What are the economic functions that financial intermediaries perform that benefit society?

(25) 1. What are the economic functions that financial intermediaries perform that benefit society? In your answer, discuss the relationship of financial intermediaries and financial markets to the savings-investment process within an economy and to each other. As part of your discussion provide an analysis of the differences in preferences among economic agents as an explanation for the wide variety of primary and secondary securities found in financial markets. Be sure to explain how depository intermediaries, like banks, differ from other financial institutions such as investment banking firms or securities brokerage companies, and how financial intermediaries profit from the transformation of primary securities into secondary claims. Carefully, DEFINE YOUR TERMS. (20) 2. Banks and other depository institutions make loans, invest in government securities, buy and sell federal funds, and accept deposits with a wide spectrum of maturities and with many payable on demand. Furthermore, depository institutions are the principal repositories of the public’s liquid assets and many of these institutions’ liabilities are considered a means of payment (money). (a) Briefly discuss the risks facing these institutions within the context of how these institutions can have such a wide variety of assets and liabilities and still maintain their ability to make illiquid loans, meet deposit withdrawals on demand, and make profits for their shareholders. Within this context, discuss the effect of different yield curve structures (upward sloping, downward sloping, or flat) on the profitability and riskiness of banks choices of loans, investments, and liabilities (deposits). (25) 3. Using the graph below of the supply of loanable funds, SLF, and the demand for loanable funds, DLF, discuss the following: a. What is meant by the equilibrium rate of interest ? b. Illustrate and discuss how an autonomous increase in the expected rate of inflation will change the equilibrium nominal interest rate. Consider an initial real rate of interest of 3 percent and an expected inflation rate of 4 percent. If the expected rate of inflation rises to 6 percent with the real interest rate constant, what would the resulting nominal interest rate become, using the Fisher relationship? HINTS: Recall the Fisher relationship where (1+i) = (1+r)(1+pe), where i is the nominal interest rate, r is the required real rate of return before taxes, and pe is the expected rate of inflation.) DLF = I + G – T + NX; I = real investment; NX = net exports G – T = the government deficit (excess of government spending over tax revenues). SLF = S + ∆Ms – H; S = private savings; H = desired hoarding ∆Ms = change in the money supply (a Federal Reserve action) (15) 4. There are a number of theories of the term structure of interest rates including the pure expectations hypothesis, preferred habitat hypothesis, and market segmentation hypothesis. Discuss the implications of each of these theories in the context of the following problem. Problem: For a two-year, default-free, pure discount security, compute its yield to maturity and draw the respective yield curves assuming two different expectations of inflation employing the Fisher Effect(see Hints in 3 above): (a) 10 percent one year from now, and (b) 15 percent one year from now. In addition, define and compute the implied forward yield on a one-year security one year from now, assuming the current two-year yield is 10.695 percent. Discuss the assumptions underlying this calculation and how it can be used to evaluate the implied forward yield on a 1-year loan, next year. Use the following definitions and values: • r = 0.03 (constant real rate of interest) p1 = 0.05 (period 1 rate of inflation) (a) p2e = 0.10 (expected period 2 rate of inflation) (b) p2e = 0.15 (expected period 2 rate of inflation) 1y1 = current yield on one-year securities 2y1e = Expected period 2 yield on one-year securities 1y2 = current yield on two-year securities Pure Expectations Hypothesis (1 + 1ym) = [(1 + 1y1)(1 + 2y1e). . .(1 + my1e)]1/m and jy1e = the forward rate, jf1. (15) 5. Consider the following bank balance sheet (fixed rates and pure discount securities unless indicated otherwise). Interest rates on liabilities are 10 percent and on assets are 12 percent. Assets $m Duration (years) Liabilities and Equity $m Duration (years) Prime-Rate Loans (rates set daily) 50 1.0 Super Now Checking Accounts (rates set daily) 100 1.0 2-Year Car Loans 65 1.0 6-Month Certificates of Deposit 40 0.5 30-Year Mortgages 60 7.0 3-Year Certificates of Deposit 25 3.0 Total Assets 175 ? Total Liabilites 165 ? Equity (E) 10 ? • a. What is the duration of assets, DA, liabilites, DL, and Equity, E. b. The bank will benefit or be hurt if all interest rates rise (assume by the same amount). c. Compute the repricing gap for the bank using those assets and liabilities repricing or maturing in 2 years or less. From this information, will the bank be hurt or benefit by a 200 basis point rise in interest rates on assets and liabilities? d. If the bank gets an additional $100 in a 6-month certificate of deposit, what investments (using the above portfolio possibilities) should it make to control interest rate risk (∆ y = ± 200 basis point change in all interest rates) by changing the duration of its portfolio? State the advantages and disadvantages of using net worth immunization and asset/liability duration as a means of controlling interest rate risk. Define your terms. ∆ E = change in market value of the portfolio, DA = duration of assets, DL = duration of liabilities, DE = duration of the portfolio or equity, E = market value of equity, L = market value of liabilities, A = market value of assets, and ∆ y = change in interest rates. (15) 6. Suppose that the current (simple annual) yields on 3-month U.S. (RA) and U.K. T-bills (Rb) are 16 percent and 8 percent, respectively, and that the dollar value of the pound