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Financial Institutions Paper

International Technological University FINN 918 Financial Institutions Final Exam: Answers Textbook: Foundations of Financial Markets and Institutions, 4th Edition, Fabozzi, Modigliani, and Jones, Prentice Hall, 2010,| ISBN –13: 978-0-13613531-9| ISBN –10: 0-13-613531-5| 1. Indicate whether each of the following instruments trades in the money market or the capital market: a. General Motors Acceptance Corporation issues a financial instrument with four months to maturity. b. The U. S. Treasury issues a security with 10 years to maturity. c.

Microsoft Corporation issues common stock. d. The State of Alaska issues a financial instrument with eight months to maturity. e. GMAC issue trades in the money market. f. U. S. security trades in the capital market. g. Microsoft stock trades in the capital market. h. State of Alaska security trades in the money market. 2. Give three reasons for the trend toward greater integration of financial markets throughout the world. There are several reasons. These include: a. Deregulation and/or liberalization of financial markets to permit greater participants from other countries; b.

Technological innovations to provide globally-available information and to speed transactions; c. Institutionalization — financial institutions are better able to diversify portfolio and exploit mis-pricings than are individuals. 3 Why does increased volatility in financial markets with respect to the price of financial assets, interest rates, and exchange rates foster financial innovation? Increased volatility of the prices of financial assets has fostered innovation as investors and institutions seek ways to mitigate financial risk.

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Among other things, these innovations include the advancement of the modern derivatives markets. Chapter 2 1. Each year, millions of American investors pour billions of dollars into investment companies, which use those dollars to buy the common stock of other companies. What do the investment companies offer investors who prefer to invest in the investment companies rather than buying the common stock of these other companies directly? In investing funds with the investment companies, investors are reducing their risk via diversification and the cost of contracting and information.

These companies also provide liquidity to the investor. 2. a. Why is the term hedge to describe “hedge funds” misleading? b. Where is the term hedge fund described in the U. S. securities laws? a. Hedge denotes hedging risk. Many hedge funds, however, do not use hedge as a strategy, and these funds take significant risk in their attempt to achieve abnormal returns. b. The term is not described in US securities laws, and hedge funds are not regulated by the SEC. 3. Some hedge funds will refer to their strategies as “arbitrage strategies. ” Why would this be misleading?

Arbitrage means riskless profit. These opportunities are few and fleeting. Hedge funds take great risk. The arbitrage typically taken is where there is a disparity between the risk and the return, such as pricing disparities across markets. Chapter 3 1. What is the Basel Committee for Bank Supervision? a. What do the two frameworks, Basel I and Basel II, published by the Basel Committee for Bank Supervision, address regarding banking? a. It is the organization that plays the primary role in establishing risk and management guidelines for banks throughout the world. b.

The frameworks set forth minimum capital requirements and standards. 2. Explain each of the following: a. reserve ratio b. required reserves a. The reserve ratio is the percentage of deposits a bank must keep in a non-interest-bearing account at the Fed. b. Required reserves are the actual dollar amounts based on a given reserve ratio. 3. How did the Glass-Steagall Act impact the operations of a bank? The Glass-Steagall Act prohibited banks from carrying out certain activities in the securities markets, which are principal investment banking activities. It also prohibited banks from engaging in insurance activities.

Chapter 4 1. What is the role of a central bank? The role of a central bank has several functions: risk assessment, risk reduction, oversight of payment systems, and crisis management. It can do this through monetary policies, and through the implementation of regulations. 2. Why is it argued that a central bank should be independent of the government? Central banks should be independent of the short-term political interests and political influences generally in setting economic policies. 3. What is the discount rate, and to what type of action by a bank does it apply?

The discount rate is the rate a bank pays to borrow at the “discount window” of the Fed. Such borrowings are often undertaken to meet temporary liquidity needs. Bank needs are monitored and the Fed likes to state that borrowing from it is a “privilege and not a right. ” 4. a. What is an open market purchase by the Fed? b. Which unit of the Fed decides on open market policy, and what unit implements that policy? c. What is the immediate consequence of an open market purchase? a. An open market purchase by the Fed consists of the purchase of U. S. Treasury securities. . The FOMC decides on open market policy and directs the Federal Reserve Bank of New York to implement it through sales and purchases of these securities. c. The immediate consequence of an open market purchase is to supply the seller of the security with a check on the Federal Reserve System that he can deposit in his bank, thereby immediately increasing the excess reserves and thus nation’s money supply. Chapter 5 1. Why is it impossible for the Fed to target, at the same time, both the Fed funds interest rate and the level of reserves in the banking system?

