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金融市场与金融机构基础课后答案

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ANSWERS TO QUESTIONS FOR CHAPTER 1

(Questions are in bold print followed by answers.)

1. What is the difference between a financial asset and a tangible asset?

A tangible asset is one whose value depends upon certain physical properties, e.g. land, capital equipment and machines. A financial asset, which is an intangible asset, represents a legal claim to some future benefits or cash flows. The value of a financial asset is not related to the physical form in which the claim is recorded.

2. What is the difference between the claim of a debtholder of General Motors and an equityholder of General Motors?

The claim of the debt holder is established by contract, which specifies the amount and timing of periodic payments in the form of interest as well as term to maturity of the principal. The debt holder stands as a creditor and in case of default, he has a prior claim on firm assets over the equity-holder.

The equity holder has a residual claim to assets and income. He can receive funds only after other claimants are satisfied. Income is in terms of dividends, the amount and timing of which are not certain.

3. What is the basic principle in determining the price of a financial asset?

The price of any financial asset is the present value of the expected cash flows or a stream of payments over time. Thus, the basic variables in determining the price are: expected cash flows, discount rate and the timing of these cash flows.

4. Why is it difficult to determine the cash flow of a financial asset?

The estimation and determination of cash flows is difficult because of several reasons. These include accounting measures, possibility of default of the issuer, and embedded options in the security. Interest payments can also change over time. There is uncertainty as to the amount and the timing of these payments.

5. Why are the characteristics of an issuer important in determining the price of a financial asset?

The characteristics of the issuer are important because these determine the riskiness or uncertainty of the expected cash flows. These characteristics, which determine the issuer’s creditworthiness or default risk, have an impact on the required rate of return for that particular financial asset.

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6. What are the two principal roles of financial assets?

The first role of financial assets is to transfer funds from surplus spending units (i.e. persons or institutions with funds to invest) to deficit spending units (i.e. persons or firms needing funds to invest in tangible assets).

The second role is to redistribute risk among persons or institutions seeking and providing funds. Funds providers share the risks of expected cash flows generated by tangible assets.

7. In September 1990, a study by the U.S. Congress, Office of Technology Assessment, entitled “Electronic Bulls & Bears: U.S. Securities Markets and Information Technology,” included this statement:

Securities markets have five basic functions in a capitalistic economy:

a. They make it possible for corporations and governmental units to raise capital. b. They help to allocate capital toward productive uses.

c. They provide an opportunity for people to increase their savings by investing in them.

d. They reveal investors’ judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers. e. They generate employment and income.

For each of the functions cited above, explain how financial markets (or securities markets, in the parlance of this Congressional study) perform each function.

The five economic functions of a financial market are: (1) transferring funds from those who have surplus funds to invest to those who need funds to invest in tangible assets, (2) transferring funds in such a way that redistributes the unavoidable risk associated with the cash flow generated by tangible assets, (3) determining the price of financial assets (price discovery), (4) providing a mechanism for an investor to sell a financial asset (to provide liquidity), and (5) reducing the cost of transactions.

The five economic functions stated in the Congressional Study can be classified according to the above five functions:

1. “they make it possible for corporations and governmental units to raise capital” --functions 1 and 2;

2. “they help to allocate capital toward productive uses” -- function 3;

3. “they provide an opportunity for people to increase their savings by investing in them” -- functions 1 and 5;

4. “they reveal investors’ judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers” --function 3;

5. “they generate employment and income” -- follows from functions 1 and 2 allowing those who need funds to use these funds to create employment and income opportunities.

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8. Explain the difference between each of the following:

a. money market and capital market

b. primary market and secondary market c. domestic market and foreign market d. national market and Euromarket

a. The money market is a financial market of short-term instruments having a maturity of one year or less. The capital markets contain debt and equity instruments with more than one year to maturity;

b. The primary market deals with newly issued financial claims, whereas the secondary market deals with the trading of season issues (ones previously issued in the primary market);

c. The domestic market is the national market wherein domestic firms issue securities and where such issued securities are traded. Foreign markets are where securities of firms not domiciled in the country are issued and traded;

d. In a national market securities are traded in only one country and are subject to the rules of that country. In the Euromarket, securities are issued outside of the jurisdiction of any single country. For example, Eurodollars are dollar-denominated financial instruments issued outside the United States.

9. Indicate whether each of the following instruments trades in the money market or the capital market:

a. General Motors Acceptance Corporation issues a financial instrument with four months to maturity.

b. The U.S. Treasury issues a security with 10 years to maturity. c. Microsoft Corporation issues common stock.

d. The State of Alaska issues a financial instrument with eight months to maturity.

a. GMAC issue trades in the money market.

b. U.S. security trades in the capital market.

c. Microsoft stock trades in the capital market.

d. State of Alaska security trades in the money market.

10. A U.S. investor who purchases the bonds issued by the government of France made the following comment: “Assuming that the French government does not default, I know what the cash flow of the bond will be.” Explain why you agree or disagree with this statement.

One would tend to disagree with this statement. Even though there is no default risk with French bonds issued by the government, some other risks include price risk and foreign exchange risk.

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11. A U.S. investor who purchases the bonds issued by the U.S. government made the following statement: “By buying this debt instrument I am not exposed to default risk or purchasing power risk.” Explain why you agree or disagree with this statement.

This is not true. There is no default (credit) risk of U.S. government securities. However, it is not free of purchasing power or inflation risk. There is also price risk, which is related to maturity of any bond.

12. In January 1992, Atlantic Richfield Corporation, a U.S.-based corporation, issued $250 million of bonds in the United States. From the perspective of the U.S. financial market, indicate whether this issue is classified as being issued in the domestic market, the foreign market, or the offshore market.

The corporate bonds issued by Atlantic Corporation are in the domestic market, but the investors can also be from foreign markets.

13. In January 1992, the Korea Development Bank issued $500 million of bonds in the United States. From the perspective of the U.S. financial market, indicate whether this issue is classified as being issued in the domestic market, the foreign market, or the offshore market.

This issue can be classified as a domestic issue. 14. 14. Give three reasons for the trend toward greater integration of financial markets throughout the world.

There are several reasons. These include:

a. Deregulation and/or liberalization of financial markets to permit greater participants from other countries;

b. Technological innovations to provide globally-available information and to speed transactions;

c. Institutionalization -- financial institutions are better able to diversify portfolio and exploit mis-pricings than are individuals.

15. What is meant by the “institutionalization” of capital markets?

The term “institutionalization” refers to the dominance of large institutional investors such as pension funds, investment companies, banks, insurance companies, etc. in the money and capital markets.

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16.a. What are the two basic types of derivative instruments?

b. “Derivative markets are nothing more than legalized gambling casinos and serve no economic function.” Comment on this statement.

a. The two basic types of derivative instruments are futures and options contracts. They are called derivatives because their values are derived from the values of their underlying stocks or bonds.

b. The statement implies that derivative instruments can be used only for speculative purposes. Actually, derivatives serve an important economic function by permitting hedging, which involves shifting risks on those individuals and institutions (speculators) that are willing to bear them.

17. What is the economic rationale for the widespread use of disclosure regulation?

The economic rationale is that disclosure mitigates the potential for fraud by the issuer. Typically, there information asymmetry between the issuer (management) and the investors, and disclosure regulation mitigates the harm to investors that could result from this informational disadvantage. As a result, there is confidence in the market and the pricing mechanism of the market.

18. What is meant by market failure?

Market failure occurs when the market cannot produce its goods or services efficiently. In the context of financial market failure, it occurs when the pricing mechanism fails and thus the supply and demand equilibrium is disrupted. This results in failure to price securities efficiently and reduced liquidity.

19. What is the major long-term regulatory reform that the U.S. Department of the Treasury has proposed?

The long-term proposal is to replace the prevailing complex array of regulators with a regulatory system based on functions. Specifically, there would be three regulators: (1) market stability regulator, (2) prudential regulator, (3) business conduct regulator.

20. Why does increased volatility in financial markets with respect to the price of financial assets, interest rates, and exchange rates foster financial innovation?

