Practice Exam2 Solution

Page 1 Test your understanding of material for Midterm 2 The number of questions on each chapter included here are no indication of the weight to that chapter on the exam Q1. Describe how each of the following events affects stock and bond prices. Stocks have variable future streams of income, whereas bonds have fixed streams of income. The present value of both financial assets is influenced by the interest rate. (i) The economy enters a recession. (ii) A genius invents a new technology that makes factories more productive. (iii) The Federal Reserve raises its target for interest rates. (iv) People learn that major news about the economy will be announced in a few days, but they don’t know whether it is good news or bad news. (i) Often during recessions, interest rates tend to decrease. This would impact both stock and bond prices positively. However, company’s earnings will fall as well. Lower interest rates and lower earnings impact stock prices in opposite directions. The earnings impact usually outweighs the interest rate impact on stock prices during a recession. Bond prices will generally increase during a recession while stock prices fall. (ii) Future expected earnings of the companies will increase, likely increasing the dividend paid to the stockholders. This increases the value of the companies’ stock. Bond prices are not affected because the coupon payments are not affected. (iii) Higher interest rates reduce both stock and bond prices. (iv) This event increases uncertainty and can be thought of as increasing the risk premium that gets added to the safe interest rate to determine the present value of future income. With a higher interest rate future asset income gets discounted at a higher rate and both stock and bond prices will fall. Q2. Consider two stocks. For each, the expected dividend next year is $100 and the expected growth rate of dividends is 3 percent. The risk premium is 3 percent for one stock and 8 percent for the other. The economy’s safe interest rate i is 5 percent. a) What does the difference in risk premiums tell us about the dividends from each stock? b) Use the Gordon growth model to compute the price of each stock. Why is one price higher than the other? c) Suppose the expected growth rate of dividends rises to 5 percent for both stocks. Compute the new price of each. Which stock’s price changes by a larger percentage? Explain your answer a) The risk premium captures the expectation of how volatile dividends of a particular stock are. While both stocks in the example have an expected dividend of $100 next year, the stock with the higher risk premium is more likely than the low-risk stock to generate actual dividends that are either above or below $100 next period. b) The Gordon growth model states that the price of a stock = D t (1+g)/(r E – g) where D t (1+g) is the expected dividend next year, and = I + risk premium P1 = 100/(0.05 + .03 -0.03) = 100/0.05 =2000 P2 = 100/(0.05 + .08 -0.03) = 100/0.10 =1000 Other things constant, the higher the risk premium for a stock, the lower the price of is predicted to be according to the Gordon growth model. c) At the higher dividend growth rate: d) P1 = 100/(0.05 + .03 -0.05) = 100/0.03 =3333.33 e) P2 = 100/(0.05 + .08 -0.05) = 100/0.08 =1250 1

Page 2 While the price of both stocks increases when the growth rate of the expected dividend increases, the low risk stock increases proportionally more than the high-risk stock. Q3. “An efficient market is one in which no one ever profits from having better information than the rest” Is this statement true or false.? Explain. This statement is false. We define efficient markets as markets where a security's price reflects all information that is available to all market participants. Thus, all such information is priced in and no one can make guaranteed profits from it. However, it is very easy to think of a scenario where a market participant with private information can benefit. Consider a scientist for a pharmaceutical that has just found out that the firm has discovered the cure for cancer. That scientist can buy the stock of the firm, wait for the firm to announce the good news and make a lot of money very easily (the stock price would skyrocket once the market hears the news). Even though markets are efficient the scientist can profit from his private information. This is why such 'insider trading' is illegal in the United States. Q4. Investors had expected a gain of 110,000 new jobs in August. However, on September 7 it was announced that there was a loss of 4,000 jobs in the economy. What do you think happened to the stock market? What about yields in the bond market? Explain. Stock markets need to adjust to this new news. The loss of jobs in the economy implied that the economy was not as robust as investors had expected, and therefore market participants would have revised their expectation of profits downwards. This led to a decrease in stock prices. Your analysis on bond yields depends on your analysis of the stock market. If you said that stock prices decrease, then bond markets would look more attractive. Demand for bonds will increase, which means that bond prices will increase and bond yields will decrease. Q5. Draw a demand and supply graph for bonds that shows the effect on a bond that has its rating lowered. Be sure to show the demand and supply curves and the equilibrium price of the bond before and after the rating is lowered. When a company’s rating is lowered and investors in financial markets agree with the change in the rating, there is less demand for the bond, shifting the demand curve to the left, from D 1 to D 2 , as shown in the following graph. This shift lowers the price of the bond and increases the interest rate on the bond. 2

