chapter 8 and 9: practice theory questions

Question 1

Give at least three examples of a situation in which financial markets allow consumers to better time their purchases

Answer 1

● The purchase of a durable good, like a car or furniture

● Paying for tuition

● Paying the cost of repairing a flooded basement

In all three cases, consumers were able to pay for a good or service without having to wait to save enough and only then being able to afford such goods and services

Question 2

Suppose that Toyota sells yen-denominated bonds in Tokyo. Is this debt instrument considered a Eurobond?

How would your answer change if the bond were sold in New York?

Answer 2

If the yen-denominated bond is sold in Tokyo, then it is not considered a Eurobond

If the bond is sold in New York, then it is considered a Eurobond

Question 3

What is the difference between a mortgage and a mortgage-backed security?

Answer 3

Mortgages are loans to households or firms to purchase housing, land, or other real structures, where the structure or land itself serves as collateral for the loans

Mortgage- backed securities are bond-like debt instruments that are backed by a bundle of individual mortgages whose interest and principal payments are collectively paid to the holders of the security

when an individual takes out a mortgage, that loan is bundled with other individual mortgages to create a composite debt instrument, which is then sold to investors

Question 4

A significant number of European banks held large amounts of assets as mortgage- backed securities derived from the U.S. housing market, which crashed after 2006. How does this demonstrate both a benefit and a cost to the internationalization of financial markets?

Answer 4

The international trade of mortgage-backed securities is generally beneficial in that the European banks that held the mortgages could earn a return on those holdings while providing needed capital to U.S. financial markets to support borrowing for new home construction and other productive uses. In this sense, both European banks and U.S. borrowers should have benefited

However, with the sharp decline in the U.S. housing market, default rates on mortgages rose sharply, and the value of the mortgage-backed securities held by European banks fell sharply

Even though the financial crisis began primarily in the United States as a housing downturn, it significantly affected European markets; Europe would have been much less affected without such internationalization of financial markets

Question 5

How can the adverse selection problem explain why you are more likely to make a loan to a family member than to a stranger?

Answer 5

Because you know your family member better than a stranger, you know more about the borrower’s honesty, propensity for risk-taking, and other traits

There is less asymmetric information than with a stranger and less likelihood of an adverse selection problem

Question 6

Why do loan sharks worry less about moral hazard in connection with their borrowers than some other lenders do?

Answer 6

Loan sharks can threaten their borrowers with bodily harm if borrowers take actions that might jeopardize their paying off the loan

Hence, borrowers from a loan shark are less likely to increase moral hazard

Question 7

If there were no asymmetry in the information that a borrower and a lender had, could a moral hazard problem still exist?

Answer 7

Yes, because even if you know that a borrower is taking actions that might jeopardize paying off the loan, you must still stop the borrower from doing so

Because that may be costly, you may not spend the time and effort to reduce moral hazard, and so the problem of moral hazard still exists

Question 8

Why might you be willing to make a loan to your neighbour by putting funds in a savings account earning a 5% interest rate at the bank and having the bank lend her the funds at a 10% interest rate rather than lend her the funds yourself?

Answer 8

Because the costs of making the loan to your neighbour are high (legal fees, fees for a credit check, and so on), you will probably not be able earn 5% on the loan after your expenses even though it has a 10% interest rate

You are better off depositing your savings with a financial intermediary and earning 5% interest

In addition, you are likely to bear less risk by depositing your savings at the bank rather than lending them to your neighbour

Question 9

How can the provision of several types of financial services by one firm be both beneficial and problematic?

Answer 9

Financial firms that provide multiple types of financial services can be more efficient through economies of scope

it can also lead to conflicts of interest, in which the financial firm provides false or misleading information to protect its own interests

This can lead to a worsening of the asymmetric information problem, making financial markets less efficient

Question 10

Why would a life insurance company be concerned about the financial stability of major corporations or the health of the housing market?

Answer 10

Most life insurance companies hold large amounts of corporate bonds and mortgage assets

poor corporate profits or a downturn in the housing market can significantly adversely affect the value of asset holdings of insurance companies

Question 11

Financial regulation is similar, but not exactly the same, in industrialized countries. Discuss why it might be desirable—or undesirable—to have the same financial regulation across industrialized countries

Answer 11

This is a topic for which there is no clear answer

On one side, it would be beneficial to have financial regulations that are identical in all countries to avoid financial markets participants migrating their business to countries with fewer regulations

On the other side, all countries are different, and designing a common set of financial regulations seems to be a rather difficult task

Most countries would want to maintain at least part of their regulations, so consensus is difficult to reach

Question 12

For each of the following countries, identify the single most important (largest) and least important (smallest) source of external funding:

Canada

United States

Germany

Japan

Comment on the similarities and differences among the countries’ funding sources.

