ECS3701 EXAM PACK
QUESTIONS WITH
ANSWES
1
,OCTOBER/NOVEMBER 2014
Question 1
1.1 Bond attracts interest as return
stock attracts dividends as return.
1.2 They have expertise thus they can detect and prevent adverse selection.
-they have economies of scale
1.3 –to protect depositors
-to detect investors
-to prevent financial crisis.
1.4 money market is market for short-term funds eg TB
-capital market is a market for long term funds eg stock
1.5 M2 = -Is a broader definition of money
M1 plus deposits which are
-cash/currency
+cheque and transmission deposit near money
+demand deposit- consists of short-term and medium
+other short term deposits eg saving deposits, share investments
1.6 1/r = 1/0.05 = 20
1.7 5 advantages of inflation targeting
-Simple and easy
-does not rely on stable relationships between M and P;uses information inclusive
approach
-increased accountability of central bank; smaller likelihood to fall into time
inconsistency traps; less political pressure on central bank
-reduced effects of inflationary shocks; IT has good record to cut inflation.
1.8 store of value
-medium of exchange
-standard of differed payments
2
,1.9 Real interest has no inflation element
-nominal are not inflation adjusted
1.10 A financial crisis is a situation in which value of financial institutions or assets
drops rapidly due to worsened adverse selection and moral hazards.
1.11 Assets- bank loans
-Reserves
Liabilities- cheque and transmission deposits
-capital
1.12 Interest rate risk refers to the risk that is faced by bond owners from fluctuating
interest rates depending on the time to maturity and coupon rate.
1.13 Calculating return on a bond
Return on a bond is the total return on a bond by an investor over a specific time
period t to t+1.
R = C + Pt + 1-Pt
Pt
Where R = is return from holding a bond from t to time tt1
P =Price of a bond
C= Coupon payment
Question 2
2.1 Explain how lemons problem might arise
The presence of the lemons problem makes securities markets (debt and equity)
ineffective in channeling funds from savers to borrowers. Investors can not
distinguish between good firms (high profits and low risk), and bad firms (low profits
and high risk) due to lack of information. Owners of firms have better information
and are willing to sell securities for only an average price (or they require a higher
interest rate) because only bad firms investors will therefore be willing to sell
securities, investors will be unwilling to buy securities.
The lemons problem will disappear if the asymmetric information problem (adverse
selection) can be eliminated by the supply of accurate information. Private
companies can collect and produce information and sell it to investors. Firms like
Standard &Poor, Moodys etc sell information to subscribers.
This does not completely solve the problem due to the free rider problem (people
who do not pay, but take advantage of the information.
3
, -the free free riders can simply behave similar to those that have purchased the info.
Because prices of good firms are bid up,the advantage of buying at a lower price
disappears.
Financial intermediaries are usually experts in producing information about firmsand
are therefore well equipped to sort good credit risks from bad ones,people will also
be willing to buy securities with a financial intermediary “guarantee”
Governments may encourage firms to revel honesty information eg by independent
audits. However, problems like the Enron implosion may still occur (false reporting,
debt and financial contracts were kept off its balance sheet). Thus government
regulation may lesson the problems of asymmetric information, but it can not
eliminate them.
2.2 Asset price bubble means that the price of an asset, such as housing stocks or
gold, become over inflated over a short period of time and are not supported by
underlying demand for the product itself.
The bursting of a bubble can cause a financial crisis because the highest prices will
end up being unsustainable and no one buys overvalued stock as such prices will
drop drastically causing massive capital losses and worsening adverse selection
and moral hazard and resulting in financial crisis.
2.3 Assumptions of expectation theory
-long term rates are all averages of short term rates
-bonds are perfect substitutes
-No interest rate risk
Predictions of Expectations theory
- If short term interest rates are low then the long term rates are expected to be
higher.yield curve slopes upwards.
- If the average of short term rates is higher then the long term rates will be low
thus inverted yield curve.
- The yield curve can be horizontal predicting that the short term and long term
rates can be expected to be the same
-
How well it explains three empirical observations of the yield curve-
-it explains fact 1,which states that interest on bonds with different maturities move
together over time.