Page 4 a. Many investors responded by seeking higher yields in junk bonds. b. Your portfolio of long-term bonds would have been helped. The drop in interest rates increased the prices of existing bonds. c. Your investment opportunities have been hurt because the lower interest rates have made bonds and other interest-paying assets less desirable. However, given that the financial crisis occurred with the subsequent recession and slow economic recovery, the lower interest rates should help stimulate the economy and raise the return on investment opportunities. Q10. Suppose that you want to invest for three years to earn the highest possible return. You have three options: (a) Roll over three one-year bonds, which pay interest rates of 8% in the first year, 11% in the second year, and 7% in the third year; (b) buy a two-year bond with a 10% interest rate and then roll over the amount received when that bond matures into a one-year bond with an interest rate of 7%; or (c) buy a three-year bond with an interest rate of 8.5%. Assuming annual compounding, no coupon payments, and no cost of buying or selling bonds, which option should you choose? Consider what a $1,000 investment in each option would equal after three years: Option (a): ($1,000)(1.08)(1.11)(1.07) = $1,282.72 Option (b): ($1,000)(1.1)(1.1)(1.07) = $1,294.70 Option (c): ($1,000)(1.085) 3 = $1,277.29 So, if you are indifferent with respect to the maturities of the bonds you are investing in, you will choose Option (b) because it offers the highest return. ____________ Q11 . Suppose that the interest rate on a one-year Treasury bill is currently 1% and that investors expect that the interest rates on one-year Treasury bills over the next three years will be 2%, 3%, and 2%. Use the expectations theory to calculate the current interest rates on two-year, three-year, and four-year Treasury notes. 2-year: (1% + 2%)/2 = 1.5% 3-year: (1% + 2% + 3%)/3 = 2.00% 4-year: (1% + 2% + 3% + 2%)/4 = 2.00% Q12. A student says: “The interest rate on the one-year Treasury bill is currently 0.29%, while the interest rate on the 30-year Treasury bond is currently 3.10%. Why are any investors buying the Treasury bill when they can receive a much higher yield by buying the Treasury bond?” Provide an answer to the student’s question. Expectations theory indicates that an investor should expect to receive the same return from buying a 30-year bond or 30 one-year bonds during that 30-year period. In this case, if the expectations theory is correct, investors must be expecting that future one-year Treasury bills will have higher interest rates than the current one-year Treasury bill. Therefore, investors are not sacrificing return by buying the Treasury bill rather than the Treasury bond. The liquidity premium theory holds that in addition to expecting future one-year Treasury bills to have higher interest rates, investors require a term premium to compensate them for the additional interest-rate risk and lower liquidity of 30- year bonds in comparison with one-year bonds. The term premium should have a value such that investors are indifferent between holding one-year Treasury bills and 30-year Treasury bonds. Q13. Interest rates on U.S. Treasury bills are typically much lower than interest rates on U.S. Treasury notes and bonds. If the federal government wants to reduce the interest charges it pays when it borrows money, why doesn’t the Treasury stop selling Treasury notes and bonds and sell only bills? 4

Page 5 If the expectations theory is correct, then the Treasury’s borrowing cost would be the same whatever mix of bills, notes, and bonds they issue. Although the Treasury would appear to gain from paying the lower interest rate on Treasury bills, the fact that the interest rates on notes and bonds are greater than on bills indicates that investors are expecting interest rates on bills to be higher in the future. In addition, the Treasury would be subject to borrowing risk, or roll-over risk, in that after the short-term bills have matured, the interest on new short-term bills may have risen sharply. This uncertainty about future borrowing costs would make it difficult for the federal government to budget for future interest payments. Q14. In the spring of 2012, yields on Treasury securities increased. An article in the Wall Street Journal observed: “The immediate cause for the lift was the Federal Reserve’s more optimistic tenor” about the state of the economy. Why would the Federal Reserve becoming more optimistic about future economic growth cause yields on Treasury securities to increase? Source: Justin Lahart, “A Yield Curveball for the Fed,” Wall Street Journal, March 14, 2012. The Federal Reserve becoming more optimistic about future economic growth suggests that the Fed would begin to allow what had been historically low short-term interest rates to rise, which would cause expected future short-term interest rates also to rise. Higher expected future interest rates raise current yields on Treasury securities. Q15. In 2012, an article in the Wall Street Journal had the headline “As Corporate-Bond Yields Sink, Risks for Investors Rise.” Is the biggest risk of holding long-term corporate bonds at low interest rates the risk that the corporations will default? Or is there another type of risk that investors should be more worried about? Source: Matt Wirz, “As Corporate-Bond Yields Sink, Risks for Investors Rise,” Wall Street Journal, August 14, 2012. The other type of risk with long-term corporate bonds at low interest rates is the risk that interest rates will increase, decreasing bond prices and causing capital losses. Q16. In 2012, an article in the Wall Street Journal contained the following observation: “The fact that Spanish short- term yields are shooting higher than long-term yields is a particularly bad sign.” Why might this development in the market for Spanish government bonds indicate that