Increased volatility of the prices of financial assets has fostered innovation as investors and institutions seek ways to mitigate financial risk. Among other things, these innovations include the advancement of the modern derivatives markets.

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ANSWERS TO QUESTIONS FOR CHAPTER 2

(Questions are in bold print followed by answers.)

1. Why is the holding of a claim on a financial intermediary by an investor considered an indirect investment in another entity?

An individual’s account at a financial intermediary is a direct claim on that intermediary. In turn, the intermediary pools individual accounts and lends to a firm. As a result, the intermediary has a direct contractual claim on that firm for the expected cash flows. Since the individual’s funds have in essence been passed through the intermediary to the firm, the individual has an indirect claim on the firm. Two separate contracts exist. Should the individual lend to the firm without the help of an intermediary, he then has a direct claim.

2. The Insightful Management Company sells financial advice to investors. This is the only service provided by the company. Is this company a financial intermediary? Explain your answer.

Strictly speaking, the Insightful Management Company is not a financial intermediary, because it lacks the function of deposit taking and creating liabilities.

3. Explain how a financial intermediary reduces the cost of contracting and information processing.

Financial intermediaries can reduce the cost of contracting by its professional staff because investing funds is their normal business. The use of such expertise and economies of scale in contracting about financial assets benefits both the intermediary as well as the borrower of funds. Risk can be reduced through diversification and taking advantage of fund expertise.

4. “All financial intermediaries provide the same economic functions. Therefore, the same investment strategy should be used in the management of all financial intermediaries.” Indicate whether or not you agree or disagree with this statement.

Disagree. Although each financial intermediary more or less provides the same economic functions, each has a different asset-liability management problem. Therefore, same investment strategy will not work.

5. A bank issues an obligation to depositors in which it agrees to pay 8% guaranteed for one year. With the funds it obtains, the bank can invest in a wide range of financial assets. What is the risk if the bank uses the funds to invest in common stock?

Practically, it is not a valid statement as banks are not allowed to hold stocks. The bank has a funding risk. On the liability side, amount of cash outlay and timing are known with certainty (Type I). However, on the asset side, both factors are unknown. Thus, there is liquidity risk and price risk.

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6. Look at Table 2-1 again. Match the types of liabilities to these four assets that an individual might have:

a. car insurance policy

b. variable-rate certificate of deposit c. fixed-rate certificate of deposit

d. a life insurance policy that allows the holder’s beneficiary to receive $100,000 when the holder dies; however, if the death is accidental, the beneficiary will receive $150,000

a. Car insurance: neither the time nor the amount of payoffs are certain, which is Type IV liability

b. Variable rate certificates of deposit: times of payments are certain, the amounts are not, which is

Type II liability.

c. Fixed-rate certificate of deposit: both times of payments and cash outflows are known, which is

Type I liability.

d. Life insurance policy: time of payout is not known, but the amount is certain, which is Type III

liability.

7. Each year, millions of American investors pour billions of dollars into investment companies, which use those dollars to buy the common stock of other companies. What do the investment companies offer investors who prefer to invest in the investment companies rather than buying the common stock of these other companies directly?

In investing funds with the investment companies, investors are reducing their risk via diversification and the cost of contracting and information. These companies also provide liquidity to the investor.

8. In March 1996, the Committee on Payment and Settlement Systems of the Bank for International Settlements published a report entitled “Settlement Risk in Foreign Exchange Transactions” that offers a practical approach that banks can employ when dealing with settlement risk. What is meant by settlement risk?

Counterparty risk is that risk that a counterparty to a transaction cannot fulfill its obligation. It is related to settlement risk in that counterparty party risk bears on the question of whether settlement can take place or not.

9. The following appeared in the Federal Reserve Bank of San Francisco’s Economic Letter, January 25, 2002:

Financial institutions are in the business of risk management and reallocation, and they have developed sophisticated risk management systems to carry out these tasks. The basic components of a risk management system are identifying and defining the risks the firm is exposed to, assessing their magnitude, mitigating them using a variety of procedures, and setting aside capital for potential losses. Over the past twenty years or so, financial institutions have been using economic modeling in earnest to assist them in these tasks. For example, the development of empirical models of financial volatility led

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to increased modeling of market risk, which is the risk arising from the fluctuations of financial asset prices. In the area of credit risk, models have recently been developed for large-scale credit risk management purposes.

Yet, not all of the risks faced by financial institutions can be so easily categorized and modeled. For example, the risks of electrical failures or employee fraud do not lend themselves as readily to modeling.

What type of risk is the above quotation referring to?

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.

10. What is the source of income for an asset management firm?

The sources of income are a fee based on assets under management, and sometimes a performance fee based on returns that meet certain benchmarks or targets.

11. What is meant by a performance-based management fee and what is the basis for determining performance in such an arrangement?

Performance based management fees are typically seen in hedge funds. Increasingly, they are also used by managers of asset management firms. These fees are fees based on performance that meet specified criteria.

12. a. Why is the term hedge to describe “hedge funds” misleading?

b. Where is the term hedge fund described in the U.S. securities laws?

a. Hedge denotes hedging risk. Many hedge funds, however, do not use hedge as a strategy, and these funds take significant risk in their attempt to achieve abnormal returns.

b. The term is not described in US securities laws, and hedge funds are not regulated by the SEC.

13. How does the management structure of an asset manager of a hedge fund differ from that of an asset manager of a mutual fund?

Asset management firms are compensated by a fee on asset under management. Hedge funds are compensated by a combination of assets under management and a performance fees. Clearly, investment strategies of these firms will be different since hedge funds seek to generate abnormal returns.

14. Some hedge funds will refer to their strategies as “arbitrage strategies.” Why would this be misleading?

Arbitrage means riskless profit. These opportunities are few and fleeting. Hedge funds take great risk. The arbitrage typically taken is where there is a disparity between the risk and the return, such as pricing disparities across markets.

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15. What is meant by a convergence traded hedge fund?

A convergence trading hedge fund uses a strategy to take advantage of misalignment of prices or yields.

16. What was the major recommendation regarding hedge funds of the President’s Working Group on Financial Markets?

The major recommendation was that commercial banks and investment banks that lend to hedge funds improve their credit risk management practices.

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ANSWERS TO QUESTIONS FOR CHAPTER 3

(Questions are in bold print followed by answers.)

1. Explain the ways in which a depository institution can accommodate withdrawal and loan demand.

A depository institution can accommodate loan and withdrawal demands first by having sufficient cash on hand. In addition it can attract more deposits, borrow from the Fed or other banks, and liquidate some of its other assets.

2. Why do you think a debt instrument whose interest rate is changed periodically based on some market interest rate would be more suitable for a depository institution than a long-term debt instrument with a fixed interest rate?

This question refers to asset-liability management by a depository institution. An adjustable rate can eliminate or minimize the mismatch of maturity risk. As interest rates rise, the institution would have to pay more for deposits, but would also receive higher payments from its loan.

3. What is meant by:

a. individual banking b. institutional banking c. global banking

a. Individual banking is retail or consumer banking. Such a bank emphasizes individual deposits, consumer loans and personal financial trust services.

b. An institutional bank caters more to commercial, industrial and government customers. It issues deposits to them and tries to meet their loan needs.

c. A global bank encompasses many financial services for both domestic and foreign customers. It

is much involved in foreign exchange trading as well as the financial of international trade and investment. 4.

a. What is the Basel Committee for Bank Supervision?

b. What do the two frameworks, Basel I and Basel II, published by the Basel Committee for Bank Supervision, address regarding banking?

a. It is the organization that plays the primary role in establishing risk and management guidelines for banks throughout the world.

b. The frameworks set forth minimum capital requirements and standards.

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5. Explain each of the following:

a. reserve ratio

b. required reserves

a. The reserve ratio is the percentage of deposits a bank must keep in a non-interest-bearing account at the Fed.

b. Required reserves are the actual dollar amounts based on a given reserve ratio.

