Economics of Financial Markets Unit 2

Question 1

Name the Determinants of Asset Demand:

Answer 1

Wealth: the total resources owned by the individual, including all assets

Expected Return: the return expected over the next period on one asset relative to alternative assets

Risk: the degree of uncertainty associated with the return on one asset relative to alternative assets

Liquidity: the ease and speed with which an asset can be turned into cash relative to alternative assets

Question 2

Explain the Theory of Portfolio Choice:

Answer 2

Holding all other factors constant:
The quantity demanded of an asset is positively related to wealth

The quantity demanded of an asset is positively related to its expected return relative to alternative assets

The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets

The quantity demanded of an asset is positively related to its liquidity relative to alternative assets

Question 3

Liquidity Premium Theory

Answer 3

we prefer to be as liquid as possible so if an asset is less liquid there will be a higher premium; best reason for why yield curve slopes upward

Question 4

Gordon Growth Model

Answer 4

P= D(1+g) / (k-g)

D= most recent dividend paid
g= the expected constant growth rate in dividends
k= interest rate needed

Question 5

Tax Equivalent Yield Formula

Answer 5

TEY= Cm/(1-t)

Cm= coupon rate on municipal bond
t= tax bracket

Question 6

LOOK AT HW SUPPLEMENT

Answer 6

LOOK AT FORMULAS THAT ARE IMPORTANT.

Question 7

Factors that will shift the Supply Curve for bonds? (and in which direction with an increase/decrease).

Answer 7

a. Expected profitability of investment opportunities: in an expansion, the supply curve shifts to the right (to gear up for production)
b. Expected inflation: an increase in expected inflation shifts the supply curve for bonds to the right
c. Government budget: increased budget deficits shift the supply curve to the right

Question 8

factors that determine and shift the demand for money;

Answer 8

• Income Effect: a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right.
• Price-Level Effect: a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right.

Question 9

factors that determine and shift the supply for money

Answer 9

Changes in the Money Supply: When the money supply increases (everything else remaining equal), interest rates will decline

Question 10

What is the Fisher Effect?

Answer 10

ir=in -iie

• Inflation has an effect on the real interest rate
• When expected inflation rises, interest rates will rise.

Question 11

Liquidity management

Answer 11

maintaining sufficient reserves to protect against deposit outflows

Question 12

Asset management

Answer 12

seeking the highest possible returns on loans and securities, while simultaneously making adequate provision for liquidity

Question 13

Liability management

Answer 13

the acquisition of deposits at low cost in order to increase profits

Question 14

Capital adequacy management

Answer 14

meeting the regulatory requirement, protecting against loan losses, while at the same time maximizing returns to shareholders

Question 15

Credit risk management

Answer 15

minimizing the probability that borrowers will default

Question 16

Interest-rate risk management

Answer 16

reducing the bank’s exposure to dramatic swings in profitability with fluctuations in interest rates.

Question 17

Board of Governors

Answer 17

responsible for the overall operation of the Federal Reserve System and the general direction of monetary policy.

Question 18

Federal Open Market Committee

Answer 18

makes decisions regarding the conduct of open market operations and the federal funds rate

Question 19

District banks

Answer 19

make discount loans and provide operational support to member banks

Question 20

Member banks

Answer 20

are required to maintain reserves and have the ability to borrow through the discount window

Question 21

Federal Advisory Council

Answer 21

provides information to District banks as to regional economic and business conditions in their districts

Question 22

Keynes liquidity preference framework.

Answer 22

determines the equilibrium interest rate in terms of the supply of and demand for money.

Bs + Ms = Bd + Md

Question 23

Bonds with the same maturity have different interest rates due to:

Answer 23

o Default risk: probability that bond will not be repaid at maturity
o Liquidity: how easily the bond is convertible to cash (some bonds are easier/more difficult to sell)
o Tax considerations: interest rate on municipal bonds are tax-free

Question 24

against what standard is this risk for bonds measured?

Answer 24

bond Ratings by Moody’s Standard and Poor’s, and Fitch

-Ba1 and below is quite risky

Question 25

What can a slowly upward sloping starting from the bottom yield curve can tell you?

Answer 25

it can tell you the following: 
Current short-term int. rates are Low 
Monetary Policy is Expansionary 
Output is currently below potential
Unemployment is above NR
Inflation is low

Question 26

What two ways in which investors formulate their beliefs about future stock prices.

Answer 26

Adaptive expectations: expectations are formed from past experience only
rational information: expectations will be identical to optimal forecasts using all available information

Question 27

What are Liabilities?

Answer 27

Source of funds,
o	Checkable deposits
o	Nontransaction deposits
o	Borrowings
o	Bank Capital

Question 28

What are Assets?

Answer 28

Use of funds
o	Reserves(*vault cash), loans, securities, deposits at other banks.

Question 29

Efficient Market Hypothesys

Answer 29

will tell you hot tips never work, •In an efficient market, a security’s price fully reflects all available information

Question 30

portfolio diversification

Answer 30

1950 marcuwitz and won a nobel price

Question 31

Asset transformation:

Answer 31

• Take liabilities and turn it into income
• the process of creating a new asset (loan) from liabilities (deposits) with different characteristics by converting small denomination, immediately available and relatively risk free bank deposits into loans- new relatively risky, large denomination asset- that are repaid following a set …

Question 32

Calculate Return on Assets

Answer 32

ROA=Net income(after tax)/Total Assets

Question 33

Calculate Return on Equity

Answer 33

ROE=Net income(after tax)/Total Equity

the net profit after taxes per dollar of equity (bank) capital:

Question 34

Calculate GAP and Duration

Answer 34

change in profits = (rate-sensitive assets - rate-sensitive liabilities) x change in interest rates

Question 35

Calculate Capital Ratio:

Answer 35

Book says formula is: Total equity capital/ Total Assets

Regulatory Level = 10% of Total Assets =
Total Assets x .10