4
QUESTIONS WITH
ANSWES
1
,OCTOBER/NOVEMBER 2014
Question 1
1.1 Bond attracts interest as return
stock attracts dividends as return.
1.2 They have expertise thus they can detect and prevent adverse selection.
-they have economies of scale
1.3 –to protect depositors
-to detect investors
-to prevent financial crisis.
1.4 money market is market for short-term funds eg TB
-capital market is a market for long term funds eg stock
1.5 M2 = -Is a broader definition of money
M1 plus deposits which are
-cash/currency
+cheque and transmission deposit near money
+demand deposit- consists of short-term and medium
+other short term deposits eg saving deposits, share investments
1.6 1/r = 1/0.05 = 20
1.7 5 advantages of inflation targeting
-Simple and easy
-does not rely on stable relationships between M and P;uses information inclusive
approach
-increased accountability of central bank; smaller likelihood to fall into time
inconsistency traps; less political pressure on central bank
-reduced effects of inflationary shocks; IT has good record to cut inflation.
1.8 store of value
-medium of exchange
-standard of differed payments
2
,1.9 Real interest has no inflation element
-nominal are not inflation adjusted
1.10 A financial crisis is a situation in which value of financial institutions or assets
drops rapidly due to worsened adverse selection and moral hazards.
1.11 Assets- bank loans
-Reserves
Liabilities- cheque and transmission deposits
-capital
1.12 Interest rate risk refers to the risk that is faced by bond owners from fluctuating
interest rates depending on the time to maturity and coupon rate.
1.13 Calculating return on a bond
Return on a bond is the total return on a bond by an investor over a specific time
period t to t+1.
R = C + Pt + 1-Pt
Pt
Where R = is return from holding a bond from t to time tt1
P =Price of a bond
C= Coupon payment
Question 2
2.1 Explain how lemons problem might arise
The presence of the lemons problem makes securities markets (debt and equity)
ineffective in channeling funds from savers to borrowers. Investors can not
distinguish between good firms (high profits and low risk), and bad firms (low profits
and high risk) due to lack of information. Owners of firms have better information
and are willing to sell securities for only an average price (or they require a higher
interest rate) because only bad firms investors will therefore be willing to sell
securities, investors will be unwilling to buy securities.
The lemons problem will disappear if the asymmetric information problem (adverse
selection) can be eliminated by the supply of accurate information. Private
companies can collect and produce information and sell it to investors. Firms like
Standard &Poor, Moodys etc sell information to subscribers.
This does not completely solve the problem due to the free rider problem (people
who do not pay, but take advantage of the information.
3
, -the free free riders can simply behave similar to those that have purchased the info.
Because prices of good firms are bid up,the advantage of buying at a lower price
disappears.
Financial intermediaries are usually experts in producing information about firmsand
are therefore well equipped to sort good credit risks from bad ones,people will also
be willing to buy securities with a financial intermediary “guarantee”
Governments may encourage firms to revel honesty information eg by independent
audits. However, problems like the Enron implosion may still occur (false reporting,
debt and financial contracts were kept off its balance sheet). Thus government
regulation may lesson the problems of asymmetric information, but it can not
eliminate them.
2.2 Asset price bubble means that the price of an asset, such as housing stocks or
gold, become over inflated over a short period of time and are not supported by
underlying demand for the product itself.
The bursting of a bubble can cause a financial crisis because the highest prices will
end up being unsustainable and no one buys overvalued stock as such prices will
drop drastically causing massive capital losses and worsening adverse selection
and moral hazard and resulting in financial crisis.
2.3 Assumptions of expectation theory
-long term rates are all averages of short term rates
-bonds are perfect substitutes
-No interest rate risk
Predictions of Expectations theory
- If short term interest rates are low then the long term rates are expected to be
higher.yield curve slopes upwards.
- If the average of short term rates is higher then the long term rates will be low
thus inverted yield curve.
- The yield curve can be horizontal predicting that the short term and long term
rates can be expected to be the same
-
How well it explains three empirical observations of the yield curve-
-it explains fact 1,which states that interest on bonds with different maturities move
together over time.
4