6. Explain each of the following types of deposit accounts:

a. demand deposit b. certificate of deposit

c. money market demand account

a. Demand deposits (checking accounts) do not pay interest and can be withdrawn at any time (upon demand).

b. Certificates of Deposit (CDs) are time deposits which pay a fixed or variable rate of interest over a specified term to maturity. They cannot be withdrawn prior to maturity without a substantial penalty. negotiable CDs (large business deposits) can be traded so that the original owner still obtains liquidity when needed.

c. Money Market Demand Accounts (MMDAs) are basically demand or checking accounts that pay interest. Minimum amounts must be maintained in these accounts so that at least a 7-day interest can be paid. Since many persons find it not possible to maintain this minimum (usually around $2500) there are still plenty of takers for the non-interest-bearing demand deposits.

7. How did the Glass-Steagall Act impact the operations of a bank?

The Glass-Steagall Act prohibited banks from carrying out certain activities in the securities markets, which are principal investment banking activities. It also prohibited banks from engaging in insurance activities.

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8. The following is the book value of the assets of a bank:

Asset

U.S. Treasury securities

Municipal general obligation bonds

Residential mortgages Commercial loans Total book value

a. Calculate the credit risk-weighted assets using the following information:

Asset

U.S. Treasury securities Municipal general obligation bonds

Residential mortgages Commercial loans

b. What is the minimum core capital requirement? c. What is the minimum total capital requirement?

a. The risk weighted assets would be $410

BV Weight Product US T Sec. $50 0% 0 MB 50 20% 10 RM 400 50% 200 CL 200 100% 200 Total 700 410

b. The minimum core capital is $28 million (.04X700) i.e., 4% of book value.

c. Minimum total capital (core plus supplementary capital) is 32.8 million, .08X410, which is 8% of the risk-weighted assets.

9. In later chapters, we will discuss a measure called duration. Duration is a measure of the sensitivity of an asset or a liability to a change in interest rates. Why would bank management want to know the duration of its assets and liabilities?

a. Duration is a measure of the approximate change in the value of an asset for a 1% change in interest rates.

b. If an asset has a duration of 5, then the portfolio’s value will change by approximately 5% if interest rate changes by 100 basis points. 10.

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Book Value (in millions)

$ 50

50 400 200 $700

Risk Weight

0% 20 50 100

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a. Explain how bank regulators have incorporated interest risk into capital requirements.

b. Explain how S&L regulators have incorporated interest rate risk into capital requirements.

a. The FDIC Improvement Act of 1991, required regulators of DI to incorporate interest rate risk into capital requirements. It is based on measuring interest rate sensitivity of the assets and liabilities of the bank.

b. The OST adopted a regulation that incorporates interest rate risk for S&L. It specifies that if thrift has greater interest rate risk exposure, there would be a deduction of its risk-based capital. The risk is specified as a decline in net profit value as a result of 2% change in market interest rate.

11. When the manager of a bank’s portfolio of securities considers alternative investments, she is also concerned about the risk weight assigned to the security. Why?

The Basel guidelines give weight to the credit risk of various instruments. These weights are 0%, 20%, 50% and 100%. The book value of the asset is multiplied by the credit risk weights to determine the amount of core and supplementary capital that the bank will need to support that asset.

12. You and a friend are discussing the savings and loan crisis. She states that “the whole mess started in the early 1980s.When short-term rates skyrocketed, S&Ls got killed—their spread income went from positive to negative. They were borrowing short and lending long.”

a. What does she mean by “borrowing short and lending long”?

b. Are higher or lower interest rates beneficial to an institution that borrows short and lends long?

a. In this context, borrowing short and lending long refers to the balance sheet structure of S&Ls. Their sources of funds (liabilities) are short-term (mainly deposits) and their uses (assets) are long-term in nature (e.g. residential mortgages).

b. Since long-term rates tend to be higher than short-term ones, stable interest rates would be the best situation. However, rising interest rates would increase the cost of funds for S&Ls without fully compensating higher returns on assets. Hence a decline in interest rate spread or margin. Thus lower rates, having an opposite effect, would be more beneficial.

13. Consider this headline from the New York Times of March 26, 1933: “Bankers will fight Deposit Guarantees.” In this article, it is stated that bankers argue that deposit guarantees will encourage bad banking. Explain why.

The barrier imposed by Glass-Steagall act was finally destroyed by the Gramm-Leach Bliley Act of 1999. This act modified parts of the BHC Act so as to permit affiliations between banks and insurance underwriters. It created a new financial holding company, which is authorized to engage in underwriting and selling securities. The act preserved the right of state to regulate insurance activities, but prohibits state actions that have would adversely affected bank-affiliated firms from selling insurance on an equal basis with other insurance agents.

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14. How did the Gramm-Leach-Bliley Act of 1999 expand the activities permitted by banks?

a. Deposit insurance provides a safety net and can thus make depositors indifferent to the soundness of the depository recipients of their funds. With depositors exercising little discipline through the cost of deposits, the incentive of some banks owners to control risk-taking accrue to the owners. It becomes a “heads I win, tails you lose” situation.

b. One the positive side, deposit insurance provides a comfort to depositors and thus attracts depositors to financial institutions. But such insurance carries a moral hazard, it can be costly and, unless premiums are risk-based, it forces the very sound banks to subsidize the very risky ones.

15. The following quotation is from the October 29, 1990 issue of Corporate Financing Week:

Chase Manhattan Bank is preparing its first asset-backed debt issue, becoming the last major consumer bank to plan to access the growing market, Street asset-backed officials

Said…Asset-backed offerings enable banks to remove credit card or other loan receivables from their balance sheets, which helps them comply with capital requirements.

a. What capital requirements is this article referring to?

b. Explain why asset securitization reduces capital requirements.

a. The capital requirements mentioned are risk based capital as specified under the Basel

Agreement, which forces banks to hold minimum amounts of equity against risk-based assets. b. Securitization effectively eliminates high risk based loans from the balance sheet. The capital

requirements in the case of asset securitization are lower than for a straight loan.

16. Comment on this statement: The risk-based guidelines for commercial banks attempt to gauge the interest rate risk associated with a bank’s balance sheet.

This statement is incorrect. The risk-based capital guidelines deal with credit risk, not interest-rate risk, which is the risk of adverse changes of interest rates on the portfolio position. 17.

a. What is the primary asset in which savings and loan associations invest?

b. Why were banks in a better position than savings and loan associations to weather rising interest rates?

a. Savings and Loans invest primarily in residential mortgages.

b. During 1980's, although banks also suffered from the effects of deregulation and rising interest rates, relatively they were in a better position than S&L association because of their superior asset-liability management.

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18. What federal agency regulates the activities of credit unions?

The principal federal regulatory agency is the National Credit Union Administration.

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ANSWERS TO QUESTIONS FOR CHAPTER 4

(Questions are in bold print followed by answers.)

1. What is the role of a central bank?

The role of a central bank has several functions: risk assessment, risk reduction, oversight of payment systems, and crisis management. It can do this through monetary policies, and through the implementation of regulations.

2. Why is it argued that a central bank should be independent of the government?

Central banks should be independent of the short-term political interests and political influences generally in setting economic policies.

3. Identify each participant and its role in the process by which the money supply changes and monetary policy is implemented.

The Fed determines monetary policy and seeks to implement it through changes in reserves. It is up to the nation’s banking system to act on changes in reserves thereby affecting deposits, which constitute the greater part of the M1 definition of the money supply.

4. Describe the structure of the board of governors of the Federal Reserve System.

The Board of Governors of the Federal Reserve System consists of 7 members who are appointed to staggered 14-year terms. The Board reviews discount operations and sets legal reserve requirements. In addition, all 7 members of the Board serve on the Federal Open Market Committee (FOMC), which determines the direction and magnitude of open-market operations. Such operations constitute the key instrument for implementing monetary policy. 5.

a. Explain what is meant by the statement “the United States has a fractional reserve banking system.”

b. How are these items related: total reserves, required reserves, and excess reserves?

a. A fractional reserve system requires that a fraction or percent of a bank’s reserve be placed either in currency in vault or with the Federal Reserve System.

b. Total reserves are the amounts that banks hold in cash or at the Fed. Required reserves are amounts required by the Fed to meet some specific or legal reserve ratio to deposits. Excess reserves are bank reserves in currency and at the Fed which are in excess of legal requirements. Since these amounts are non-interest bearing, banks are often willing to lend these surplus funds to deficit banks at the Fed funds rate.