investors feared that the Spanish economy would enter a recession? Source: Matt Phillips, “Flatliners: Spanish Yield Curve Flattening Hard!” Wall Street Journal, July 23, 2012. An inverted yield curve implies weak economic conditions. According to expectations theory, an inverted yield curve indicates that investors expect short-term interest rates to fall. Households and firms expect that short-term interest rates will fall when they anticipate weaker economic conditions, and possibly a recession. During a recession, the demand for funds declines as households and firms reduce borrowing. This lower demand for credit combined with declining inflation rates helps to reduce interest rates. Q17 . State whether you think the following statements are True or False. Explain your answers. “A liquidity/term premium can cause the yield curve to slope upward even if no increase in short-term interest rates is anticipated.” (Use the expression for the term structure of interest rates, assuming the liquidity premium theory, to answer this question.) True. i 2 tt = (i 1 t + i 1 t + 1 e +………+ i 1 t + n − 1 e )/n + h nt where h nt = the liquidity premium which increases as n increases. 5

Page 7 Q23. State whether each of the following statement is true or false and, using the efficient market hypothesis briefly explain why. a) Stock prices do not change b) Stock prices go up with published good news and down with published bad news c) Stock prices reflect true underlying (fundamental) value. False – prices respond to changing market conditions and new information; False – by the time information is published, stock prices will already have incorporated this information in the price (i.e., professional investors will “price in” the information; True – according to the EMH, stock prices reflect the underlying value. Q24. Why are fads inconsistent with the predictions of the efficient market hypothesis? Fads are characterized by overreaction to good or bad news, so prices do not reflect fundamental value. Someone could profit by investing when there is bad news and selling when there is good news. Q25. Suppose you find that after accounting for differences in risk, liquidity and information costs some stocks are overpriced (P t + 1 = 1.1 P t + 1 e + Error t + 1 ) and others are underpriced (P t + 1 = 0.9 P t + 1 e + Error t + 1 ). Are markets efficient? What should you do to make expected profits? No; you should sell the overpriced stocks, and buy underpriced ones. Q26. According to the efficient market hypothesis, would you be better off paying someone 5% of your savings to pick stocks for you or picking your own stocks by throwing darts at the stock pages of the newspaper? Why? Darts are cheaper (but don’t balance risk). Q27. A student makes the following observation: “The Dow Jones Industrial Average currently has a value of 13,500, while the S&P 500 has a value of 1,500. Therefore, the prices of the stocks in the DJIA are nine times as high as the prices of the stocks in the S&P 500.” Briefly explain whether you agree with the student’s reasoning. Disagree. Like other indexes—such as the Consumer Price Index—indexes of stock prices are set equal to 100 in an arbitrarily chosen base year. The absolute values of index numbers cannot be compared to each other. In addition, each stock index is calculated using a different methodology and has a different number of stocks in the index. Stock price indexes can only be used to analyze movements over time in the average prices of the stocks included in the index. Q28. A student remarks: “135,000,000 shares of General Electric were sold yesterday on the New York Stock Exchange, at an average price of $25 per share. That means General Electric just received over $3.4 billion from investors.” Briefly explain whether you agree with the student’s analysis. If these shares of stock were newly issued by GE and sold to the public in a public offering, then this statement would be true. However, it is likely that these were already existing shares traded in the secondary market, in which case GE does not receive any of the money. The transactions take place between the stockowners and the new buyers. Q29. An article in the Wall Street Journal notes that “investors tend to view [preferred stock] more like bonds than like [common] stock.” a. In what sense is preferred stock more like bonds than like common stock? 7

Page 8 b. Many companies issue preferred stock with a provision that allows the company to buy back the preferred stock at its original price after five years. The article notes that this provision “can produce unexpected losses for investors.” When would companies be likely to buy back their preferred shares? Why might these buybacks causes losses to investors? a. Preferred stock does not carry voting rights, but it does receive a fixed dividend that is set when the corporation issues the stock. These dividends are more like coupon payments than the dividends a corporation pays on common stock because dividends on common stock can fluctuate with the corporation’s profits. So, the preferred stock represents a somewhat lower risk investment than do a corporation’s shares of common stock. b. Companies would be more likely to buy back their preferred shares when their stock prices have risen. These buybacks at the original price of the shares would prevent the shareholders of the companies from realizing a capital gain. Q30. A friend has started a business selling software. The software is a great hit, and the firm quickly grows large enough to sell stock. Your friend’s firm promises to pay a dividend of $5 per share every year for the next 50 years, at which point your friend intends to shut down the business. The firms stock is currently selling for $75 per share. If you believe that the company really will pay dividends as stated and if