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Final Exam
Money and Banking
Economics 333
Thursday, December 14, 2005
Answer All Questions on this exam sheet. Do not turn in the scratch
paper bluebooks.
Short Answer (2 points each)
1.
We see that for a 10-period coupon bond, the current yield is greater than the
coupon rate. This implies:
a. The price is higher than the face value and the yield to maturity is higher
than the current yield.
b. The price is higher than the face value and the yield to maturity is lower
than the current yield.
c. The price is lower than the face value and the yield to maturity is higher
than the current yield.
d. The price is lower than the face value and the yield to maturity is lower
than the current yield.
___________________
2.
Assume that uncovered interest parity and the expectations theory of the term
structure are true. The yield on 1 year HK dollar bonds is 5% and the yield on 1 year
Singapore dollar bonds is 10% indicating that the market expects a depreciation of the
Singapore dollar (relative to the HK dollar) over the upcoming year. The yield on a 2
year HK dollar bond is 8% and the yield on a 2 year Singapore dollar bond is 10%.
a. the interest rates on 1 year HK dollar bonds to be greater than 5% next
year and the depreciation rate of the HK dollar to be negative in the
upcoming year and positive in the subsequent year.
b. the interest rate on 1 year HK dollar bonds to be greater than 5% next year
and the depreciation rate of the HK dollar to be negative in the next
coming year and negative in the subsequent year.
c. the interest rates on 1 year HK dollar bonds to be less than 5% next year
and the depreciation rate of the HK dollar to be negative in the upcoming
year and positive in the subsequent year.
d. the interest rate on 1 year HK dollar bonds to be less than 5% next year
and the depreciation rate of the HK dollar to be negative in the next
coming year and negative in the subsequent year.
___________________
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3.
We see that in the United States there is a high-tech investment boom coupled
with a large government budget deficit. Assuming that Hong Kong maintains a credible
exchange rate peg with the US dollar, we should observe:
a. An increase in the supply of bonds in the US dollar market and an increase
in bond yields in HK.
b. An increase in the supply of bonds in the US dollar market and a decrease
in bond yields in HK.
c. A decrease in the supply of bonds in the US dollar market and an increase
in bond yields in HK.
d. A decrease in the supply of bonds in the US dollar market and a decrease
in bond yields in HK.
___________________
4.
A bank with no excess reserves faces a sudden large withdrawal of funds by a
depositor. To improve the liquidity of its balance sheet, the bank could
a. Sell secondary reserves to adjust the liquidity of the banks assets or lend in
the interbank market to adjust the liquidity of the banks liabilities.
b. Buy secondary reserves to adjust the liquidity of the banks assets or lend
in the interbank market to adjust the liquidity of the banks liabilities.
c. Sell secondary reserves to adjust the liquidity of the banks assets or
borrow in the interbank market to adjust the liquidity of the banks
liabilities.
d. Buy secondary reserves to adjust the liquidity of the banks assets or
borrow in the interbank market to adjust the liquidity of the banks
liabilities.
___________________
5.
The central bank intervenes in the foreign exchange market and sells foreign
currency. If this intervention is sterilized, we should expect to see,
a. an increase in foreign reserves and an increase in bank reserves
b. an increase in foreign reserves and a decrease in bank reserves
c. a decrease in foreign reserves and an increase in bank reserves
d. a decrease in foreign reserves and a decrease in bank reserves
__________C______
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6.
Comparing Core Deposits and Managed Liabilities
a. Core Deposits have greater non-interest costs and managed liabilities have
greater liquidity risk.
b. Core Deposits have greater non-interest costs and managed liabilities have
lower liquidity risk.
c. Core Deposits have greater interest costs and managed liabilities have
greater liquidity risk.
d. Core Deposits have greater interest costs and managed liabilities have
lower liquidity risk.
_______________
7.
Subordinated debt is
a. Tier One Capital and Managed Liabilities
b. Tier One Capital and Core Deposits
c. Tier Two Capital and Managed Liabilities
d. Tier Two Capital and Core Deposits.
___________
8.
In the United States, we observe an increase in expected inflation. Using the bond
market perspective, we should observe
a. An increase in the price of US dollar bonds and an ambiguous effect on
quantity of US dollar bonds.
b. A decrease in the price of US dollar bonds and an ambiguous effect on the
quantity of US dollar bonds.
c. An ambiguous effect on the price of US dollar bonds and an increase in
the quantity of US dollar bonds.
d. An ambiguous effect on the price of US dollar bonds and a decrease in the
quantity of US dollar bonds.