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6. What is the required reserve ratio, and how has the 1980 Depository Institutions Deregulation and Monetary Control Act constrained the Fed’s control over the ratio?

The required reserve ratio is the fraction of deposits a bank must hold as reserves. The DIDMCA constrained the Fed’s control over the ratio by letting Congress set ranges of reserves for demand and time deposits.

7. In what two forms can a bank hold its required reserves?

A bank can hold its reserves in the form of currency in vault or in deposit at the Fed. 8.

a. What is an open market purchase by the Fed?

b. Which unit of the Fed decides on open market policy, and what unit implements that policy?

c. What is the immediate consequence of an open market purchase?

a. An open market purchase by the Fed consists of the purchase of U.S. Treasury securities. b. The FOMC decides on open market policy and directs the Federal Reserve Bank of New York to implement it through sales and purchases of these securities.

c. The immediate consequence of an open market purchase is to supply the seller of the security with a check on the Federal Reserve System that he can deposit in his bank, thereby immediately increasing the excess reserves and thus nation’s money supply.

9. Distinguish between an open market sale and a matched sale (which is the same as a matched sale-purchase transaction or a reverse repurchase agreement).

A matched sale or reverse repo involves the sale of a Treasury security with an agreement to buy it back at a later date and at a higher price as the cost for borrowing the funds. This contrasts with an outright sale at some discounted or premium price.

10. What is the discount rate, and to what type of action by a bank does it apply?

The discount rate is the rate a bank pays to borrow at the “discount window” of the Fed. Such borrowings are often undertaken to meet temporary liquidity needs. Bank needs are monitored and the Fed likes to state that borrowing from it is a “privilege and not a right.”

11. Define the monetary base and M2

The monetary base includes total bank reserves plus currency in the hands of the public. M2 = M1 (currency and demand deposits) + savings and time deposits.

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12. Describe the basic features of the money multiplier.

The money multiplier is crucial to the concept of money creation and is analogous to the idea of the autonomous spending multiplier and formula for a perpetuity. It is the inverse of the required reserve ratio (1/rr). If the reserve ratio is .2 then the money supply will expand five times any increase in new deposits. The multiplier will be less if banks hold excess reserves or experience cash drains.

13. Suppose the Fed were to inject $100 million of reserves into the banking system by an open market purchase of Treasury bills. If the required reserve ratio were 10%, what is the maximum increase in M1 that the new reserves would generate? Assume that banks make all the loans their reserves allow, that firms and individuals keep all their liquid assets in depository accounts, and no money is in the form of currency.

The maximum increase in M1 will be $1 billion assuming no cash drains in the system, and banks are fully loaned up.

14. Assume the situation from question 13, except now assume that banks hold a ratio of 0.5% of excess reserves to deposits and the public keeps 20% of its liquid assets in the form of cash. Under these conditions, what is the money multiplier? Explain why this value of the multiplier is so much lower than the multiplier from question 13.

Substitute the given values of currency ratio, required reserves ratio, and excess reserves ratio of 20%, 10% and 0.5% respectively into the formula given on page 94 of the textbook. Now we have a lower multiplier value of 3.9=1.20/. 305. This is because public and banks do not deposit or lend, all they can.

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ANSWERS TO QUESTIONS FOR CHAPTER 5

(Questions are in bold print followed by answers.)

1. Name three widely accepted goals of monetary policy.

Price stability, high employment and economic growth.

2. What keeps the Fed from being able to achieve its goals in a direct way?

The Fed can only control reserves. What happens after that is a function of the demand for holding money and the desire of consumers, business firms, and governments to borrow and invest in real assets.

3. Comment on this statement by an official of the Federal Reserve:

[the Fed] can control nonborrowed reserves through open market operations [but] it cannot control total reserves, because the level of borrowing at the discount window is determined in the short run by the preferences of depository institutions.

Quoted from Alfred Broaddus, “A Primer on the Fed,” Chapter 7 in Sumner N. Levine (ed.), The Financial Analyst’s Handbook (Homewood, IL: Dow Jones-Irwin, 1988), p. 194.

Individual banks decide whether or not to borrow at the discount window and thus add to their reserves. Even if the window is shut and banks desire additional reserves they can obtain them through fed funds borrowing, creating additional deposits, or issuing more securities on the money and capital markets.

4. Why is it impossible for the Fed to target, at the same time, both the Fed funds interest rate and the level of reserves in the banking system?

An increase in reserves should have an opposite effect on interest rates (a decrease in rates as banks have more reserves to lend). However, the interest rate is a function of both the supply of money and the public’s demand for money. It is thus possible for an increase in reserves to be met by an increase in the demand to hold money; hence no decrease in interest rate levels. In like manner, when an interest rate is the target, the Fed must let the growth in reserves vary as it strives to keep certain levels of interest rates.

5. Explain the change in the Fed’s targets that occurred with the 1979 Volcker announcement about inflation and the new Fed policy.

The policy was a victory for monetarist. The growth in money supply (using non-borrowed reserves as targets) was linked to growth in output to avoid inflationary tendencies. The short-term result was an increased volatility in interest rates.

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6. It is often said that you cannot hit two targets with one arrow. How does this comment apply to the use of monetary policy to “stabilize the economy”?

Often there are countervailing effects of the Fed’s actions. As seen, the Fed must choose either a short-term rate or the level of some reserves and cannot choose to target both kinds of variables as an operating target. The Fed can stimulate an economy through a reduction in interest rates, but such stimulation could lead to inflation or bubbles. As well, dampening unsustainable growth can be achieved, but such actions can lead to recession.

7. Describe the differences and similarities of the conduct of Chairmen Greenspan and Bernanke in managing Fed policy.

Up until the mortgage and crisis, Bernanke mostly maintained Greenspan’s policies, but he was viewed as being more open with respect to communications about the Fed’s policy and FOMC meetings. Additionally, Bernanke was expected to advocate a more quantitative approach to policy as opposed to Greenspan’s subjective, eclectic approach.

8. What are tools and responsibilities of the Fed in monitoring and affecting the level of the stock market?

The primary tool is the Fed funds rate, which affects the cost of credit. In times of crisis, the Fed can also be the lender of last resort to banks and investment banks.

9. Interpret the following, the concluding sentence in “The Effectiveness of Monetary Policy,” by Robert M. Rasche and Marcela M.Williams, appearing in the Federal Reserve Bank of St. Louis Review, (September/October 2007), p. 477:

Finally, the case for consistently effective short-run monetary stabilization policies is problematic—there are just too many

dimensions to uncertainty in the environment in which central banks operate.

This can be interpreted as saying that there are a number of factors that affect the economy, and that monetary policies can only affect a few such factors. This being the case, consistent short-term monetary stabilization policies may be ineffective.

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ANSWERS TO QUESTIONS FOR CHAPTER 6

(Questions are in bold print followed by answers.)

a. What are the major sources of revenue for an insurance company? b. How are its profits determined?

a. An insurance company's revenue is generated from two sources: (1) premium income for policies written during the year; (2) investment income resulting from the investment of both the reserves established to pay off future claims and the P&C's surplus (asset less liabilities). b. Profit is determined by subtracting from the revenue for the year (as defined above in question 1a) each of the following items: (1) claim expenses: funds that must be added to reserves for new claims for policies written during the year; (2) claim adjustment expenses: funds that must be added to reserves because of underestimates of actuarially projected claims from previous years; (3) taxes; (4) administrative and marketing expenses associated with issuing policies. If annual premiums exceed the sum of (1), (2) and (4), the difference is said to be the underwriting profit. An underwriting loss results otherwise.

