Download Ch 11: 1.1

1.1
Investment banking involves, among other activities, underwriting new security issues and
providing advice on mergers and acquisitions, whereas commercial banking primarily involves
taking deposits and making loans.
1.2
Repo financing is borrowing funds short term using a repurchase agreement, which is the sale of
securities together with an agreement for the seller to buy back the securities at a slightly higher
price either the next day or within a few days. Repos are short-term loans with the securities
serving as collateral. Leverage is the financing of investments by borrowing rather than using
capital. Investment banks became more reliant on repo financing and more highly leveraged
because by the 1990s most of these banks had converted from partnerships to publicly traded
companies and proprietary trading became a more important source of profits. Investment
banks borrowed to finance their investments in securities and their direct loans to firms.
1.3
The large stand-alone investment banks either went bankrupt, were taken over, or converted to
bank holding companies to obtain access to Federal Reserve lending to survive the financial
meltdown.
1.5
a. Underwriting is where investment banks guarantee (typically) a price to the issuing firm for new
stocks or bonds and then sell the new stocks or bonds at a higher price in financial markets or
directly to investors. Underwriting is financial intermediation because the bank brings together
savers and the firms who issue new securities.
b. An investment bank that buys securities with its own capital is not acting as a financial
intermediary. It is buying securities with the expectation of profit from the yield or from
changes in the prices of the securities. Investing in this way does not involve acting as an
intermediary by funneling funds from savers to borrowers.
1.6
a. Leverage involves investing using borrowed funds rather than using capital or equity to invest.
The excerpt indicates that the Long-Term Capital Management hedge fund used $5 billion in
capital to get an additional $125 billion in funds. The $125 billion in funds were then used to
control $1.25 trillion in securities. So, Long-Term Capital Management was highly leveraged
because it used relatively little capital and a great amount of borrowing to control investments
that were many times larger.
b. Leverage is a double-edged sword. It can increase profits, but it can also magnify losses. These
losses were so massive that they created systemic risk to the rest of the system. If Long-Term
Capital Management had defaulted on its loans, many other financial firms would have taken
large losses.
1.8
The leverage ratio equals the value of assets divided by the value of equity. So, the leverage
ratios are:
a. $200,000/$200,000  1
b. $200,000/$40,000  5
c. $200,000/$20,000  10
d. $200,000/$10,000  20
The return on investment equals the increase in the price of the house divided by the amount
invested:
a. $20,000/$200,000  10%
b. $20,000/$40,000  50%
c. $20,000/$20,000  100%
d. $20,000/$10,000  200%
2.1
Investment institutions are similar to commercial banks because they are financial
intermediaries that raise funds and invest the funds in loans and securities. Unlike commercial
banks, investment institutions do not raise funds through deposits and they can invest in a wider
variety of assets.
2.2
Mutual funds differ from hedge funds in that hedge funds are usually partnerships with a
relatively small number of investors. Mutual fund activities are more transparent and mutual
funds provide a list of the assets that the fund owns. Hedge funds are generally less regulated,
take more risks for higher returns, and are less liquid.
2.3
Finance companies have an advantage over commercial banks in monitoring the value of
collateral, which gives them an advantage in lending for consumer durables, inventories, and
business equipment.
2.4
Deposits in bank savings accounts are covered by federal deposit insurance whereas money
market mutual fund shares are not. Also, money market mutual funds restrict savers to writing
checks only above a specified amount, such as $500.
3.1
Contractual savings institutions are similar to commercial banks because they are financial
intermediaries that raise funds and invest the funds in loans and securities. Contractual savings
institutions are different from commercial banks in that they do not raise funds through deposits
but receive payments from individuals as a result of a contract, and they can invest in a wider
range of assets.
3.2
In a defined contribution plan, the firm places contributions from employees (which some
employers match up to a certain limit) into investments chosen by the employees. The
employees own the funds in the plan. In a defined benefit plan, the firm promises employees a
particular dollar benefit payment, based on each employee’s earnings and years of service. In a
401(k) plan, employees are not taxed on what they contribute to their 401(k), or on the earnings
on those investments, until the funds are withdrawn during retirement.
3.3
Insurance companies are financial intermediaries in that they obtain funds by charging
premiums to policyholders and use these funds to make investments. Life insurance insures
against loss of life or disability, and property and casualty insurance insures against loss of
property.
3.4
In a defined benefit plan, a worker’s retirement payout is determined by a formula so that
the worker can plan on receiving a specific pension payment. However, the worker could lose some
of his or her pension benefits if the plan is underfunded or if the employer goes out of business. In a
defined contribution plan, the worker’s retirement payout depends on the performance of the
invested funds, so it may be riskier than a defined benefit plan. It is possible, though, for the return
to be high and, therefore, the payouts could be higher than under a defined benefit plan. In addition,
the worker often has some control over how the money is invested and ordinarily has ownership of
the funds. From the employer’s point of view, the defined contribution plan involves less risk than
the defined benefit plan because the firm is not committed to making specific pension payments.
3.5
a. Traditional pension plans are defined benefit plans under which retirement payouts are fixed by
a formula that is typically based on the worker’s years on the job and final salary. 401(k) plans
are defined contribution plans under which payouts depend on the return earned by the plan’s
investments.
b. 401(k) plans might be more desirable to employers because they do not face the risk of having
poor investment returns and underfunded pension plans that might require the employers to
divert additional revenues to their pension plans.
401(k) plans might be more desirable to employees because they own the value of the funds in
the plan, can determine within a set of choices how to invest the funds, and need to be less
concerned that an employer’s financial problems might undermine the solvency of a defined
benefit plan. 401(k) plans might be less desirable to employees because they bear the risk of
poor investment returns and do not have a guarantee of a particular dollar benefit payment.
3.6
Pension funds have vesting periods in order to reduce turnover among employees who are not
yet vested and to avoid making pension payments to employees who have worked for the firm
only briefly. Vesting requirements limit pension payments to only those workers who have
been at the firm for a considerable period of time, typically at least several years. Because of
vesting requirements, employees who work for a firm for many years will receive higher
pension payments than they would if pension funds included workers who had worked for the
firm only briefly.
4.1
The shadow banking system is a collection of nonbank financial institutions that channel money
from savers to borrowers. The shadow banking system is largely unregulated and can invest in
more risky assets and become more highly leveraged than commercial banks. Unlike
commercial banks, there is no federal deposit insurance for the investors providing funds to the
shadow banking system.
4.2
A run on a financial firm is the attempt by investors to get their money out before the firm fails.
Commercial banks do not typically have bank runs because their deposits are insured by the
Federal Deposit Insurance Corporation (FDIC), which reduces the risk to depositors. The
shadow banking industry does not have an equivalent to the FDIC because their short-term
borrowing is not in the form of deposits.