is expected to rise 1 percent during the next three months. (a) How might the British and American T-bill and foreign exchange markets adjust to this situation? Present and discuss an equilibrium consistent with the concept of interest rate parity (IRP) and discuss the processes by which this equilibrium might be achieved. Should you buy U.S. or U.K. bills? At what U.S. T-bill yield would you be indifferent between U.K. and U.S. Tbills given the expected changes in the exchange rate? (b) Governments frequently buy and sell foreign exchange for the purpose of smoothing fluctuations in exchange rates. Discuss the purposes for these interventions since 1971 and describe how these actions might interfere with the efficient allocation of resources by causing forward exchange rates to be biased predictors of spot rates. Hints: IRP Condition: (1 + Ra) = (1 + Rb)(1 + Ee) = (1 + Rb)(1 + F/S) where Ra = 3-month U.S. T-bill yield, • Rb = 3-month U.K. T-bill yield, Ee = expected proportional change in the dollar value of the British pound, Æ’ . F = forward exchange rate ($/Æ’ ), S = spot exchange rate ($/Æ’ ). (15) 7. Describe the objectives involved in the management of a bank’s overall liquidity position and the costs to the bank of poor liquidity management. In your discussion, identify the major sources of demand on a bank’s liquidity position, including reserve requirements, and the major sources of funds to meet liquidity needs. As part of your discussion, consider how the predictable fluctuations in loan demand and deposit flows can cause changing liquidity needs and how a bank might anticipate such changes.  (15) 8. In evaluating credit risk, discuss the statement: “An increase in collateral is a direct substitute for an increase in default risk.” In your discussion, evaluate the credit risk premium on a one-year loan with and without collateral using the following formula and values: Risk Premium: where, k = required yield on a risky loan, i = 0.1 (default risk free interest rate), (1-p) = 0.1 (probability of default over the year), and γ = 0.9 (the portion of the loan collateralized
). (15) 9. As a financial institutions and markets analyst for MoreGaine Securities, Inc., a highly reputable financial institutions’ securities underwriter, you must prepare an analysis of the financial condition of a broad range of financial institutions of various sizes, localities, and product lines. Using the “probability of insolvency” model discussed in class where E(ROA) is the expected value of after-tax earnings on assets, σ 2 is the variance of ROA, and K/A is the firm’s equity capital plus contingency and loan loss reserves to total assets, discuss, based upon your economic assumptions, what financial ratios you might use to assess the level and expected future course, over the next few years, of each of these indicators of financial soundness. As a preliminary to this discussion, clearly state your assumptions about general economic growth and cyclical movements, interest rates (level and term structure), and potential developments in individual industries and regional economies (e.g., agriculture, energy, Asian Markets). Primarily, discuss how the federal regulatory agencies’ capital adequacy policy, in the form of risk-based capital adequacy standards and Prompt Corrective Action, might affect financial institution soundness, costs of moral hazard and portfolio choices. NOTE: the maximum probability of insolvency = σ 2 /[E(ROA) + K/A]2 (15) 10. Public policy toward financial institutions, and depositories in particular, has attempted to promote competition within a framework of regulation intended to ensure the financial integrity of the institutions. a. Detail the fundamental reasons for financial regulation as discussed in class and in the text. As part of this discussion, provide an analysis of the potential conflicts between a policy of promoting competition and a policy of reducing the chance of financial institution failure. In this context what are the dangers of the too-big-to-let-fail policy in promoting financial intermediary efficiency, productivity and competition as more large FIs are formed through mergers and consolidation. Consider whether the problem of moral hazard facing regulators and the federal deposit insurance funds is more or less of a problem under this policy. b. Give an example of a recent regulatory reform or change in federal or state laws that are intended to promote competition among financial intermediaries and how they are to do so. Within your discussion, provide an analysis of how market forces, such as rising interest rates, inflation, and financial innovation, have stimulated the development of new financial instruments and new institutional arrangements and intensified competition among financial institutions. c. Several dominant movements in determining the structure of U.S. banking have been the spread of branch banking, the growth of bank holding companies and interstate banking which permits the geographic expansion of banking services and the ability of banking organizations to offer new and diversified product lines. In the 1970s, nonbank financial firms, such as insurance companies and stock brokers, began competing with depository institutions. Does this revitalized competition, recently characterized by the innovation of by specialized banking firms and the potential for expanded product lines, cause present prudential regulation (e.g., capital adequacy standards, examinations or asset composition constraints) and federal deposit insurance to be outmoded? In your answer, discuss the role and administration of prudential regulation when major depository institutions may be highly diversified financial service companies providing life and casualty insurance sales and underwriting, corporate securities underwriting, household and business depository services, sophisticated EFT and telecommunications services as well as traditional lending to business.

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