2. Name the major types of insurance and investment oriented products sold by insurance companies.

The major types of insurance products sold are: Life insurance, Health insurance, Property and casualty insurance, Liability insurance, Disability insurance, long-term care insurance, GIC and annuities. 3.

a. What is a GIC?

b. Does a GIC carry a “guarantee” like a government obligation?

a. A guaranteed investment contract (GIC) guarantees a fixed interest income compounded over the life of the contract. It is like a zero-coupon bond issued by an insurance company, usually to pension funds. A GIC shifts the interest rate risk from a pension fund to the issuer.

b. The guarantee is given only by the insurance company. There is no government bailout in case of insolvency of the issuer.

4. What are some key differences between a mutual fund and an annuity?

In a mutual fund, all income is taxable, and no guarantees are given in its performance. An annuity is an investment product often called a “mutual fund is in an insurance wrapper”. The wrapper is the guarantee by the insurance company. The company will pay the annuity holder.

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5. Why should a purchaser of life insurance be concerned about the credit rating of his or her insurance company?

The credit rating of an insurance company is extremely important to the purchaser of the LIC product. The credit risk of insurance company has been prominent by the default of several major issues of GIC e.g. mutual Benefits and Executive Life in 1991. 6.

a. Does the SEC regulate all insurance companies? b. If not, who regulates them?

a. No. The insurance industry is regulated by individual states and only the SEC regulates those insurance companies whose stock is publicly traded.

b. State laws and NAIC, a voluntary association of state insurance commissioners.

7. Does the insurance industry have a self-regulatory group and, if so, what is its role?

Model laws and regulations are developed by the National Association of Insurance Commissioners (NAIC), a voluntary association of the state insurance commissioners, for application on insurance companies in all states. An adoption of a model law or regulation by the NAIC is not, however, binding on any state. States typically use these as a model when writing their own laws and regulations.

8. What is the statutory surplus and why is it an important measure for an insurance company?

For an insurance company, surplus is simply total assets minus liabilities, or net worth. Due to state regulations the size of the surplus dictates the amount of common stock that an insurance company can hold and ultimately the amount of business it can write.

9. What is bank assurance?

“Banc assurance” means combining the activities of banking and insurance companies. Several factors could explain the growing interest in banc assurance in certain regions: (1) deregulation and increased competition are forcing banking and insurance firms to seek new markets and products, (2) a growth in savings, and (3) an increased demand for insurance with investment features.

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10.

a. What is meant by “demutualization”?

b. What are the perceived advantages of demutualization?

a. Demutualization refers to changing structure of insurance companies from being mutual companies stocks to ownership companies. This recent trend of demutualization in 1990’s is changing the landscape of insurance industry.

b. The advantages of demutualization is more competition, transparency and pressure for better performance for the shareholders.

11. Comment on the following quotation from Frank J. Jones, “An Overview of

Institutional Fixed Income Strategies,” in Volume 1 of Professional Perspectives on Fixed Income Portfolio Management (Hoboken, NJ: John Wiley & Sons, 2000):

An important impediment to the use of the total rate of return objective by stock life

insurance companies is the role of equity analysts on Wall Street. . . . These equity analysts emphasize the stability of earnings and thereby prefer stable income to capital gains.

Therefore, they consider only income and not capital gains, either realized or unrealized, in operating income—an important measure in their overall rating. While this practice of not considering capital gains may be appropriate for bonds, it certainly is inappropriate for common stock and provides a significant disincentive to life insurance companies for owning common stock in their portfolios. . . . this equity analyst practice does a disservice to policyholders of stock life insurance companies since their insurance companies end up having inferior asset allocations.

The statement by Jones has elements of subjective judgment and has several dimensions. It begs the merit of stocks vs. mutual structure of ownership and the respective rates of returns for the shareholders. It may be true that equity analysts emphasize the stability of earnings at the cost of capital gains. But those capital gains are reflected in the current price of the stock. It is up to the shareholders to realize those gains. Thus, the total rate of return objective by stock life insurance companies is not a real impediment.

12. What are term insurance, whole life insurance, variable life insurance, universal life insurance, and survivorship insurance?

Term insurance is pure life. If the insured person dies while the policy is intact, the beneficiary receives the death benefit.

Whole life insurance pays off a stated amount upon the death of the insured and accumulates a cash value that can be redeemed by the policyholder.

Universal life pays a dividend that is tied to market interest rates. Essentially, the cash value of a universal life policy builds and is used to buy term insurance.

Variable life insurance provides a death benefit that depends on the market value of the investment at the time of the insured’s death. The premiums are typically invested in common stock; hence such policies are referred to as equity-linked policies. While the death benefits are variable, there is a guaranteed minimum death benefit that the insurer agrees to pay regardless of the market value of the portfolio.

Universal Life Insurance: the main element of the universal life insurance is the flexibility of

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premium for the policyholder. It separates term insurance from cash value element of the policy.

13. Why are all participating policies written in an insurance company’s general account?

All participating policies by the insurance company are written in the general account. The general account of an insurance company refers to the investment portfolio of the overall company. Such products “Written by the company itself” are said to have a “general account guarantee” i.e. they are a liability of the insurance company. The rating agencies provide a credit rating based on products written by or guaranteed by the general account.

14. Whose liabilities are harder to predict, life insurers or property and casualty insurers? Explain why.

Property and casualty insurers P&Cs. Life insurance actuaries can predict death rates among various age groups based upon historical data. With P&Cs, the timing and amount of payoffs are almost random by nature. Past experience provides little predictive assistance. Homeowner claims are just as likely to arise in the first year of a policy or ten years later. Even then, the dollar amount of damage claims can be small or for the entire value of the policy.

15. How does the Financial Modernization Act of 1999 affect the insurance industry?

The Financial Modernization Act of 1999 will affect significantly the insurance industry in several ways. Even before this act, there was an increase overlap of insurance, investment, pension products and the distribution of products. The passage of this act has accelerated this convergence. This act has eliminated the barriers between insurance companies, commercial banks, and investment banks and various combinations will continue to evolve.

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ANSWERS TO QUESTIONS FOR CHAPTER 7

(Questions are in bold print followed by answers.)

1. An investment company has $1.05 million of assets, $50,000 of liabilities, and 10,000 shares outstanding.

a. What is its NAV?

b. Suppose the fund pays off its liabilities while at the same time the value of its assets double. How many shares will a deposit of $5,000 receive?

a. Net asset value = (Total assets minus liabilities) / numbers of shares = 1,050,000 – 50,000 = $100 10,000

b. Net asset value = 2,100,000 – 0 = $210 10,000

No of shares = 5000 = 23.81 shares. 210

2. “The NAV of an open-end fund is determined continuously throughout the trading day.” Explain why you agree or disagree with this statement.

Disagree. NAV of open-ended fund is the closing price of the day.

3. What are closed-end funds?

These funds issue a limited number of shares, are sold on the open market.

4. Why do some closed-end funds use leverage to raise more funds rather than issue new shares like mutual funds?

Under the 1940 Act, these funds are capitalized only once. The number of shares is fixed. Thus many funds become leveraged to raise more funds without issuing new (additional) shares.

5. Why might the price of a share of a closed-end fund diverge from its NAV?

The price of closed-end funds may differ from NAV (often at a discount) because the fund has a large built-in tax liabilities and investors are discounting the share’s price for future tax liabilities. Leverage may be another factor for price below NAV.

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6. What is the difference between a unit trust and a closed-end fund?

With a unit trust a number of securities are assembled in a portfolio package and held for a specified number of years and then liquidated. The charges are low since there is no trading of securities or redemption prior to maturity. 7.

a. Describe the following: front-end load, back-end load, level load, 12b-l fee, management fee.

b. Is there a limit on the fees that a mutual fund may charge?

a. Back-end load funds charge sales fees upon redemption within a period of a few years. Front end is commissioned charged up front of the time of sale. A level load is amount of sales commission a fund may charge. A 12b-1 fund is a no-load fund that charges an annual sales fee of around 1.5% annually.

b. Yes the security rule specifies these fees.

8. Why do mutual funds have different classes of shares?

Different classes of shares offered by mutual funds is determined by the needs of the investors and their risk preferences. It permits the distributor and its client to select the type of load they prefer.

