Finance Topic 7

Question 1

any rate comprises of….
how are interest rates set ?

Answer 1

1. rate of pure time preference
2. inflation premium (if nominal)
3. risk premium (if not risk free)

-up to lenders/inv = assess risk premium level req by reference to risk being asked to take
market = expectations regarding inflation

Question 2

where does risk free rate come from?

Answer 2

rate of pure time preference (nominal or real)
Rf in CAPM

Question 3

UK role of Bank of England
Monetary Policy Committee (MPC) of BOE

Answer 3

meet month = set base rate
deciding whether to raise/lower considers:
-inflation/inflation target
-eco growth, employment
-currency ER price of imports/exports

-operation and decisions = autonomous and independent of HM treasury

Question 4

base rate

Answer 4

rate banks can obtain short term (overnight) secured lending from BoE

Recently - historically low, pushing up base rate in response to inflation

Question 5

impact of base rate changes

Answer 5

changes = quickly reflected in all rate/req yields across economy

-asset/project and firm values (changes in discount rate)
-cost of capital
-propensity for inv in different asset classes
-exchange rate

Question 6

quantitative easing

Answer 6

low base rate - longer term rates remain higher than desired

attempt by BoE directly to downwards influence LT rates & stimulate inv in real economy
involves BoE entering bond mkt to buy back long term bonds = raise market price
reduce GRY
some inv & firms will sell, liberate cash, look for higher return inv
sums involved = highly economically significant
advocates - satisfied QE worked/working critics see as an akin to printing money & inviting inflation

Question 7

relationship between interest rates and exchange rates

Answer 7

expected future exchange rates = linked to current ER, and risk free interest rates in jurisdictions concerned

Question 8

flow of funds in a financial system

Answer 8

invests/lenders/savers (SURPLUS SECTOR) -> financial mkt -> need funding borrowers (DEFICIT SECTOR)
(direct finance)

include financial intermediaries (indirect finance)

Question 9

financial intermediaries

Answer 9

-act on behalf of….
-lenders/borrowers (agency broker)
-just themselves (agency dealer)

roles (transformations)
-asset (maturity/provision of liquidity & size & risk
-transaction costs
-info (mitigating moral hazard and adverse selection)

Question 10

Types of financial intermediaries

Answer 10

1. deposit taking/bank FI (BFIs)
   -retail & commerical banks
   -investment (wholesale/merchant)
   -universal banks
2. non deposit taking/non bank FI (NBFIs)
   -finance houses
   -building societies
   -pension funds
   -insurance companies (general & life)
   -unit trusts

Question 11

NBFIs

Answer 11

-finance ST & LT expenditure
-finance Lt contingent claims/retirement pension
-finance general contingent claims
-facilitates risk spreading and pool of savings

Question 12

BFI - banks

Answer 12

bank - accepts deposits and channel those desposits into lending activities (directly or through capital mkts)

process of linking capital deficit units to capital surplus units

Question 13

Types & classifications

Answer 13

1. retail (high street) & commercial banks
   -traditional (personal/business deposits and turn into personal and business loans)
2. inv (wholesale)
   -raising funds in wholesale money and capital mats for large corporations and gov
3. universal
   -retail commercial and inv banking services

Question 14

retail (small) commercial banking

Answer 14

-households & small business
-deposit taking & loan granting
-aggressive monitor & manage cash to deposit ratio = meet likely withdrawals or req liquidity on continuous basis
-large volume = low value
-heavy regulation
-dense geographic presence

Question 15

services/products provided by retail/commercial banking

Answer 15

1. deposit taking/bank acct
2. lending
3. advisory
4. payments/clearance/cash
5. insurance/pension schemes
6. custodian/safe keeping

Question 16

investment/wholesale banking

Answer 16

-medium/large companies, institutional inv, local/central gov
-involve provision retail banking but gov institutions usually at negotiated rates
-no direct deposits from public
-low volume = high value
-less regulated
-strategic geographic presence

Question 17

investment/wholesale banking products and services

Answer 17

• Corporate (or governmental) finance
  – raising capital, equity, debt or hybrid
  – Originating and underwriting IPOs and bond issues
  – Large (sometimes syndicated) corporate loans … merchant banking – Project finance – Innovative Products
  – Securitisation, collateralised debt obligations (CDOs), credit default swaps (CDSs), etc. – Sovereign lending – granting loans to local and central governments and government agencies
• Asset management or private banking
• – Personalised banking, investment and financial services offered to individuals with sizeable wealth
• Trade/export finance
  – Guarantees, bills of exchange and letters of credit (LOC) to facilitate international trade
• Agency and brokerage
  – Buying and selling securities on behalf of clients
• Financial asset trading(so-called ‘casino operations’)
• – Market-making – purchase and sale of derivatives for profit-making and risk management, stocks, bonds, commodities, foreign exchange, etc.
• Advisory and research