An increase in reserves should have an opposite effect on interest rates (a decrease in rates as banks have more reserves to lend). However, the interest rate is a function of both the supply of money and the public’s demand for money. It is thus possible for an increase in reserves to be met by an increase in the demand to hold money; hence no decrease in interest rate levels. In like manner, when an interest rate is the target, the Fed must let the growth in reserves vary as it strives to keep certain levels of interest rates. 2.

It is often said that you cannot hit two targets with one arrow. How does this comment apply to the use of monetary policy to “stabilize the economy”? Often there are countervailing effects of the Fed’s actions. As seen, the Fed must choose either a short-term rate or the level of some reserves and cannot choose to target both kinds of variables as an operating target. The Fed can stimulate an economy through a reduction in interest rates, but such stimulation could lead to inflation or bubbles. As well, dampening unsustainable growth can be achieved, but such actions can lead to recession. . Describe the differences and similarities of the conduct of Chairmen Greenspan and Bernanke in managing Fed policy. Up until the mortgage and crisis, Bernanke mostly maintained Greenspan’s policies, but he was viewed as being more open with respect to communications about the Fed’s policy and FOMC meetings. Additionally, Bernanke was expected to advocate a more quantitative approach to policy as opposed to Greenspan’s subjective, eclectic approach Chapter 7 1. An investment company has $1. 05 million of assets, $50,000 of liabilities, and 10,000 shares outstanding. a. What is its NAV? b.

Suppose the fund pays off its liabilities while at the same time the value of its assets double. How many shares will a deposit of $5,000 receive? a. Net asset value = (Total assets minus liabilities) / numbers of shares = 1,050,000 – 50,000 = $100 10,000 b. Net asset value = 2,100,000 – 0 = $210 10,000 No of shares = 5000 = 23. 81 shares. 210 2. “The NAV of an open-end fund is determined continuously throughout the trading day. ” Explain why you agree or disagree with this statement. Disagree. NAV of open-ended fund is the closing price of the day 3. Why might the price of a share of a closed-end fund diverge from its NAV?

The price of closed-end funds may differ from NAV (often at a discount) because the fund has a large built-in tax liabilities and investors are discounting the share’s price for future tax liabilities. Leverage may be another factor for price below NAV. 4. What is an index fund? An index fund e. g. Fidelity Magellan and Vanguard S&P 500 are mutual funds, which invests in stocks included in S&P 500, and aim to achieve its performance to the benchmark S&P500 returns 5. What are the advantages of an ETF relative to open-end and closed-end investment companies?

As said earlier, price is continuously changing during the trading period. 6. Briefly describe the following in the context of mutual funds: a. supermarket b. wrap program c. segregated managed accounts d. family of funds a. Supermarkets: The introduction of the first mutual fund supermarket in 1992 by Charles Schwab & Co. introduced its One Source service. These supermarkets allow investors to purchase funds from participating companies without investors having to contact each fund company. b. Wrap program: Wrap accounts are managed accounts, typically mutual funds “wrapped” in a service package.

The service provided is often asset allocation counsel; that is advice on the mix of managed funds. c. Segregated managed accounts: are in response to individuals who object to mutual funds because of their lack of control over taxes and other investment decisions. Many investors with medium-size portfolio are utilizing segregated accounts. d. Family of funds: In the U. S. system, a family of funds consists of an investment company that offers several different funds. In Japan the family fund allows investors to buy new certificates in a grouping of existing unit trusts.

Chapter 9 1. Suppose you own a bond that pays $75 yearly in coupon interest and that is likely to be called in two years (because the firm has already announced that it will redeem the issue early). The call price will be $1,050. What is the price of your bond now, in the market, if the appropriate discount rate for this asset is 9%? PO = $75 (PVIFA) 2. 09 + $1050 (PVIF) 2. 09 =$75 X 1. 7591 + $1050 X . 8417 = $1015. 72 2. You have been considering a zero-coupon bond, which pays no interest but will pay a principal of $1,000 at the end of five years.