9. What is an index fund?

An index fund e.g. Fidelity Magellan and Vanguard S&P 500 are mutual funds, which invests in stocks included in S&P 500, and aim to achieve its performance to the benchmark S&P500 returns. 10.

a. What is meant by a target-date fund?

b. What is the motivation for the creation of such a fund?

a. Target date funds are mutual funds that base their asset allocations on a specific date, the assumed retirement date for the investor, and then rebalance to a more conservative allocation as that date approaches.

b. These funds are designed to be “one-size-fits-all” portfolios for investors with a given number of

years to retirement.

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11. What are the costs incurred by a mutual fund?

Costs typically incurred by an investment company (Mutual fund) include advisory fees, selling/marketing expenses, custodial/accounting fees, and transactions costs. There are two types of costs borne by investors in mutual funds. The first is shareholder fee, usually called the sales charge. This type of charge is related to the way the fund is sold or distributed. The second cost is the annual fund operating expense usually called the expense ratio, which covers the fund’s expenses. The largest of which is for investing managements.

12. Why might the investor in a mutual fund be faced with a potential tax liability arising from capital gains even though the investor did not benefit from such a gain?

Investor in a closed fund is faced with a potential tax gain on capital gains that swell the net asset value. The investor is pricing future-tax distributions.

13. Does an investment company provide any economic function that individual investors cannot provide for themselves on their own? Explain your answer.

Yes. An investment company provides risk reduction through diversification and lower costs of transactions and information processing, which is hardly to come by an individual investor.

14. Why might a family of funds hire subadvisors for some of its funds?

They are used because (1) to develop a fund in an area in which the fund family has no expertise, (2) to improve performance, (3) to increase assets under management, (4) to obtain an attractive manager at a reasonable cost. 15.

a. How can a fund qualify as a regulated investment company? b. What is the benefit in gaming this status?

a. A regulated investment company must provide information on its fees and its objectives. It must file financial reports and indicate amount of income distributed.

b. A regulated investment company is exempt from taxation on all its ordinary and capital gains income as long as at least 90% of these funds are distributed to the stockholders. Such distributions are then taxable to the stockholders.

16. What is an ETF?

An exchanged traded fund is a new investment vehicle that is similar to mutual funds but trade like a stock on an exchange. The price is determined continuously rather than the closing price e.g. QQQ.

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17. What are the advantages of an ETF relative to open-end and closed-end investment companies?

As said earlier, price is continuously changing during the trading period.

18. Explain the role of the authorized participant in an ETF.

The role of the authorized participants is to engage in arbitrage transactions that maintain the market price of the ETF as compared to an index portfolio.

19. Why is tracking error important for an ETF?

Since ETFs are based on passive indexes where value is represented by the NAV, investors in ETFs expect their return to be equal to that of the portfolio’s NAV. Large tracking error s are bad for ETFs because it undermines the investor’s expectation.

20. Comment on the following statement: “Exchange traded funds are typically actively managed funds.”

Since they are mostly index funds, they are passively managed.

21. Briefly describe the following in the context of mutual funds: a. supermarket b. wrap program

c. segregated managed accounts d. family of funds

a. Supermarkets: The introduction of the first mutual fund supermarket in 1992 by Charles Schwab & Co. introduced its One Source service. These supermarkets allow investors to purchase funds from participating companies without investors having to contact each fund company.

b. Wrap program: Wrap accounts are managed accounts, typically mutual funds “wrapped” in a service package. The service provided is often asset allocation counsel; that is advice on the mix of managed funds.

c. Segregated managed accounts: are in response to individuals who object to mutual funds because

of their lack of control over taxes and other investment decisions. Many investors with medium-size portfolio are utilizing segregated accounts.

d. Family of funds: In the U.S. system, a family of funds consists of an investment company that offers several different funds. In Japan the family fund allows investors to buy new certificates in a grouping of existing unit trusts.

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ANSWERS TO QUESTIONS FOR CHAPTER 8

(Questions are in bold print followed by answers.)

1. What is a plan sponsor?

A plan sponsor is a corporation or public agency that establishes a retirement plan for its employees. Plan sponsors include private businesses, federal, state, and local governments, unions, not-for-profit organizations, and even individuals setting up plans for themselves.

2. How does a defined-benefit plan differ from a defined-contribution plan?

In a defined contribution plan, the sponsor and/or employees are responsible only for making specified (hence “defined”) contributions to the plan. There is no guarantee of what amount will be available upon retirement. Hence the employee bears the risk of whether he will have an adequate retirement income. Under a defined benefit plan the sponsor agrees to provide specified dollar payments to employees upon their retirement. The amount to be paid is usually determined by a formula, which considers length of time of employment and income level. Herein the employer takes the risk of having sufficient funding to meet future needs. Vested benefits are guaranteed by the Pension Benefit Guaranty Corporation (PBGC), wherein an employer contributes a certain amount each year. A pre-set minimal benefit level is specified, but if the plan does not meet this goal, the employee must make up the deficit.

3. Why have some corporations frozen their defined benefit plans?

Pension plans are too costly and some companies have found it difficult to compete with other firms. 4.

a. What is a cash balance plan?

b. Discuss the resemblance of a cash balance plan to a defined-benefit and a defined-contribution plan.

a. A cash balance plan is basically a defined benefit that has some of the features of a defined contribution plan. It defines future pension benefits. Each participant in a cash balance plan has an account that is credited with a dollar amount that resembles an employer contribution and is generally determined as a percentage of pay. The plan usually provides benefits in the form of a lump-sum distribution as an annuity. Interest is credited to the employee’s account at a rate specified in the plan and is unrelated to the investment earnings of the employer’s pension trust.

b. A cash balance plan is similar to defined benefits in the sense that benefits are fixed based on a formula. Investment responsibility is borne by the employer, and employees are automatically included in the plan. It is similar to defined contribution in the sense that assets are accumulated in an “account” for each employee and vested assets may be taken as a lump sum and rolled into an IRA.

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a. What is an insured pension plan? b. What is the function of PBGC?

a. An insured plan is one administered by an insurance company providing annuities upon retirement. Unless the PBGC is involved for defined benefits, there is no further insurance. b. The Pension Benefit Guaranty Corporation insures vested benefits under defined benefits plans in the event of corporate failures. It charges premiums for this service. Currently, the PBGC itself is close to insolvency due to fact that many corporate plans are under-funded and PBGC itself has little enforcement power. Also, many companies have dropped defined benefit plans in favor of defined contribution plans to save themselves premium payments and pass on the risks of providing adequate retirement income to the employees themselves.

6. What role do mutual funds play in 401(k) plans?

A 401k plan is a defined contribution plan. The employee can select a qualified plan in which to place his retirement contributions. These contributions are tax deferred as is the income generated by the fund. A mutual fund can qualify as a 401k plan, thus allowing it to generate tax-deferred earnings on behalf of the employee.

7. Can and do pension plans invest in foreign securities or tax-exempt securities?

U.S. pension funds are free to invest in foreign securities. However, plan sponsors may set local restrictions. It is also true for tax-exempt securities. 8.

a. What is the major legislation regulating pension funds?

b. Does the legislation require every corporation to establish a pension fund?

a. Pension plans are regulated under the Employee Retirement Income Security Act of 1974 as amended. This legislation establishes the types of plans covered, funding and vesting requirements, and the PBGC.

b. There is currently no legislation that requires a corporation to establish a pension plan. But if it does so, it must comply with ERISA regulations.

9. Discuss ERISA’s “prudent man” rule.

ERISA’s “prudent man role” establishes fiduciary standards for pension fund trustees and managers. The rule seeks to determine which investments are proper to make sure that the trustee takes the role seriously in acquiring and using the information pertinent to making an investment decision.

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10. Who are plan sponsor consultants and what is their role?

In addition to money managers, advisors call plan sponsor as consultants they provide other advisory services to pension plan sponsors. Among the functions that consultants provide to plan sponsors include developing plan for investment policy, providing actuarial advice, designing benchmarks and measuring and monitoring the performance of the fund’s money managers.