________________
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9.
Assume that inflation in the US and HK move independently from one another.
Then we could say that
a. An increase in US inflation increases HK real interest rates and an
increase in HK inflation increases HK real interest rates.
b. An increase in US inflation increases HK real interest rates and an
increase in HK inflation decreases HK real interest rates.
c. A decrease in US inflation increases HK real interest rates and an increase
in HK inflation increases HK real interest rates.
d. A decrease in US inflation increases HK real interest rates and an increase
in HK inflation decreases HK real interest rates.
______B_________
10.
Your bank’s economist predicts that over the next 6 months, there will be a sharp
rise in both US GDP and in US inflation rates. If the U.S. central bank responds
according to the Taylor rule, which two derivative contracts will both be profitable:
a. the purchase of a HIBOR future with a settlement date of 6 months and a
plain vanilla swap in which the bank pays a HK$ floating rate and receives
a HK$ fixed rate.
b. the purchase of a HIBOR future with a settlement date of 6 months and a
plain vanilla swap in which the bank pay a HK$ fixed rate and receives a
HK$ floating rate.
c. the sale of a HIBOR future with a settlement date of 6 months and a plain
vanilla swap in which the bank pays a HK$ floating rate and receives a
HK$ fixed rate.
d. the sale of a HIBOR future with a settlement date of 6 months and a plain
vanilla swap in which the bank pay a HK$ fixed rate and receives a HK$
floating rate.
________________
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Verbal Answers
11.
(3 points) Name 3 elements of measuring a bank’s credit risk and a specific way
to measure each element.
i.
ii.
iii.
12.
(4 points) Explain two similarities in the way that the structure of the US and
Japanese banking markets have evolved in the last decade.
i.
ii.
13.
i.
ii.
iii.
(3 points) List 3 strategies for the operation of an independent central bank.
Central Bank sets monetary policy free of direct government control.
Long-terms of Office for Central Bank Policymakers, difficult for Central Bankers
to be Fired.
Central Bank has independent sources of revenue.
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14.
(10 points) The regulation of banks in Hong Kong has a number of parts.
Describe, in a few sentences, the following aspects.
i.
CAMEL Grading & Loan Classification
ii.
Capital Requirements
iii.
Liquidity Requirements
iv.
Restrictions on Lending
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15.
(5 points) Your boss would like you to predict next year’s short-term interest rates
in Hong Kong by noon today. You only have access to information from today’s
financial markets. Describe two ways to predict the interest rate next year. Be as specific
as possible.
i.
ii.
16.
(4 points) The Bank of Japan engages in an open market operation of 100 million
yen to push up the interbank interest rate. Describe this transaction using the following TAccount.
Bank of Japan
Liabilities & Net
Worth
Assets
-100 Government Bonds
-100 Reserves
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Graphing Question
17.
(6 points) Economic forecasters are predicting that there will be a recession in the
USA in the next year with falling output and slowing inflation. Assume that no such
recession occurs in East Asia. Draw two Graphs. The first will show the impact of these
events on the interbank market in Hong Kong. The second will show the impact on the
Korean Won foreign exchange market. Label the graphs clearly, but no further writing is
necessary.
A.
Hong Kong Interbank Market
1
iUS
iUS’
2
D
B.
Korean Won Forex Market
S
Supply
Demand’
1
Demand
2
Supply’
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Calculations
18.
(5 points) See the attached Consolidated Balance Sheets and Consolidated Profit
and Loss Accounts for DBS (Hong Kong). The bank’s accountant tells you that the
current market value is exactly equal to the book value, the duration of the bank’s assets
are dA = 4.5 and the duration of the banks liabilities are dL =2.5.
a. Calculate the Duration Gap for the bank
b. Calculate what fraction of the bank’s operating income comes from net
interest income.
19.
(5 points) A borrower can issue a 3 year discount bond with a face value of 100
and sell it for a price of 60. Calculate the yield to maturity for the discount bond.
Alternatively, the borrower could issue a coupon bond with a face value of 60. What
coupon would the bond issuer have to offer to sell the coupon bond at a price of 60,
assuming that the market demands a yield to maturity for the coupon bond that was equal
to the yield to maturity of the discount bond?
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20.