The price of the bond is now $712. 99, and its required rate of return is 7. 0%. This morning’s news contained a surprising development. The government announced that the rate of inflation appears to be 5. 5% instead of the 4% that most people had been expecting. (Suppose most people had thought the real rate of interest was 3%. ) What would be the price of the bond, once the market began to absorb this new information about inflation? The nominal required rate of return is (real rate plus inflation) ir + if or currently 3% plus 4% = 7%. If if becomes 5. % then the new required rate of return becomes 8. 5%. The price of the bond would then be $1000/(1. 085)5 or $665. 05. 3. What is the cash flow of a 6% coupon bond that pays interest annually, matures in seven years, and has a principal of $1,000? a. Assuming a discount rate of 8%, what is the price of this bond? b. Assuming a discount rate of 8. 5%, what is the price of this bond? c. Assuming a discount rate of 7. 5%, what is the price of this bond? d. What is the duration of this bond, assuming that the price is the one you calculated in part (b)? e.

If the yield changes by 100 basis points, from 8% to 7%, by how much would you approximate the percentage price change to be using your estimate of duration in part (e)? f. What is the actual percentage price change if the yield changes by 100 basis points? a. $60 a year interest for 7 years plus $1000 principal in year 7 for a total of $1420 in cash flow. b. 5. 2064 X $60 + . 583 X $1000 = $895. 38 c. 5. 119 X $60 + . 565 X $1000 = $872. 14 d. 5. 297 X $60 + . 603 X $1000 = $920. 82 e. D = $920-. 82-$872. 14 =$48. 68/8. 95=5. 44 $895. 38 (0. 85-. 075) f.

Applying the formula-D (change in yield) = -5. 44 (. 01) or a price increase of 5. 42%. g. Price at 8% =$895. 88, at 7% = $946. 06, so actual percentage change is ($946. 06 – $895. 88)/$895. 88=5. 6%. Chapter 10 1. How do the assets, money, and bonds differ in Keynes’s liquidity preference theory? a. How does a change in income affect the equilibrium level of the interest rate in Keynes’s theory? b. How does a change in the money supply affect that rate? a. Money (as demand deposits and cash) is considered the liquid asset that serves as a medium of exchange and a store of value.

Such funds pay little or no interest. Bonds are not as liquid and do pay some interest. b. In Keynesian theory, the rate of interest is determined by the demand to hold money (liquidity preference) and the money supply. An increase in income will lead to an increase in the demand for transactions purposes; hence an increase in the equilibrium rate of interest. c. An increase in the money supply will initially create a situation where more money exists than public wish to hold. They will then use these excess funds for investments, driving down interest rates. 2.

Consider three bonds, all with a par value of $1,000: Bond| Coupon Rate| Market Price| A| 8%| $1,100| B| 7| 900| C| 9| 1,000| a. What is the yield to maturity of bond C? b. Is the yield to maturity of bond A greater than or less than 8%? c. Is the yield to maturity of bond B greater than or less than 9%? a. The yield to maturity of bond C is 9% because its market price is equal to the par value. b. The yield to maturity of bond A is less than 8% since it is selling at a premium over par. An investor will get the 8% coupon payments but only $1000 at maturity, less than the $1100 he had paid for it. . Since bond B is selling at a discount, its yield is greater than the coupon rate, but how much depends upon the term to maturity. In the near term the yield exceeds 9%, but if the term of the bond goes out to 20 years, the actual yield to maturity will be less than 9%. a. Show the cash flows for the two bonds below, each of which has a par value of $1,000 and pays interest semiannually: Bond| Coupon Rate| Years to Maturity| Price| W| 7%| 5| $884. 20| Y| 9| 4| 967. 70| b. Calculate the yield to maturity for the two bonds. a. Bond W pays $35 twice a year for 5 years, pays $1000 in year 5. ond Y pays $45 semi-annually for 4 years and $1000 in year 4. b. Bond W’s cash flows must be discounted to equal $884. 20. Using a trial-and-error method of several rates the closest yield to maturity is 10. 6%. Try also using financial calculator to confirm this yield. Bond Y’s cash flows must be discounted to equal $967. 70. Using the trial-and-error method results this time in a yield to maturity of 9. 4%. 8. a. What is the credit risk associated with a U. S. Treasury security? b. Why is the Treasury yield considered the base interest rate? c. What is meant by on-the-run Treasuries? d.