you require a 10% rate of return to make this investment, should you buy the stock? Briefly explain. Although the firm is promising to pay the $5 dividend for 50 years rather than forever, we can still use the perpetuity formula from Problem 2.8 to calculate an upper bound on the price you would be willing to pay: ($5/0.10) = $50. Because this price is less than the $75 price you would have to pay to buy a share of this stock, you should not buy the stock. That is, even if the company were promising to pay a dividend of $5 per share forever, rather than for 50 years, the price would still be too high. Q31. Suppose that Coca-Cola is currently paying a dividend of $1.75 per share, the dividend is expected to grow at a rate of 5% per year, and the rate of return investors require to buy Coca-Cola’s stock is 8%. Calculate the price per share for Coca-Cola’s stock. Using the Gordon growth model, the price per share of Coca-Cola equals: $1.75  ((1 + 0.05)/(0.08 - 0.05)) = $61.25. Q32. An article in the Wall Street Journal in 2012 described investors’ behavior since 2000 as a “flight to safety” that has led to “a high equity risk premium.” a. What does “flight to safety” mean? In this situation, which types of assets are investors likely to be buying, and which are they likely to be selling? b. Would an increase in the equity risk premium likely lead to higher stock prices or to lower stock prices? Briefly explain. a. A “flight to safety” means that investors move their funds into assets with less risk. Investors would likely be buying Treasurys, high-quality corporate bonds, and lower-risk stocks and selling higher-risk stocks. b. The equation on page 168 of the text for determining the price of a stock shows that an increase in the equity risk premium by increasing the required return on equities will result in a decrease in stock prices. Q33. Suppose that you buy an Apple iPad, you like it, and you think it will be a big seller. You expect that Apple’s profits will increase tremendously as a result of booming iPad sales. Should you buy Apple stock? If the efficient markets hypothesis is correct, all the available information—including the current and expected future sales of the iPad—is reflected in the current price of Apple’s stock, meaning that financial arbitrage has already taken 8

Page 10 Q38. A columnist in the Economist argues: The past ten years have dealt a series of blows to efficient-market theory. In the late 1990s dot-com companies with no profits and barely any earnings were valued in billions of dollars; and in 2006 investors massively underestimated the risks in bundling together portfolios of American subprime mortgages. a. Explain how the incidents this columnist discusses may be inconsistent with the efficient markets hypothesis. b. Is it possible that these incidents might have occurred even though the efficient markets hypothesis is correct? Source: Buttonwood, “The Grand Illusion,” Economist, May 5, 2009. a. During the dot-com stock bubble, investors overvalued the prices of Internet stocks for an extended period of time despite having a lot of information about these firms. Mortgaged-backed securities are an example of investors not requiring significantly higher risk premiums to compensate for the risk involved in the bundling of subprime mortgages into mortgage-backed securities. The magnitude of the market’s inability correctly to assess the value of Internet stocks and to assess the risk in mortgage-backed securities led some observers to conclude that asset prices do not always accurately reflect all available information. b. Rational expectations does not mean perfect foresight. It is possible that even with full information investors overestimated the profitability of Internet companies and underestimated the risk of mortgaged-backed securities. Q39 . The graph below shows the yield curve immediately before and after the Fed’s announcement of “Operation Twist” in September 2011. 1 Mo 3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr 0 0.5 1 1.5 2 2.5 3 3.5 09/20/11 09/21/11 a) In “Operation Twist”, did the Fed buy or sell long-term bonds? How can you tell from the graph? In “Operation Twist”, the Fed bought long-term bonds. From the graph, we see that the yields on long-term bonds fell, which means that their prices must have increased, which means that demand must have increased. b) On September 20, 2011, the yield on 1-year bonds was 0.09% and the yield on 2-year bonds was 0.18%. Assuming the expectations theory is correct, compute the expected 1-year yield a year later. i 2t =(i 1t +i 1t+1 )/2 => i 1t+1 = 2*i 2t - i 1t = 2*0.18 - 0.09 = 0.27 10

Page 11 c) On September 21, 2011, the yield on 1-year bonds was 0.11% and the yield on 2-year bonds was 0.21%. Assuming the expectations the theory is correct, compute the new expected 1-year yield a year later. Based on your answer to the question above, did Operation Twist have an effect on expected future short-term rates? i 2t = 2*0.21 – 0.11 = 0.31 Operation Twist increased expected future short-term rates. Q40. Distinguish symmetric information from asymmetric information and state why the distinction is important for the financial system? Symmetric information is known to both borrowers and lenders; asymmetric information occurs when borrowers have private information—something the borrowers know that the lenders do not know. Information asymmetry makes channeling funds efficiently from lenders to borrowers more difficult. Q41. What is the difference between moral hazard and adverse selection? How does each contribute to making information asymmetric? Moral hazard occurs when borrowers make different use of borrowed funds than they would have made with their own; adverse selection occurs when bad risks are more likely to accept a financial contract than are good risks. The lender may not