Question 18

reasons for financial intermediation

Answer 18

problems with direct financing
1. different needs/desires of lenders & borrowers
2. transaction costs
3. problems arising from info asymmetries

Question 19

direct financing

Answer 19

direct exchange of securities between surplus unit and deficit units
direct connection of borrowers and lenders to financial mkt without financial intermediary

Question 20

direct financing

Answer 20

direct exchange of securities between surplus unit and deficit units
direct connection of borrowers and lenders to financial mkt without financial intermediary

Question 21

different needs of lenders/borrowers

Answer 21

Borrowers = securities with long-term maturities (low liquidity), low returns and high risks & borrow large sums

Lenders/investors would like to buy securities with short- term maturities (high liquidity), high returns and low risks & only be able to grant loans in smaller sums

Question 22

4 types of transaction costs

Answer 22

1. Search costs - finding potential lending/investment opportunities, obtaining information about them and negotiating terms
2. Verification costs - evaluating borrowing proposals
3. Monitoring costs - monitoring actions of borrowers to ensure compliance with the terms of the loan contract
4. Enforcement costs - Mechanisms to enforce the contract if borrowers fail to meet terms of the loan contract or agreement

Question 23

Problems arising from info asymmetries

Answer 23

1 party to a transaction has more info than other
borrower = more info about risks/potential returns/initiative for which funds are being sought
= problems for lender before deciding to make the loan at verification stage & monitoring and enforcement stages

Question 24

2 main problems of info asymmetry

Answer 24

both decrease supply of loans and increase costs of loans
1. adverse selection
-search/verification stage
-lender is selecting among potential borrowers
-selecting a potential borrower who is likely to default, i.e., a ‘bad risk’.
-lenders may decide reduce or curtail lending, even though there borrowers with good credit risks in the market

2. moral hazard
   -both before and after a loan has been granted
   -borrower may wilfully misrepresent the circumstance surrounding the loan before the loan is granted
   -borrower may engage in activities that are undesirable from the lender’s point of view after the loan has granted = make it less likely that the loan will be repaid Individuals and firms tend to take more risks when using borrowed funds rather than their own funds

Question 25

process of financial intermediation

Answer 25

1. asset transformation
   -transformation of maturity and provision of liquidity
   -size
   -risk
2. transaction costs transformation
3. information transformation

Question 26

asset transformation

Answer 26

1. maturity & provision of liquidity
   -On av liabilities of intermediaries (banks) = shorter term maturities than their assets
   -Transform short maturing liabilities (deposits) to long maturing assets (e.g., mortgages, commercial term loans)
   -Transform high liquidity liabilities (on demand deposits) to low liquidity assets (e.g., 30-year mortgage)
   -borrow ‘short’, but lend ‘long’
   -Mismatching = liquidity risks
2. size * FI = put together smaller deposits of lenders and parcel them into larger loans required by borrowers
   existence of EOS enable FI to reduce unit transaction costs
3. risk
   Transform extremely low risk and high liquid liabilities (on demand deposits) into high risk and illiquid assets (mortgages, term loans, etc.) by …
   Deploying specialised expertise in risk analysis to screen out bad risks
   Pooling and diversifying risks (i.e., lending to different types borrower
   Holding sufficient capital to meet any unexpected losses and still honour obligations to depositors

Question 27

transaction cost transformation

Answer 27

• Through economies of scale and specialism: Reduce search, verification, monitoring and enforcement costs
• Provide a convenient, safe location/forum in which to transact
• Develop and use standardised forms for bonds, term loans, mortgages, account services, etc.
• Create tax efficient financial instruments

Question 28

information transformation

Answer 28

• Reduce adverse selection by …
• Selecting less likely defaulters using credit rating and private information * Taking collateral (e.g., charge security)
• Reduce moral hazard …
• Expertise in evaluation of borrowers
• Restrictive covenants with borrowers
• Monitoring expertise, capabilities and capacity
• No free-rider problems – single lender (bank) responsible for monitoring