What is meant by off-the-run Treasuries? a. Essentially no credit risk — Treasury securities are backed by the full faith and credit of the federal government. b. It has the least risk in terms of default risk and is highly liquid, since Treasury securities comprise the largest and most actively traded financial instruments in this country. c. “On-the-run” Treasury issues are the most recently auctioned issues for each maturity. “Off-the-run” issues are the older ones, auctioned before the current coupon issues 3. In the May 29, 1992, Weekly Market Update, published by Goldman Sachs & Co. the following information was reported in various exhibits for certain corporate bonds as of the close of business Thursday, May 28, 1992: Issuer| Rating| Yield | Spread| Treasury Benchmark| General Electric Capital Co. | Triple A| 7. 87%| 50| 10| Mobil Corp. | Double A| 7. 77| 40| 10| Southern Bell Tel & Teleg | Triple A| 8. 60| 72| 30| Bell Tel Co Pa| Double A| 8. 66| 78| 30| AMR Corp| Triple B| 9. 43| 155| 30| a. What is meant by rating? b. Which of the five bonds has the greatest credit risk? c. What is meant by spread? d. What is meant by Treasury benchmark? e.

Explain how each of the spreads reported above was determined. f. Why does each spread reported above reflect a risk premium? a. A rating refers to a published indicator of creditworthiness or probability of default. b. The AMR Corp. has the greatest credit risk, because at Triple B it has the lowest rating of the group. c. Spreads are differences in yields among bonds. Most commonly the spread is calculated as the excess yield over a benchmark Treasury security. d. The Treasury benchmark is the government security with the same maturity as the corporate security under consideration. e.

Each spread was determined by subtracting the appropriate Treasury benchmark yield as of May 29, 1992 from the non-Treasury security of the same maturity. f. The spread in each case constitutes a risk premium for bearing default and liquidity risks that are not inherent in Treasury securities. 4. What is meant by an embedded option in a bond? a. Give three examples of an embedded option that might be included in a bond issue. b. Does an embedded option increase or decrease the risk premium relative to the base interest rate? a. An embedded option in a bond can be associated with convertible bonds.

The holder has a call option to convert into stock at his will and he is willing to pay a premium in terms of a lower yield for this privilege. The issuer may have an embedded option in terms of callability , forcing the bondholder to sell back the security at a given price at a time of the issuer’s choosing. b. Convertible features, putable bonds (that allow bondholders to sell the securities back to the issuers at par), and warrants attached to bonds are examples of options that may be included in bond issues. c. The answer depends on the nature of the option.

If the buyer has a call option he will pay more for the bond and accept a lower yield. If the issuer has an option like a callable feature on a bond, he is paying a price in terms of a higher yield or lower bond price. Chapter 11 1. What is a yield curve? a. Historically, why has the Treasury yield curve been the one that is most closely watched by market participants? a. A yield curve is a geographical representation of the term structure (the relationship between yield to maturity and the term to maturity) of securities having the same credit rating. . Treasury securities are risk-free with respect to credit and liquidity, and their yields serve as benchmarks for other securities. 2. What are the types of risks associated with investing in bonds and how do these two risks affect the pure expectations theory? The expectations theory suggests that rates will change over time in some direction. The prospect of changing yields creates two risks related to bond investment: (1) the price risk (value of principal if sold prior to maturity) and the reinvestment risk.

Low rates may be good for price increases, but their favorable impact is partially offset by investors having to reinvest earnings at these low rates Chapter 12 1. Assume the following: Expected market return = 15% Risk-free rate = 5. 7% If a security’s beta is 1. 3, what is its expected return according to the CAPM? The expected return is: .07+1. 3 (. 15-. 07) =. 174=17. 4%, (assume risk free rate =7%). 2. What are the difficulties in practice of applying the arbitrage pricing theory model? a. Does Roll’s criticism also apply to this pricing model? b. In the CAPM investors should be compensated for accepting systematic risk: for the APT model, investors are rewarded for accepting both systematic risk and unsystematic risk. ” Do you agree with this statement? a. The difficulty lies in identifying the systematic factors. b. Roll’s criticism does not apply to the APT model because that model does not rely on a true market index. c. This statement is true for the CAPM, but not for the APT model. The latter also asserts that investors should be compensated only for accepting systematic risk. But unlike the CAPM, there is more than one systematic risk. Chapter 17 1.

How does common stock differ from preferred stock? b. Why is preferred stock viewed as a senior corporate security? a. Preferred stock is entitled to a fixed participation in the form of dividends of the earnings of the company. Dividends must be declared and ordinarily they are at the discretion of the board. Common stock is entitled to the residual cashflow, and is junior to the preferred stock both in terms of distribution and liquidation preference. b. Preferred stock is considered a senior instrument because dividends must be paid before any distribution of dividends can be made to the common stockholders.