know what the borrower will do with the funds because of moral hazard, and the lender may not know the riskiness of the borrower because of adverse selection. Q42. Explain why information collection in financial markets is subject to the free rider problem. How do banks overcome the free rider problem? Even those who do not pay for the collection of information in financial markets can benefit from that information by monitoring the trading patterns of those investors who do pay for the information. Banks overcome this free-rider problem by holding the loans they make. Q43. Explain what the “lemons problem” is. How does the lemons problem lead many firms to borrow from banks rather than from individual investors? The “lemons problem” refers to the adverse selection problem that arises from asymmetric information. Because potential investors have difficulty in distinguishing good borrowers from bad borrowers, they offer good borrowers terms they are reluctant to accept. Because banks specialize in gathering information, they are able to overcome this problem. Q44. Why might the number of loans that aren’t repaid to banks rise as interest rates rise? What might be a better strategy for banks than raising interest rates? The answer is adverse selection: Good borrowers’ projects will not be viable at the higher interest rate, so the bank has a higher percentage of bad borrowers. Alternatively, the bank could use credit rationing and not raise interest rates to match the quantity of loans demanded and supplied. Q45. Suppose that a bank makes a loan to a business and the loan contract specifies that the business is not to engage in certain lines of business. What is this type of provision called? Why would the bank make such a provision? Such provisions are restrictive covenants; banks use them in order to reduce moral hazard problems. 11

Page 13 b) A new law makes it a felony to default on a bank loan. c) All the economy’s small firms are bought by large firms. d) Mutual funds reduce their minimum balances for shareholders. a) With new regulations that make it easier to replace company directors, captive boards who are not properly supervising company managers are easier to re- place. This ensures that boards of directors are more likely to protect shareholder interests and to supervise management, which reduces the moral hazard problem. Stocks become more attractive to savers. Fewer companies need to rely on bank loans for financings. The volume of bank loans decreases. b) If it becomes a felony to default on a bank loan, the cost of bank loans in- creases for potential borrowers. Fewer companies will take out bank loans to finance investment projects when they are uncertain about the outcome of their projects. In- stead, companies will try to obtain financing through the bond market. The volume of bank loans decreases. On the other hand, banks are more likely to give loans when more severe consequences are attached to defaulting. Making it a felony to default will solve some of the adverse selection and moral hazard problems. Only the better credit risks will still be interested in taking out a loan. Banks can therefore be more confident about loan applicants’ credit. This has the potential to increase the volume of bank loans. The net impact on bank loans from the new law is unclear. c) Large firms are more likely to have a bond rating provided by rating agencies. These ratings decrease adverse selection and make it more likely that firms will obtain financing through the bond market rather than bank loans. The volume of bank loans will decrease. d) Reducing the minimum balance for shareholders in mutual funds encourages more small savers to purchase shares in mutual funds rather than deposit funds in banks. Banks will have fewer funds available to loan out. The volume of bank loans decreases. Make sure that in the chart on page 3 of the notes “Information, Subprime Lending and the Current Economic Crises” posted on Blackboard you understand exactly the role of adverse selection and moral hazard at each link between the various parties involved. Also, you should understand how exactly the housing bubble formed and how it burst and how the housing market correction spread to the financial sector, banking sector and the rest of the economy and the world. Q53. Suppose you are hiring a worker for your firm. You advertise a position for $50,000, but an applicant offers to work for $40,000. Should you jump at this offer? Paying a salary of $40,000 is only a good deal for the firm if the applicant is as productive (in relation to the salary paid) as another worker who gets paid the advertised salary of $50,000. If the firm is hiring the worker for a job that is hard to monitor, then the worker who gets paid the lower-than-advertised salary is more prone to goofing off. The moral hazard problem is more pronounced at the lower salary. Also, the fact that the worker volunteered to take a lower salary may indicate that this worker does not plan to work very hard in the first place. The willingness to accept a lower salary matches the worker’s knowledge of his or her productivity and indicates an adverse selection problem. In either case, the firm needs to consider both moral hazard and adverse selection problems before jumping at the offer of paying a lower salary. Q54. Suppose you have $1,000 to lend and offer it for 10 percent interest. Someone promises to pay 20 percent if you lend to him. Should you jump at this offer? The person offering to pay 20 percent may be engaged in a highly risky venture that pays high returns if successful, but has a high probability of failure and default. In the case of default, the person will not be able to pay any interest 13