Answer 12

For each country, the largest (most important) is listed first, and smallest (least important) is listed second

United States: nonbank loans, stocks

Germany: bank loans, bonds

Japan: bank loans, stocks

Canada: bank loans, stocks

For the United States, bank loans are relatively unimportant, but for the other countries, this makes up a very large part of overall external financing

For these countries (with the exception of the United States), stock and bond financing are relatively unimportant

Question 13

Explain why dating can be considered a method to solve the adverse selection problem

Answer 13

When a couple dates, they are (explicitly or implicitly) extracting information about the significant other. At the same time, they are sharing information about themselves

This information flow helps both individuals to make better decisions about a probable (or not) future life together

In this way, one can think that this process is formally no different from the one in which the loan officer tries to choose the right borrower

Question 14

Suppose you go to your local bank, intending to buy a certificate of deposit with your savings.

Explain why you would not offer a loan, at an interest rate that is higher than the rate the bank pays on certificates of deposit (but lower than the rate the bank charges for car loans), to the next individual who enters the bank and applies for a car loan.

Answer 14

During your visit at the bank, you will probably realize that you will receive an annual interest rate of 1% or 2% if you buy a certificate of deposit, while an individual asking for a car loan will be required to pay an annual interest rate of 7% or 8%

At the beginning, it seems tempting for you to offer an interest rate of 4%, which would make both of you better off

However, you would probably like to know that individual better, in particular, his net worth (to assess his ability to pay you back), or his credit history (has he or she defaulted on a loan before?). This process will probably be time-consuming and costly for you

Your local bank is much more efficient in dealing with the adverse selection and moral hazard problems created by asymmetric information, so much so that you are better off by buying a certificate of deposit and avoiding all the transaction costs associated with making a loan

Question 15

Suppose you have data about two groups of countries, one with efficient legal systems and the other with slow, costly, and inefficient legal systems.

Which group of countries would you expect to exhibit higher living standards?

Answer 15

One would expect the group of countries with more efficient legal systems to exhibit higher living standards

Legal systems are an important part of the lending process, precisely because they are part of the mechanisms of enforcement of contracts that deal with the moral hazard problem

Costly, slow, and inefficient legal systems do not promote lending and thereby funding of investment opportunities

basically, the one with an efficient legal system

Question 16

Would you be more willing to lend to a friend if she had put all of her life savings into her business than you would be if she had not done so?

Why?

Answer 16

Yeeeee

The person who is putting her life savings into her business has more to lose if she takes on too much risk or engages in personally beneficial activities that don’t lead to higher profits

Question 17

How can asymmetric information problems lead to a bank panic?

Answer 17

bank depositors do not know as much as bank managers do about how much risk banks are taking

they are uncertain about the safety of their deposits and their banks’ ability to pay them back in full

If some banks fail because they have become insolvent and cannot repay their deposits, these bank failures increase the uncertainty facing all depositors, who lack the information needed to determine whether their banks (and their deposits) are safe or not

This increase in uncertainty, the result of asymmetric information, can lead to bank runs in which depositors are scrambling to withdraw their deposits before their banks run out of cash

Question 18

How does the free-rider problem aggravate adverse selection and moral hazard problems in financial markets?

Answer 18

The free-rider problem means that private producers of information will not obtain the full benefit of their information-producing activities, and so less information will be produced

there will be less information collected to screen out good from bad risks, making adverse selection problems worse

there will be less monitoring of borrowers, increasing the moral hazard problem

Question 19

How do standardized accounting principles help financial markets work more efficiently?

Answer 19

Standardized accounting principles make profit verification easier

this reduces adverse selection and moral hazard problems in financial markets, hence making them operate better

make it easier for investors to screen out good firms from bad firms, thereby reducing the adverse selection problem in financial markets

they make it harder for managers to over- or understate profits, thereby reducing the principal–agent (moral hazard) problem

Question 20

How can the existence of asymmetric information provide a rationale for government regulation of financial markets?

Answer 20

Because there is asymmetric information and the free-rider problem

not enough information is available in financial markets

government encouragement to produce information will reduce asymmetric information

by enforcing standard accounting principles and prosecuting fraud, moral hazard will be reduced

Question 21

Explain how the separation of ownership and control in Canadian corporations might lead to poor management

Answer 21

The separation of ownership and control creates a principal–agent problem

the managers (the agents) do not have as strong an incentive to maximize profits as the owners (the principals)

the managers might not work hard, might engage in wasteful spending on personal perks, or might pursue business strategies that enhance their personal power but do not increase profits

Question 22

Gustavo is a young doctor who lives in a country with a relatively inefficient legal and financial system. When Gustavo applied for a mortgage, he found that banks usually required collateral for up to 300% of the amount of the loan.

Explain why banks might require that much collateral in such a financial system.

Comment on the consequences of such a system for economic growth.

Answer 22

Financial intermediaries operating in countries with relatively weak property rights and legal systems usually require a lot of collateral when making loans

in the event that the borrower defaults, the bank knows that it will be quite difficult and expensive to recover its loan

requesting extra collateral might help the bank speed up the process

a bank that has requested two other houses as collateral for a mortgage has better chances to recover its loan in the event of default

fewer individuals will have access to mortgages (even those with excellent credit risk are left out)

Inefficient financial systems make access to credit much more difficult in some countries, but it is fair to say that this might be the result of inefficient legal systems