Also, in a liquidation, the preferred stockholders are paid before the common stockholders, who are considered residual claimants. 2. Explain the mechanics and some key rules of a short sale. a. What restrictions are imposed on short selling activities? a. A short seller borrows the stocks to sell on the market, giving the proceeds of the sale to his broker as collateral. Should prices decline he will buy the stocks, return them to the broker and obtain the sales proceeds. b. A short sale must be announced at the time the order is given , and it can occur only after an uptick in the market price of the stock.

The short seller is also responsible for paying any dividends due on the stocks before he covers them with a purchase. 3. What are the three general types of stock market indicators? Stock market indicators can be classified into three groups: (1) those produced by stock exchanges based on all stocks traded on the exchange; (2) those produced by organizations that subjectively select the stocks to be included in indexes; (3) those where stock selection is based on an objective measure, such as the market capitalization of the company. Chapter 18 1.

Explain the two ways in which an order-driven market can be structured. An order-driven market can be structured in two ways: (1) continuous market, where a trade can be made at any moment in continuous time; (2) call auction, where orders are batched together for a simultaneous execution in multilateral trade at a specific point in time 2. Why is the Nasdaq referred to as a “fragmented market”? Nasdaq is a fragmented market because its stocks can be traded off the exchange. 3. What are the two sections of the Nasdaq stock market? The two sections are the Nasdaq National Market (NNM) and the Small Cap Market. . What are the three parts of the OTC market for stocks? There are three parts to the OTC market: two under Nasdaq and a third market for truly unlisted stocks (which is composed of OTC Bulletin Board and the Pink Sheets). Chapter 26 1. Suppose you bought a stock index futures contract for 200 and were required to put up initial margin of $10,000. The value of the contract is 200 times the $500 multiple, or $100,000. On the next three days, the contract’s settlement price was at these levels: day 1, 205; day 2, 197; day 3, 190. a. Calculate the value of your margin account on each day. b.

If the maintenance margin for the contract is $7,000, how much variation margin did the exchange require you to put up at the end of the third day? c. If you had failed to put up that much, what would the exchange have done? a. Day 1 Price = $205 x 500 = $102,500, Margin = $12,250 Day 2 Price = $197 x 500 = $ 98,500, Margin = $ 8,500 Day 3 Price =$190 x 500 = $ 95,000, Margin = $ 5,000 b. Add $2,000 to meet variation margin requirements on the third day. c. If the margin call was not met, the exchange would have liquidated the position. 2. “The futures market is where price discovery takes place. ” Do you agree with this statement?

If so, why? If not, why not? Agree. This is true when there is a well-developed futures market that is more advantageous to use by market participants for changing their price exposure to an asset. Investors can more easily become involved in the market because the wealth required to participate is relatively small. a. What is meant by open interest? b. Why is open interest important to an investor? a. Open interest is the number of contracts outstanding. It is a measure of the liquidity of the contract and therefore important to portfolio managers who want to implement strategies using the contract 3.

What is meant by an OTC derivative product? Customized derivative products, such as forward contracts, are called Over-the-counter derivatives. 4. What is the major concern with banks creating OTC derivative products? Banks that create OTC derivative products may put themselves in a position that could create severe financial problems. These banks may not have proper risk management systems in place to effectively monitor their risk exposure. Identify and explain the key features of an option contract. The exercise price is the price at which the holder of an option has the right to buy or sell a security.

The expiration date is when the option holder’s right to sell or buy a stock expires. The premium is the price paid for an option. It is the consideration given for a contract, which binds the other party to buy or sell a security, if required. The underlying asset is the item which can be bought or sold by the option holder. 5. What is the difference between a put option and a call option? A put option is the right to sell a security at a specified price within a specified period of time. A call option is the right to buy a security at a specified price within a specified period of time. 6.

What is the difference between an American option and a European option? An American option can be exercised anytime up to the date of expiration. A European option can only be exercised at the time of expiration 7. Explain why you agree or disagree with this statement: “Buying a put is just like short selling the underlying asset. You gain the same thing from either position, if the underlying asset’s price falls. If the price goes up, you have the same loss. ” Buying a put indicates the same intention as short-selling a security. In both cases the speculator hopes to take advantage of a decrease in price of the security.

The effect, however, is different on two counts. First, the short seller is taking a risk that prices may rise, that he may have to purchase the security at a higher price than he sold it. The put option holder’s maximum loss would be the price of the premium should he not exercise the option. Second, leverage also makes a difference. The short seller has to place the entire amount of his sale with the broker as collateral. The put holder has only a small amount invested, i. e. , the premium. Modest price decreases magnify his gains.

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