engages in activities that are undesirable from a lender's point of view. This is the
A) transaction costs problem.
B) moral hazard problem.
C) liquidity problem.
D) adverse selection problem.
3) The free-rider problem:
A) will make more people willing to provide information services.
B) makes it easier for an investor to continue to buy securities at less than the true value.
C) will only occur if information costs are zero.
D) is that people who do not pay for information take advantage of information
other people have paid for.
4) High net worth helps to diminish the problem of moral hazard problem by
A) requiring the state to verify the debt contract.
B) collateralizing the debt contract.
C) making the debt contract incentive compatible.
D) giving the debt contract characteristics of equity contracts.
5) Collateral is
A) a prevalent feature of debt contracts for households.
B) a prevalent feature of debt contracts for business.
C) is property that is pledged to the lender if a borrower cannot make his or her debt
payments.
D) all of the above.
6) The concept of adverse selection helps to explain
A) which firms are more likely to obtain funds from banks and other financial
intermediaries, rather than from the securities markets.
B) why indirect finance is more important than direct finance as a source of business
finance.
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C) why direct finance is more important than indirect finance as a source of business
finance.
D) both (a) and (b) of the above.
7) One way for bank regulators to assure depositors that banks are not taking on too much risk
is to require that banks
A) diversify its loan portfolio.
B) reduce its equity capital.
C) reduce the size of its loan portfolio.
D) do both (a) and (b) of the above.
8) The main motive behind the forces that have shaped the development of the current
regulatory system has been the
A) desire to prevent monopolistic practices.
B) desire to ensure a sound banking system.
C) desire to create an interstate banking system.
D) desire to foster a highly competitive banking system.
9)
The principal-agent problem
A) occurs when managers have more incentive to maximize profits than the stockholdersowners do.
B) would not arise if the owners of the firm had complete information about the
activities of the managers.
C) in financial markets helps to explain why equity is a relatively important source of
finance for American business.
D) all of the above.
10) Short-term security holdings by banks are often referred to as:
A) excess reserves
B) total reserves
C) secondary reserves
D) required reserves
11) The ________ number of banks in the United States indicates that past regulation of
banking fostered ________ competition among banks.
A) small; weak
B) large; strong
C) large; weak
D) small; strong
12) A danger of the too-big-to-fail policy practiced by the FDIC during the 1980s was that it
created incentives for ________ banks to take ________ risks, increasing their likelihood of
failure.
A) large; more
B) small; fewer
C) large; fewer
D) small; more
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13) The banking crisis of the 1980's
A) Was worsened by the elimination of interest rate ceilings, which increased the
cost of funds.
B) Was worsened by the decrease in the amount of federal deposit insurance available to
depositors.
C) Was worsened by the implementing of tighter regulations regarding asset holdings.
D) Was worsened by the ceilings on interest rates which banks and S&L's could pay
customers.
14) Financial intermediaries, particularly banks,
A) are experts in the production of information about firms so that it can sort good risks
from bad ones.
B) overcome the free-rider problem by primarily making private loans, rather than
purchasing securities that are traded in the open market.
C) play a greater role in moving funds to corporations than do securities markets.
D) all of the above.
15) Which of the following statements are true?
A) A bank's assets are its sources of funds.
B) A bank's liabilities are its uses of funds.
C) A bank's balance sheet shows that total assets equals total liabilities plus equity
capital.
D) Each of the above.
16) Banks can protect themselves from the disruption of deposit outflows by
A) holding excess reserves.
B) selling securities.
C) "calling in" loans.
D) doing all of the above.
17) In 1987, Far West Savings & Loan Association, with a negative net worth of $290 million,
persuaded the Federal Home Loan Bank of Seattle to lend the thrift more than $1 billion.
This regulatory response to insolvency is an example of
A) loophole mining.
B) regulatory forbearance.
C) securitization.
D) none of the above.
