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current econ issues > week 2: typology > Flashcards

week 2: typology Flashcards

1
Q

What did Robert Shiller say about prices?

A

“Prices are actually very volatile so not an efficient forecast”

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1
Q

In an efficient market what forecasts profit?

A

PRICES

e.g. an increase in prices correlates to stronger demand or weaker supply

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2
Q

how is equity derived from this?

A

cash + fixed assets - loans

what it owns - what it owes!

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3
Q

Suppose a firm has 500 shares outstanding. The book value of each share is what?

A

Book value of each share is:

⭐ Ratio of Equity to the total number of shares outstanding ⭐

⭐ EQUITY/NO. OF SHARES OUTSTANDING ⭐

E.g. here 3000/500 = 6

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4
Q

Suppose by the end of the year, the firm made 1000 in profits, if management of firm distributes profits as dividends (2 per share) the balance sheet will be …?

A

The same as that on Jan 1, 2017

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5
Q

However if firm makes 1000 in profits + firm DOES NOT distribute profit as dividends, what happens to the balance sheet?

A

Cash increases to 2000, so equity is now 4000

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6
Q

What is the new book value of shares now?

A

4000/500 = 8

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7
Q

What are dividends?

A

Dividends are payments made by a corporation to its shareholders as a distribution of profits.

They are typically distributed regularly, usually quarterly, and are a portion of the company’s earnings.

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8
Q

How will the equilibrium price (market value) of shares be determined on Jan 1, 2017 in the competitive stock exchange market?

A

depends on expectations of investors

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9
Q

Case 1: Investors do not anticipate any profits for 2017 & any year after

What happens to book value of share?

A

stays at 6

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10
Q

Case 2: investors anticipate increase in profit by 1000 but no additional future profits & company doesn’t offer dividends

A

Market price of each share is now 8

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11
Q

Case 3: investors anticipate increase in profit by 1000 but no additional future profits PLUS company offers dividends

A

Market price of each share is now **8 + dividend **

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12
Q

What is the famous Modigliani - Miller theorom?

A

Shows that in markets without friction, the value of the firm is the firm’s capital structure + dividend policy.

Note: when investors fully anticipate the profits generated in 2017, competition ensures that the market price immediately adjusts on Jan 1st.

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13
Q

The above cases are a simple demonstration of the __________ Hypothesis?

A

Efficient Market Hypothesis - prices provide a forecast for profits

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14
Q

What is the random walk model?

A

“The best predictor of tomorrow’s price is today’s price”

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15
Q

What is the formula for the random walk model?

A

P(t+1) = P(t) + ε(t)

ε(t): errors that are independently distributed across time + drawn from a normal distribution with mean 0

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16
Q

Explain the random walk model in detail

A

Randomness: Imagine taking a walk where each step you take is random. You might take a step forward, then two steps back, then sideways, and so on. In the same way, the random walk model suggests that the movement of prices or values in financial markets is unpredictable and can go in any direction without following a specific pattern.

Independence: In a random walk, each step you take is independent of the previous step. For example, the direction you go in the next step is not influenced by the direction you went in the previous step. Similarly, in the financial context, future price movements are considered independent of past movements. This means that just because a stock went up yesterday, it doesn’t mean it will go up again today.

Efficiency: The random walk model assumes that financial markets are efficient, meaning that all available information is already reflected in current prices. This implies that there are no “undervalued” or “overvalued” assets because all relevant information is already priced into the market. Therefore, future price movements cannot be predicted based on past information or patterns

In essence, the random walk model suggests that the best forecast for the future price of an asset is its current price, as future movements are unpredictable and random. This concept has important implications for financial markets and investment strategies

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17
Q

What is a random walk with growth?

A

It’s where asset returns are normally distributed w mean μ (drift) and variance σ^2 (volatility)

asset returns follow a random walk pattern with a consistent trend or growth component. The returns are normally distributed around the mean with a certain level of variance or volatility, representing the randomness and uncertainty in the movement of asset prices over time.

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18
Q

What are asset returns?

A

Asset returns refer to the change in value of an investment or asset over a specific period of time, typically expressed as a percentage. It represents the gain or loss experienced by an investor from holding an asset during that period.

For example, if you purchase a stock for $100 and it increases in value to $110 over one year, the asset return would be 10%

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19
Q

As random processes are displayed on a normal bell curve with thin tail distribution, what does this say about results?