Page 14 and may, in fact, not be able to repay any of the principal, the initial loan of $1,000. Thus, the promise to pay a higher interest rate should be regarded with caution. It is likely that adverse selection is a problem here. Q55. Why do people commit each of the following crimes? Who is hurt by the crimes? Discuss who is hurt directly and also the broader effects on the financial system. (As an analogy, shoplifting hurts store owners directly; its broader effects include higher prices for goods.) a) False accounting. b) Insider trading. a) False accounting that makes a firm’s financial situation look better than it actually is immediately benefits the managers of the firm, who often own stock or have stock options. This false accounting directly hurts savers who consider buying a bond issued by this firm. Overstating the firm’s financial situation leads to a higher bond rating than deserved and allows the firm to pay lower interest rates on bonds. Savers are not adequately compensated for the risk they take on. Once the false ac- counting becomes common knowledge, shareholders of this company are hurt be- cause the stock price of this company will decline. False accounting makes efforts to overcome the asymmetric information problem more difficult. Generally, this will lead to fewer transactions between savers and investors. Some profitable projects may not get financed because savers find it difficult to rely on accounting information. b) Insider trading involves buying or selling securities based on information that is not public. Insider trading benefits managers, employees, accountants, and lawyers, who have more information than the average saver and who can buy stock before good news becomes public. Insiders are then able to gain from the increase in stock prices once the good news becomes public knowledge. Conversely, insiders are able to sell stock before bad news becomes public, thus avoiding losses. Aver- age savers are hurt by these trades. Average savers who sell stock without the knowl- edge of the good news that will drive up the price the next day forgo the gains they could have earned if they held onto the stock. Average sellers are also not able to avoid losses because of bad news. Widespread insider trading will make it harder to issue securities. Fewer transactions between savers and investors will take place. Q56. Many economists argue that the rescue of a financial institution should protect the institution’s creditors from losses but not protect its owners: they should lose their equity. Supporters of this idea say it reduces the moral hazard created by bailouts. a) Explain how this approach reduces moral hazard compared to a bailout that protects both creditors and equity holders. b) Does this approach eliminate the moral hazard problem completely? Explain. a) A full bailout of both creditors and equity holders (owners) of a particular financial institution sends the message to other financial institutions that losses will be limited since taxpayers will bear the full loss of the rescue. This will change the cost-benefit analysis of all financial institutions when they engage in loans for risky projects. Financial institutions will take on excessive risk. The higher risk is compensated with higher returns for the institution while the potential losses are shifted to tax- payers. This mechanism describes the moral hazard problem that ensues after a “full” bailout. A partial bailout of creditors will maintain the incentive for owners to take a substantial loss of a project into account. A situation of insolvency with negative net worth for the financial institution means that owners will lose their capital even after the creditors are bailed out. This will prevent the owners from engaging in projects that are too risky. The owners know that they will bear part of the cost of a failure. The moral hazard problem is less severe. b) While the moral hazard problem is reduced because the owners’ equity is at risk, the moral hazard problem is not completely eliminated. Any time a financial institution is funded by both creditors and owners, the financial institution has an incentive to engage in overly risky projects that generate high returns when they are suc- cessful, but create losses when they fail. When creditors know that they will be bailed out, it is easier for the bank owners to 14

Page 16 a. Yes. Landlords know more about the quality of the property, and therefore its true value, than renters. For example, landlords know more about how well an apartment’s heating and air conditioning systems work, whether the apartment has problems with insects, and whether the apartment is quiet, than will potential renters. b. Landlords with bad apartments will attempt to charge a higher price than they otherwise would receive in the absence of this information asymmetry, while landlords with good apartments will have trouble renting them for their true value because potential renters will be suspicious that the apartments have hidden defects. So, there is the possibility of the “lemons problem” of bad rental properties driving good rental properties out of the market. c. The rental property market and the used car market are similar in that the landlord and the current car owner know more about the property or the car than the potential renter or buyer. However, the landlord and car owner differ in that the landlord is not selling the apartment, merely renting it. So, if a landlord wants the tenant to renew the lease, the landlord will be forced to maintain the property so that its value approaches the rental rate. This incentive to maintain the property would be similar to the car dealer offering a warranty. Q61. An article in the Economist magazine on crowd-funding argued: “Start-ups are especially needy now, since many banks are loth to lend even to well-established companies.” a. Why might banks be reluctant to lend to startups? b. Why might startups have an easier