(6 points) The monetary base is $100. The central bank imposes a required
reserves ratio of 20% of demand deposits. The ratio of currency to demand deposits is
fixed at .8. Assuming no excess reserves, calculate the level of cash, reserves and M1.
1 C
D  1.8 The money supply is 180. The ratio of reserves to
R
D
D
deposits is .2. The ratio cash to deposits is ..8. The ratio of reserves to cash is .25.
Cash + Reserves = Base = Cash + .25*Cash implies Cash = 80 and Reserves = 20.
M! Multiplier is
C
21.
(4 points) You buy a 3 month HIBOR future (n = 90) with a principal of
HK$1,000,000 at a price quoted as 95 with a settlement date 9 months from now. In 9
months, the yield on 3 month HIBOR changes to 3%. What is the profit (or loss) on this
transaction?
10
22.
(7 points) A bank makes a 3 year constant payment loan of $1 Million at an
interest rate of 10%. Calculate the size of the fixed annual payment. Calculate the
duration of the loan assuming a discount factor of 10%
23.
(8 points) Assume that the bond market is restricted to 1 year discount bonds with
face value equal to 100. There are two types of borrowers in the bond market: risky
borrowers (“lemons”) and non-risky borrowers (“cream puffs). Fifty percent of
borrowers are known to be lemons and fifty percent of borrowers are known to be
creampuffs. Savers are willing to pay 90 for a lemon bond and 95 for a cream puff bond.
Lemon borrowers are willing to borrow if they can pay a yield no greater than 15% and
creampuff borrowers will issue bonds if they can pay a yield no greater than 6%.
Assume borrowers and savers are equally good bargainers, so that the price of bonds is
midway between the maximum price that savers are willing to pay for a bond and the
minimum price that borrowers are will to expect.
A.
If there is perfect information and borrowers and savers can easily distinguish
between lemon and creampuff bonds, what will be the prices at which lemon and
creampuff bonds will be sold?
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B.
Assume that savers cannot distinguish between lemon and creampuff bonds and are
willing to pay (at most) the expected value of a bond that is equally likely to be a
lemon or creampuff. What will be the price that savers will be willing to pay for a
bond of unknown type?
C.
Assume asymmetric information, so borrowers know the type of the bond but
savers do not. Is the price that savers will pay for a bond of unknown type greater
than or less than the minimum price that issuers of a creampuff bond will be willing
to accept? Will any creampuff bonds be sold? What price will prevail for a lemon
bond?
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12.
(10 points) A bank’s owners have $200 worth of capital to invest in a banking
business. A bank can raise up to $800 in 1-year time deposits by promising to pay a
5% interest rate (so the bank will have to repay $840 in 1 years’ time or default).
Assume that the bank takes deposits of $800 and is able to make $1000 in loans. The
bank can pursue two strategies.
i.
Under the first strategy, the bank makes $1000 in simple 1-year loans at an interest
rate of 10%. These simple loans are risk-free, so the bank will be able to collect
$1100 in 1 year. Calculate the banks profits as the difference between the amount
collected from borrowers and the amount that must be paid to depositors. Calculate
the return on equity and the net interest margin for a bank that pursues the safe
strategy.
ii.
Under the second strategy, the bank makes a risky loan of $1000 at an interest rate
of 55%. In the bad case which occurs with a 50% probability, the borrower defaults
and pays nothing. In the good case which occurs with a 50% probability, the
borrower pays the bank $1550. In the bad case, the bank will collect no money and
pay depositors nothing. In this case, bank owners will lose all of their capital so
Profits = -$200. In the good case, the owners will earn profits equal to the interest
earned minus the interest they must pay depositors. Calculate the expected value of
the bank owners’ profits.
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Now assume that bank regulators limit the Equity Multiplier that a bank can operate at by
limiting the amount of deposits that a bank with a given amount of capital can take. The
upper limit in deposits that a bank with capital of $200 can take is D , so the bank can
lend D +200. The bank can make safe loans with a 10% interest rates or they can make
risky loans at an interest rate of 55% (with a 50% chance of default in which case the
bank owners have a profit of -200). The bank must pay their depositors an interest rate of
5% on D .
iii.
Calculate the maximum level of D at which the bank owners would prefer to make
safe loans. What is the limit on the bank’s equity multiplier which the regulators
should impose if they want banks to lend safely? What would be the bank’s return
on equity in this case?
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