A

Unlikely to see extremes as most results will be covered within 2 standard deviations

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20
Q

What would we call μ in the model?

A

Drift, this would be 0

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21
Q

What would we call variance σ^2 in the model?

A

Volatility, this would be 1

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22
Q

What are ‘fat tails’ or excess volatility?

A

In summary, “fat tails” or excess volatility refer to the observation of more extreme movements in financial markets compared to what would be expected based on theoretical models like the normal distribution

suppose, we plot the monthly movements of the Dow Jones index on a chart according to their frequency

  • Theoretical models predict the plot would follow the Bell Curve
  • The actual plot would show much less clustering around the average & many more extreme movements.
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23
Q

If the movements followed the normal distribution

A

An annual decline of greater than 10% would happen once ** every 500 years**

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24
Q

In the Dow Jones, an annual decline of greater than 10% it has happened once every _____ years

A

5 years

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25
Q

If the movements followed the normal distribution, Declines of 20%+ would be extremely unlikely but in fact there were _ such crashes during the past century.

A

9

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26
Q

These observations of fat tails contradict the predictions of the …

A

efficient market model

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27
Q

Wat does this mean

A
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28
Q

What is the fundamental principle of optimal forecasting?

A

The forecast must be less variable than the variable forecasted.

forecast in this case: p(t)
variable forecasted: p(t+1)

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29
Q

If this is a good forecasting model, the variance of the forecast profits/the price of tomorrow will be ________ than the forecast today.

A

much smaller

30
Q

Liquid assets are?

A

Cash OR government bonds that can be traded into cash immediately

31
Q

How does the bank make profit?

A

Takes your money and makes loans + mortgages

32
Q

How to calculate equity?

A

Assets - Liabilities

33
Q

What happened in 2008 in Scotland?

A

Bankruptcy

34
Q

Companies vs Banks what is the difference in Liabilities?

A

Companies: Liabilities NEVER higher than (equity) 50% of assets - cannot borrow any more

Banks: Liabilities can be higher than 50%

35
Q

For apple to become insolvent, the value of its assets must decrease by…?

A

50%

36
Q

How to calculate leverage ratio?

A

Liabilities/Equity

Apple LR: 1
RBS: 19

37
Q

What is another risk on a bank’s balance sheet?

A

Illiquidity

38
Q

What is illiquidity?

A

They don’t have enough reserves

It is not bankrupt - they have more than enough assets to cover the value of deposits.

but if all depositors go at the same time to withdraw at the bank, the bank will NOT have enough money.

39
Q

If illiquidity is the only problem, what can governments do to fix it?

A

Government can intervene to create extra liquidity through various methods.

40
Q

Why might people withdraw their deposits at the same time?

A

Speculation and worries

41
Q

What is a demand deposit?

A

Depositors have the right to go to the bank and demand for money any time they want.

42
Q

Draw the general equillibrium model for bank panic

A
43
Q

you have deposited X at the bank. bank offers an interest rate r on the account, you need to decide whether or not to go and withdraw your funds. What should you do if everyone decides to stay?

A

You stay too

44
Q

you have deposited X at the bank. bank offers an interest rate r on the account, you need to decide whether or not to go and withdraw your funds. What should you do if everyone decides to go?

A

RUN!

45
Q

Why might a bank become insolvent? [2]

A
  1. RUMOURS that a bank might be in risk of becoming insolvent can lead to a bank run - causing the bank to become insolvent.
    [SELF FULLFILING PROPHECY]
  2. LIQUIDITY PROBLEMS - when a bank faces liquidity problems it needs to liquidate (sell) some of its assets so that it can satisfy demand for funds by depositors.

Some of these assets are loans to households + firms, which the bank has better info than outsiders

– due to this asymmetrical information, bank may sell these assets at prices below their book value - causing the bank to become insolvent

46
Q

What is contagion?

A

When a bank becomes insolvent (negative equity) it cannot fulfil all its obligations to its creditors including other banks, and in turn might affect the solvency status of those other banks

47
Q

Banks that require more liquidity can borrow funds from …?

A

other banks that have excess liquidity

48
Q

Banks sharing liquidity can create a complex _________

A

Interbank network

49
Q

If the financial system is in trouble, the existence of the interbank network can have serious implications about size of systemic losses - we have to worry about ____________.

A

Systemic risk

50
Q

If the financial system is in trouble + too many banks are liquidated, there are ____________ willing to buy their assets

A

fewer buyers

51
Q

Why might fewer buyers wish to buy assets if too many banks are liquidated?