time obtaining equity investments from small investors through crowd-funding sites than obtaining loans from banks? Source: “Many Scrappy Returns,” Economist, November 19, 2011. a. Banks would be reluctant to lend to startups for two key reasons: 1) There is substantial risk that startups would fail, particularly during sluggish economic times, and 2) banks want to continue to recover from the consequences of the financial crisis and recession by improving the quality of their loans (loaning to borrowers who are likely to pay back the loans). b. Startups might have an easier time obtaining equity investments from small investors through crowd-funding sites than obtaining loans from banks because: 1) Small investors are not investing large amounts of money, 2) the social networking sites reach large numbers of people, and 3) small investors may enjoy funding innovative, new ideas even though the returns on their investments are low. Q62. Commercial real estate loans are mortgages that use apartment buildings, office buildings, or other commercial real estate as collateral. An article in the New York Times discussing the securitization of commercial real estate loans makes the following observation: The boom in commercial mortgage-backed securities in the middle of the last decade provided a lot of money for underwriters, enabled banks to earn fees from making and servicing bad loans and allowed property owners to withdraw large amounts of cash. The losers were the investors. a. What is securitization? b. Why would banks make bad commercial real estate loans? Don’t banks lose money if these loans default? c. Why would investors buy securities that contain bad commercial real estate loans? Is it likely that the interest rates on these securities were high enough to compensate investors for the additional risk involved with these securities? Briefly explain. Source: Floyd Norris, “Commercial Mortgages Show How Bad It Got,” New York Times, July 5, 2012. 16

Page 17 a. Securitization is the process of combining (bundling) loans, such as mortgages, into securities that can be sold on financial markets. b. When the loans are bundled together and sold off, the bank that issued the loan doesn’t bear the cost if the borrower fails to pay back the loan. The bank that issues the loan makes its money by originating and selling the loans on the secondary market. This process creates a moral hazard problem. c. The investors did not know that the securities contained bad commercial real estate loans. It is highly unlikely that these securities had high enough interest rates to compensate investors for the additional risk because during this period the market consistently underestimated the risk involved with mortgage-backed securities. Q63. Yves Smith runs the popular financial blog nakedcapitalism.com. In one of his postings, he noted: “Amex [American Express] is offering very hefty balance reductions (20%) to business accounts who pay off balances early on credit line products that Amex has discontinued.” Smith worried that Amex’s offer would expose the credit card company to adverse selection. Briefly explain whether you agree. Source: Yves Smith, “Credit Card Defaults Stabilizing?” nakedcapitalism.com, August 18, 2009. You should agree. Only the most financially sound firms are likely to take advantage of the offer. As a result, the remaining firms who do not pay off their credit lines early are likely to be riskier borrowers. So, American Express is likely to suffer adverse selection with respect to the remaining firms using this credit line product. Q64. Briefly explain in which of the following situations moral hazard is likely to be less of a problem. a. A manager is paid a flat salary of $150,000. b. A manager is paid a salary of $75,000 plus 10% of the firm’s profits. Moral hazard is less likely to be a problem in scenario (b), because when a manager receives a percentage of the firm’s profits, the manager’s objective will be closer to the shareholders’ objective of maximizing the firm’s profits. Q65. After a report appeared that many projects financed through crowd-funding site Kickstarter failed to meet their completion deadlines, an article in Bloomberg Businessweek noted: “The company says on its website that it doesn’t vet or track whether projects fulfill their promises, though it encourages people to be skeptical.” Crowd-funding sites typically take a percentage of the funds firms raise but do not make equity investments in the firms. a. How do crowd-funding sites differ from venture capital firms? b. Do crowd-funding sites reduce the transactions costs faced by small investors looking to make equity investments in startups? Do crowd-funding sites reduce asymmetric information problems faced by small investors? Explain. Source: Mark Milian, “After Raising Money, Many Kickstarter Projects Fail to Deliver,” Bloomberg Businessweek, August 21, 2012. a. Unlike crowd-funding sites, venture capital funds often take a large ownership stake in a startup firm and frequently place their own employees on the board of directors or have them serve as managers. b. Crowd-funding sites reduce the transactions costs faced by small investors who want to make equity investments in startups by acting as a financial intermediary. The crowd-funding sites identify startup firms and ensure that the investors’ funds are invested in accordance with federal securities laws. Crowd-funding sites probably somewhat reduce asymmetric information problems by screening firms that request permission to solicit investors on their sites, but substantial asymmetric information problems still remain. Crowd-funding sites may be subject to moral hazard problems because they keep a percentage of the funds they raise but they do not make equity investments in firms and so they are not exposed to the risk that the firms may fail. 17