11. In 2001, investor Warren Buffett had this to say about pension accounting:

Unfortunately, the subject of pension [return] assumptions, critically important though it is, almost never comes up in corporate board meetings. . . . And now, of course, the need for discussion is paramount because these assumptions that are being made, with all eyes looking backward at the glories of the 1990s, are so extreme.

a. What does Mr. Buffett mean by the “pension return assumption”?

b. Why is the pension return assumption important in pension accounting in accordance with generally accepted accounting principles?

c. Why is the pension return assumption important in pension accounting in accordance with Internal Revenue rules?

d. Mr. Buffet went on to warn that too high an assumed return on pension assets risks litigation for a company’s chief financial officer, its board, and its auditors. Why?

a. The assumptions that management or plan administrator uses to project pension fund growth rates, and amounts of assets and liabilities.

b. The assumptions determine whether plan assets can meet liabilities. Overly optimistic return lead to conclusions that liabilities will be met and that the fair value of the plan is positive.

c. There are IRS regulations that determine the actual amount of funding required.

d. Too high an assumed return on pension assets may mislead plan participants on the issue of plan solvency. Such deception may lead to litigation.

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ANSWERS TO QUESTIONS FOR CHAPTER 22

(Questions are in bold print followed by answers.)

1. What type of property is security for a residential mortgage loan?

Real residential property secures a residential mortgage loan. 2.

a. What are the sources of revenue arising from mortgage origination? b. What are the risks associated with the mortgage origination process? c. What can mortgage originators do with a loan after originating it?

a. Mortgage originators generate income from mortgage activities by: (1) charging an origination or application fee, expressed in terms of “points” or a percentage of the borrowed amount, (2) obtaining a possible profit if the mortgage is sold for a higher price than the amount loaned to the borrower, and (3) in the case of a mortgage sale or securitization the originator may continue to service the account, thereby gaining a servicing fee from the new holder.

b. The risks associated with originating mortgage loans can be referred to collectively as pipeline risk. This risk consists of price risk and fallout risk. Price risk refers to the adverse effects on the value of mortgage loans in the pipeline if mortgage rates rise. Fallout risk refers to the risk that applicants or persons with commitment letters from the lender do not close on the contract, a situation which could arise if rates dropped and the borrower found lower-cost financing elsewhere.

c. Mortgagees have three options on completed mortgage loans: (1) they can keep the loans for their portfolio (rare these days), (2) they can sell the mortgage to another party, thereby gaining liquidity and eliminating credit risk to themselves, or (3) they can securitize the mortgage by issuing debt with the mortgage payments as collateral. The effect is the same as (2). 3.

a. In selling a mortgage loan for future delivery, what is the advantage of obtaining an optional rather than mandatory delivery agreement? b. What is the disadvantage of optional delivery?

a. The originator can eliminate fallout risk.

b. The agency or private conduit has sold the option to the mortgage originator and thus charges a fee for allowing optional delivery.

4. What are the sources of revenue for mortgage servicers?

Servicing the mortgage involves collecting payments of principal, interest and escrow payments for taxes and insurance where applicable, keeping the account records, and passing the payments through to bondholders.

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5. What are the two primary factors in determining whether or not funds will be lent to an applicant for a residential mortgage loan?

The two primary factors for individual mortgage loan qualification are: (1) payment-to-income, whether the applicant has sufficient income to meet payment terms, and (2) loan-to-value, whether the appraised value of the property is sufficiently higher than the loan value so that the lender has sufficient collateral in the property lien.

6. All other factors constant, explain why the higher the loan-to-value ratio, the greater the credit risk to which the lender is exposed.

A high loan to value means that the financing is highly leveraged. A decrease in the asset value may result in a loan value that exceeds the asset value. According, there is greater credit risk since a homeowner may simply walk away from the house.

7. What is the difference between a cash-out refinancing and a rate-and-term refinancing?

When the loan amount requested exceeds the original loan amount, the transaction to refinance is the cash-out refinancing. When the loan balance remains unchanged, the refinancing is called rate-and-term refinancing.

8. What is the front ratio and back ratio and how do they differ?

They are both income ratios. The front ratio is computed by dividing the total monthly payments by the applicant’s pretax monthly income. The back ratio is computed in a similar manner, but it adds other debt payments such as auto loan and credit card payments. 9.

a. What is the difference between a prime loan and a subprime loan? b. How are FICO scores used in classifying loans? c. What is an alternative-A loan?

a. A subprime loan is one belonging to a borrower with a lower credit score. b. The FICO scores determine the credit quality of the borrower.

c. Alt-A loans are considered to be prime loans, but they have some attribute that increases the credit risk. 10.

a. What is an FHA-insured loan? b. What is a conventional loan?

a. A FHA loan is a government loan that is sponsored by the Federal Housing Administration, and it is guaranteed by the full faith and credit of the United States.

b. A conventional loan is a loan that is not guaranteed by the full faith and credit of the United States.

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11.

a. What is meant by conforming limits? b. What is a jumbo loan?

a. A conforming limit is the loan amount limit set by government sponsored entities such as Fannie Mae and Freddie Mac.

b. A jumbo loan is a loan that exceeds the conforming limit. 12.

a. When a prepayment is made that is less than the full amount to completely pay off the loan, what happens to future monthly mortgage payments for a fixed-rate mortgage loan?

b. What is the impact of a prepayment that is less than the amount required to completely pay off a loan?

a. The loan is not recast. The borrower continues to make the same monthly mortgage payment. b. The net effect of the prepayment is that the loan is paid off faster than the scheduled maturity date.

13. Consider the following fixed-rate, level-payment mortgage:

Maturity = 360 months

Amount borrowed = $100,000 Annual mortgage rate = 10%

a. Construct an amortization schedule for the first 10 months.

b. What will the mortgage balance be at the end of the 360th month, assuming no prepayments?

c. Without constructing an amortization schedule, what is the mortgage balance at the end of month 270, assuming no prepayments?

d. Without constructing an amortization schedule, what is the scheduled principal payment at the end of month 270, assuming no prepayments?

a. An amortization schedule can be constructed as follows:

Beginning Mortgage

Month Balance 1 $100,000.00 2 99,955.76 3 99,911.15 4 99,866.16 5 99,820.88 6 99,775.15 7 99.729/04 8 99,682.54 9 99.635/66 10 99,588.39

Monthly

Mortgage Payment 877.57 877.57 877.57 877.57 877.57 877.57 877.57 877.57 877.57 877.57

Interest Charge 833.33 832.96 832.59 832.29 831.84 831.46 831.07 830.69 830.30 829.90

Principal Payment 44.24 44.61 44.99 45.28 45.73 46.11 46.50 46.88 47.27 47.67

Ending Mortgage Balance 99,955.76 99,911.15 99,866.16 99,820.88 99,775.15 99,729.04 99,682.54 99,635.66 99,588.39 99,540.72

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b. Since the level-rate payment provides for gradual repayment of principal over the term of the loan, the mortgage balance at the end of the 360th month will be zero. c. The mortgage balance is calculated as:

d. The principal payment is calculated as:

14. Explain why in a fixed-rate mortgage the amount of the mortgage payment applied to interest declines over time, while the amount applied to the repayment of principal increases.

In amortization, the amount of the loan balance decreases with time and payments. Thus, the interest payment decreases and the principal payment increases. 15.

a. a.Why is the cash flow of a residential mortgage loan unknown?

b. In what sense has the investor in a residential mortgage loan granted the borrower (homeowner) a call option?

a. The cash flow of a mortgage is unknown because the borrower usually has a right to prepay the mortgage at any time, in whole or in part.

b. The call option occurs in the borrower’s right to prepay the loan at any time.

16. Why do depository institutions prefer to invest in adjustable-rate mortgages rather than fixed-rate mortgages?

An ARM adjusts to the changing interest rate environment. Therefore, a fixed rate exposes the investor to basis risk, the adverse change in interest rate.

17. What is a hybrid ARM?

A hybrid ARM is an adjustable rate mortgage that has a fixed rate for a specified period of time.

18. What is the advantage of a prepayment penalty mortgage from the perspective of the lender?

A prepayment penalty provides protection against prepayment, which is the risk that borrowers will refinance at lower rates when rates decrease in the borrower’s favor.