A

Not only that

  1. These assets may be problematic but also
  2. Other potential buyers might be banks that also face liquidity problems

THEREFORE, prices of these assets dramatically decline (fire sales) causing problems to other banks + thus further boosting size of systemic losses

52
Q

What are fire sales?

A

When asset prices decline dramatically

53
Q

What is a systemic loss?

A

A systemic loss refers to the overall loss in the financial system that can result from a domino effect triggered by the failure of one or more financial institutions.

It’s called “systemic” because the loss spreads throughout the system, affecting multiple institutions and potentially the entire financial market.

e.g., Lehman brothers were v. well connected w other banks

54
Q

Why might systemic loss occur in the first place?

A

Due to the interconnectedness of financial institutions, especially in situations like bank runs, where the insolvency of one bank can lead to a chain reaction of insolvencies in other banks.

55
Q

For many currencies, the ER against other currencies are ________

A

Flexible (freely determined by market forces)

56
Q

Historically, many gov decided to keep ER of their currency ___________

A

pegged (against some other currency)

57
Q

Reasons for pegging the ER of a currency to another?

A

Reduction in ER uncertainty (inc. investors) + gaining credibility.

58
Q

Aim of Central Bank is to avoid a __________ of the currency.

A

depreciation

59
Q

When demand for currency is weak what does the central bank do?

A

CB uses its international reserves to buy it in the FEX and support the peg.

60
Q

*Suppose there’s a bond originally priced at $100 with an interest rate of 3%. *

This means at the end of the term, it will yield $103.

However, if the general market interest rate rises to 5% what happens to the bond?

A

The bond becomes less attractive since potential buyers can get $105 with the same $100 investment elsewhere.

61
Q

To make the bond more appealing, what can the bond issuer do?

A

The price can be lowered, e.g to $98. Now, if a buyer purchases this bond for $98, they will still receive $103 at the end of the term, effectively getting a return rate of approximately 5.1%, making the bond competitive with the market again.

62
Q

What happened in california when the bank invested lots into government bonds?

A
  1. Bank invested a lot in gov bonds
  2. Interest rate went down
  3. Prices went down of bonds

→ bank made huge losses

This bank happened to be huge and lent other financial institutions.

so Investors decided to withdraw in mass and bank was taken down.

63
Q

How many Bahts does Thailand CB need to buy to keep their exchange rate pegged? draw

A

They artificially keep the price high, but in order to do that you need lots of foreign reserves.

64
Q

Suppose, the central bank pegs the exchange rate but has limited reserves.

You are a trader that holds baht + consider if you should exchange them for $.

  • There is a transaction cost c for currency conversion.

What will happen to your payoff?

A

Depends on what every other identical trader does.

65
Q

If the CB has insufficient reserves to support the peg (all traders sell their baht).

The CB does what?

A

The CB abandons the peg and devalues the currency

So each trader is able to make a profit v by converting $ → baht again.

66
Q

If all traders decides to hold you _______

A

you hold too

67
Q

If all traders decide to sell? You ______

A

You sell too

Successful Speculative attack!

68
Q

What are twin crises?

A

combinations of banking AND currency crises

69
Q

Define Maturity mismatch

A

Maturity Mismatch:

Banks usually borrow short-term (deposits, interbank loans) but lend long-term (loans to firms, mortgages)

Occurs when a bank’s debts are due before its assets can generate returns, potentially causing liquidity issues.

e.g, if foreign lenders withdraw loans and banks must sell assets to meet demands, they may not raise enough funds.

This is due to assets being valued in domestic currency, and the conversion to the foreign currency of the loans may result in a shortfall due to unfavorable exchange rates.

70
Q

What is currency mismatch?

A

Currency mismatch:

In many countries, banks also borrow in foreign currencies while they lend in the domestic currency.

71
Q

Such mismatches can significantly _______ the ____________ of a currency crises.

A

such mismatches can significantly increase the economic costs of a currency crises.

72
Q

Maturity mismatch can lead to what type of problems?

A

Liquidity problems.

E.g if foreign lenders suddenly stop providing loans, banks may need to liquidate their assets to meet the demand of foreign creditors.

Given that these assets are denominated in the domestic currency, converting the liquidation proceeds into currency of foreign loans may not yield enough foreign funds to repay these loans.

current econ issues (8 decks)

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