Page 19 Q70. Why might deposit insurance encourage banks to take on too much risk? Is deposit insurance, therefore, a bad idea? Briefly explain. Because deposits are insured, banks can focus on increasing the spread between the rates at which they borrow and lend. Banks can increase the riskiness of their loans and investments without worrying about whether depositors will withdraw their funds. With deposit insurance, depositors have no incentive to monitor the behavior of bank managers and to withdraw their deposits if the managers made reckless investments. Nevertheless, deposit insurance is not necessarily a bad idea, because deposit insurance has substantially decreased systemic risk in the commercial banking system in the United States by eliminating commercial bank runs. Q71. Suppose the interest rate on 1 year bonds is currently i 1 t = 5% and the interest rate on a bond with two-year maturity is 6.5%. Which of the following is true? The expectations theory predicts that the expected future rate of 1- year bond is i 1 t + 1 e = a) 8% b) 7% c) 8.5% d) 7.5% e) none of the above A (5 + i 1 t + 1 e )/2 = 6.5% => i 1 t + 1 e = 8% Q72 . If a one-year bond currently yields 5% and is expected to yield 7% next year, the preferred habitat theory predicts that the yield today on a two-year bond will be (a) 5%. (b) less than 6% but more than 5%. (c) 6%. (d) more than 6%. (e) none of the above D (7+5)/2 + a term premium. Q73. If the expected gains on stocks rise, while the expected returns on bonds do not change, then (a) the demand curve for bonds will shift to the right. (b) the supply curve for loanable funds will shift to the right. (c) the equilibrium interest rate will fall. (d) the equilibrium interest rate will rise. (e) none of the above D Q74. A review of a biography of the British investment banker Siegmund Warburg states that Warburg believed: Investment banking should not be about gambling but about . . . financial intermediation built on client relationships, not speculative trading. . . . Warburg was always queasy about profits made from [ investing] the firm’s own capital, preferring income from advisory and underwriting fees. a. What is underwriting? In what sense is an investment bank that engages in underwriting acting as a financial intermediary? b. Is an investment bank that buys securities with its own capital acting as a financial intermediary? Briefly explain. 19

Page 20 a. Underwriting is where investment banks guarantee (typically) a price to the issuing firm for new stocks or bonds and then sell the new stocks or bonds at a higher price in financial markets or directly to investors. Underwriting is financial intermediation because the bank brings together savers and the firms who issue new securities. b. An investment bank that buys securities with its own capital is not acting as a financial intermediary. It is buying securities with the expectation of profit from the yield or from changes in the prices of the securities. Investing in this way does not involve acting as an intermediary by funneling funds from savers to borrowers. Q75. How are banks able to attract small savers if small savers can usually receive a higher interest rate from money market mutual funds than from bank savings accounts? Deposits in bank savings accounts are covered by federal deposit insurance whereas money market mutual fund shares are not. Also, money market mutual funds restrict savers to writing checks only above a specified amount, such as $500 Q76. How are banks able to attract small savers if small savers can usually receive a higher interest rate from money market mutual funds than from bank savings accounts? Deposits in bank savings accounts are covered by federal deposit insurance whereas money market mutual fund shares are not. Also, money market mutual funds restrict savers to writing checks only above a specified amount, such as $500. Q77. Why have runs on commercial banks become rare, while several shadow banking firms experienced runs during the financial crisis A run on a financial firm is the attempt by investors to get their money out before the firm fails. Commercial banks do not typically have bank runs because their deposits are insured by the Federal Deposit Insurance Corporation (FDIC), which reduces the risk to depositors. The shadow banking industry does not have an equivalent to the FDIC because their short-term borrowing is not in the form of deposits. Q78. In March 2008, the U.S. Treasury and the Federal Reserve arranged for the sale of the Bear Stearns investment bank to JPMorgan Chase in order to prevent Bear Stearns from having to declare bankruptcy. A columnist for the New York Times noted: It was an old-fashioned bank run that forced Bear Stearns to turn to the federal government for salvation. . . . The difference is that Bear Stearns is not a commercial bank, and is therefore not eligible for the protections those banks received 75 years ago when Franklin D. Roosevelt halted bank runs with government guarantees. a. How can an investment bank be subject to a run? b. What “government guarantees” did commercial banks receive 75 years ago? c. How did these government guarantees halt commercial bank runs? a. An investment bank can be subject to a run when investors do not renew their repurchase agreements, do not purchase the investment bank’s commercial paper, or other counterparties want to cash investments out. b. Government guarantees refer primarily to federal deposit insurance through the FDIC. c. The creation of the FDIC eliminated the incentive for depositors to run on the bank because their money was insured if the bank failed. Q79. If junk bonds are “ junk,” then why would investors buy them? Junk bonds are referred to as “junk” in that they are very risky investments, but provide high yields to investors who 20