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19. Explain whether you agree or disagree with the following statements:

a. “Freddie Mac and Fannie Mae are only allowed to purchase conforming conventional loans.”

b. “In packaging loans to create a mortgage-backed security, Freddie Mac and Fannie Mae can only use government loans.”

a. Agree. For loans guaranteed by Freddie Mac and Fannie Mac, there are limits on the loan balance.

b. Disagree. Because the guarantees of Freddie Mac and Fannie Mae do not carry the full faith and credit of the U.S. government, they are not classified as government loans. 20.

a. What features of an ARM will affect its cash flow?

b. What are the two categories of benchmark indexes used in ARMs?

a. There are two features of an adjustable-rate mortgage loan that will affect its cash flow: (1) restrictions on the new mortgage rate than can be charged to the homeowner at each reset date (periodic caps), and (2) restrictions on the minimum and maximum mortgage rates that may be charged to the homeowner at any reset date (lifetime caps and floors).

b. The two most popular indexes are the one-year Treasury rate and the 11th District Cost of Funds. The latter index is a calculation based on the monthly weighted average interest cost for liabilities of thrifts in the 11th Federal Home Loan Bank Board District, which includes the states of California, Arizona, and Nevada.

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ANSWERS TO QUESTIONS FOR CHAPTER 23

(Questions are in bold print followed by answers.)

1. What is a mortgage pass-through security?

A pass-through security is created when one or more holders of mortgages form a collection (pool) of mortgages and sell shares or participation certificates in the pool.

2. Describe the cash flow of a mortgage pass-through security.

The cash flow features of a pass-through security are as follows. The holder of the security is entitled to receive a pro rate share of the cash flow from the underlying pool of mortgages. The cash flow the investor receives and the cash flow from the underlying pool differ in two ways. First, there is a servicing fee that is paid to the servicer of the mortgages and any fee charged by the guarantor. The cash flow received by the holder of a pass-through is less than the cash flow from the underlying pool by an amount equal to the servicing fee and any guarantor fee. Second, there is a slight delay in passing the cash flow through to the investor. The number of days delayed differs from program to program.

3. How has securitization enhanced the liquidity of mortgages?

Many institutional investors are unwilling to buy individual mortgage loans. However, they are willing to buy securities backed by them. In the absence of securitization, the mortgage market would be extremely illiquid. The demand for mortgage loans for securitization purposes increases the liquidity of the market since there are participants (agencies and private conduits) ready and willing to buy these loans so that they can be pooled.

4. What are the different types of agency pass-through securities?

There are three types of agency pass-throughs: Ginnie Mae MBS, Freddie Mac participation certificates, and Fannie Mae MBS. The different features of each are described in the book.

5. How does the guaranty for a Ginnie Mae MBS differ from that of a MBS issued by Fannie Mae and Freddie Mac?

Ginnie Mae mortgage-backed securities are guaranteed by the full faith and credit of the U.S. government with respect to timely payment of both interest and principal.

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6. What is meant by prepayment risk, contraction risk, and extension risk?

An investor who owns pass-through securities does not know what the cash flow will be because of prepayments. The risk associated with prepayments is called prepayment risk. This risk can be divided into contraction (or call) risk and extension risk. Contraction risk results because of the adverse consequences when mortgage rates decline. Extension risk is the risk that prepayments will slow down when interest rates rise, resulting in the investor holding a security with a lower coupon rate than the prevailing market rate.

7. Why would a pass-through be an unattractive investment for a savings and loan association?

As mentioned in the above question, prepayment risk makes pass-throughs unattractive for certain financial institutions to hold from an asset-liability perspective. Thrifts want to lock in a spread over their cost of funds, as their funds are raised on a short-term basis. They will face a mismatch problem because a pass-through is a longer-term security.

8. What is meant by the average life of a pass-through?

The average life of a mortgage pass-through is the average time to receipt of principal payments, weighted by the amount of principal expected. The average life of pass through depends on the PSA prepayment assumption.

9. Why is an assumed prepayment speed necessary to project the cash flow of a pass-through?

A projection of assumed prepayment speed is necessary to determine the cash flow of the pass-through security in order to value a security. But the projection of cash flows require some assumptions about the prepayment rate over the life of a mortgage pool. The prepayment rate is called speed.

10. A cash flow for a pass-through typically is based on some prepayment benchmark. Describe the benchmark.

Typically, the PSA standard prepayment benchmark is used to project prepayments. (Note, however, that this is a market convention, not an actual model of prepayments). It is a series of CPRs: 0.2% for month 1 increasing by 0.2% per month for 29 months until month 30 when it levels at 6% for the remaining years.

11. What does a conditional prepayment rate of 8% mean?

A conditional prepayment rate of 8% is an annual rate, and is based on the characteristics of the pool including historical, current and future economic environment. To make it meaningful, it must be converted into a monthly rate of the remaining mortgage balance.

12. What does 150 PSA mean?

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The PSA prepayment benchmark is expressed as a monthly series of annual prepayment rates. Slower or faster speeds are referred to as some percentage of PSA. For example, 150 PSA means 1.5 times the CPR of the PSA benchmark prepayment rate.

13. How does a CMO alter the cash flow from mortgages so as to shift the prepayment risk across various classes of bondholders?

By establishing rules for prioritizing the distribution of principal payments from the underlying collateral, prepayment risk can be shifted. While the prepayment risk associated with the underlying collateral cannot be eliminated, by prioritizing the distribution of principal to different CMO classes, risk can be shifted such that those who seek protection against contraction risk but are willing to accept extension risk can purchase a CMO class with this investment feature. Or, those who seek protection against extension risk but are willing to accept contraction risk can invest in a CMO class with that investment feature.

14. “By creating a CMO, an issuer eliminates the prepayment risk associated with the underlying mortgages.” Do you agree with this statement? Explain.

Disagree. This statement is incorrect. The prepayment risk associated with the underlying mortgages in a CMO cannot be eliminated. It can only be redistributed among CMO classes.

15. Explain the effect of including an accrual tranche in a CMO structure on the average lives of the sequential-pay structures.

By including an accrual tranche in a CMO structure, the average lives of the other tranches in a sequential pay structure are reduced. This is so, because the current interest on the accrual tranche is used to pay the principal balance of the other tranches.

16. What types of investors would be attracted to an accrual bond?

Investors who are concerned with reinvestment risk would be attracted to an accrual bond. This is so because there are no coupon payments to re-invest.

17. What was the motivation for the creation of PAC bonds?

Traditional corporate bondholders seek a structure whose repayment schedule as well as credit risk was known. Traditional CMOs satisfied the second criteria but not the first. Hence, PAC bonds were created to meet the first criteria of a known repayment schedule.

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18. Describe how the schedule for a PAC tranche is created.

In order to create a schedule for a PAC tranche, one first needs to know the specified range of prepayments of the collateral. Suppose that the collateral pre-pays over its life at a speed between 90 PSA and 300 PSA. Then, the minimum principal payment is calculated for PSA numbers in this range. Thus, the schedule of principal repayments that the PAC bondholders are entitled to receive, is specified. 19.

a. Why is it necessary for a nonagency MBS to have credit enhancement? b. Who determines the amount of credit enhancement needed?

a. Because there is no government guarantee, the bonds need credit enhancement to receive an investment-grade rating.

b. The rating agencies determine the level of credit enhancement needed.

20. What is the difference between a prime and subprime MBS? Be sure to mention how they differ in terms of credit enhancement.

Private label MBS are collateralized by prime loans, whereas subprime MBS are collateralized by subprime loans. Due to the credit quality of the underlying loans, the credit enhancement required will be different between these securities. 21.

a. What is meant by a senior-subordinate structure?

b. Why is the senior-subordinate structure a form of credit enhancement?

a. A senior-subordinated structure is a bond offering with multiple tranches based on a senior and subordinate tranche structure.

b. This structure can be seen as credit enhancement because the default risk of the senior tranche is supported by the subordinate tranche.

22. How can excess spread be a form of credit enhancement?

The excess spread can be used to realize any losses. Therefore, it is a form of credit enhancement.

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