18) Bonus Question: “Putting things in order” presents some commonly held views on the
Chinese currency exchange rate that include
A) It has been pegged to the dollar for a decade, and there is a widespread belief that it is
unfairly cheap
B) By fixing the yuan to the dollar, China has been forced to hold interest rates lower than
is prudent, leading to inefficient investment and excessive bank lending.
C) A commonly heard argument is that China cannot let its exchange rate move more
freely before it has fixed its dodgy banking system
D) All of the above
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19. 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 $10/share whereas those of H-type firms are worth $ 60/share.
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 40% whereas that of H-type firms is 60%.
a. (6 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? (Show your work)
b. (5 points) Suppose now that H-type firms are not willing to sell at a price lower than
$60/share. Which firms would be selling their stocks now and at what price? (Show your
work)
Answer: a. With no knowledge about the quality of a firm an investor will be willing to pay the
expected price, i.e E(P) = Probability that it is a high quality stock * dollar value of high quality
stock + Probability that it is a low quality stock * dollar value of low quality stock, or
E(P) = 0.6*60+0.4*10 = 40$
Hence, an investor will be willing to pay $40/share.
b. When high quality firms don’t sell their stock at $40, 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 $10. Thus because of the adverse selection
problem only low quality stocks will be sold at a price of $10.
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20. Here are the summary balance sheets of two banks A and B.
A
Assets
Liabilities
Reserves: $10 m
Deposits: $105m
Loans: $100m
Bank’s Capital: $5m
B
Assets
Reserves: $10 m
Loans: $100m
Liabilities
Deposits: $102m
Bank’s Capital: $8m
a. (5 points) Suppose both banks have similar loans in regard to their expected returns and
default risk. If, for each bank, $5 m loans become non-performing i.e., and the borrowers
default, the banks will have to write them off. Which bank is in trouble now? Why?
(Show your work)
b. (5 points) Suppose there is no default problem and both banks have equal net profits of $
2m from interest on their loans. Which bank’s shareholders are happier? Why? (Show
your work)
c.
Answer: a. When the banks write off $5 m of loans that default, their new balance sheets will be
A
Assets
Reserves: $10 m
Loans: $95m
Liabilities
Deposits: $105m
Bank’s Capital: $0m
B
Assets
Reserves: $10 m
Loans: $95m
Liabilities
Deposits: $102m
Bank’s Capital: $3m
We can see that Low Capital bank has a zero net worth ($0m). If the loss was any more than $5m,
say $6m, the bank would have a negative net worth, (-$1m, if the loss was $6m). Although bank is
not yet insolvent, in case of any more loan default it is likely to become insolvent or bankrupt. Thus,
Low Capital bank is in trouble.
b. In the no-default situation, the return on capital for High Capital is
Return on capital (A) = net profit/equity capital = 2/5 = 0.4 = 40%
On the other hand, for Low Capital bank
Return on capital (B) = net profit/equity capital = 2/8 = 0.25 = 25%
Shareholders of Low Capital bank are better off compared with High Capital bank’s shareholders.
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21.
The dollar euro exchange rate on March 15th 2004 was at 0.9 euro/$. On
th
March 15 2005 the rate had changed to 0.8 euro/$. By how much did the dollar appreciate or
depreciate against the euro?
B) (5 points) Now assume that the markets were expecting this change in exchange rate on
March 15th 2004 itself. Assuming that one year interest rate on euro deposits was at 0% on
March 15th 2004, what would have been the implied interest rate on dollar deposits if interest rate
parity condition is assumed to hold?
Answer: a. Dollar appreciation is given by
E t1 E t
Et
Et 1  0.8, Et  0.9. Thus the appreciation equals
0.8  0.9
 0.111 ,
0.9
or dollar depreciates by 11.1%.
b. Now, if this depreciation was expected in March 2004, then interest rate parity will imply
i dollar  i euro 
Ete1  Et
Et
 0   0.111  0.111
Thus,
i US  11.1%

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