Download EC381: Financial and Capital Markets

EC381: Financial and Capital Markets
Outline Solutions May 2015
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Question 1
Assess the view that financial innovation is more about evading regulation and increasing profit
than it is about raising social welfare.
There should be an overview of what innovation means and how it can give any firm some
competitive advantage. There should be an assessment of some of the main innovations in the
financial services industry. These can range from those that are tied to retail financial services like
automated teller machines to recent developments in capital markets like credit default swaps
(CDS) and collateralised debt obligations (CDO). An assessment of the relationship between
regulation and financial innovation is also needed. There should be some discussion of the
meaning of social welfare and the way that financial innovation could assist in the payment system,
intermediation and the transfer of risk. Can bring HSBC into the discussion.
Question 2
This question has two parts. Each part has equal weight. Where there are sections within the
part, each section carries equal weight.
Part 1. Using the bank balance sheet to explain the following terms:
a) Capital adequacy
b) Liquidity management
c) Asset management
d) Off balance sheet activity
Part 2. How can changes to the bank regulatory regime help to reduce the risk of future banking
crisis?
a)
The answer should explain the importance of banking capital as a buffer against a decline in
asset value and say something about the general principals of capital adequacy. A good
answer will also consider the tension between profit-maximisation and capital adequacy.
b)
The answer should explain what liquidity is and should give some examples of liquid and
illiquid assets. A good answer would also relate liquidity to the nature of liabilities.
c)
There should be a discussion of the range of assets that are held by banks and an overview
of the relationship between risk and return. A good answer will consider credit risk and
diversification.
d)
There should be a clear understanding of on-balance sheet and off-balance sheet. There
should be some examples of off balance sheet activity. A good answer will consider the
regulatory advantage of having activity off the balance sheet.
The second section is more open but the answer should consider the way that maturity and
liquidity transformation makes banks vulnerable to credit risk and losses of confidence. The
reforms should address this fundamental weakness and therefore can include measures to
increase capital or make capital more aligned with the risk or liquidity of the assets; measures to
increase the liquidity of the assets; measures to address the maturity of the liabilities; measures to
reduce the risk of assets held (this may also include a discussion of bonus payments and other
incentives to increase risk, including the ownership structure). There may also be some coverage
of other banking activities, such as the trading activity that is conducted by investment banks and
how this may spill-over to conventional banks.
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EC381: Financial & Capital Markets (MS)
May 2015
Question 3
Please answer the following questions. Each question is equally weighted.
a)
Provide an overview of the main participants in the bond markets and an assessment of what
each is trying to achieve by their purchase of sale of bonds.
b)
Use supply and demand to explain how (assuming everything else remains constant) the
government bond yield would be expected to response to
i) an increase in inflation expectations
ii) an expansion in government spending
iii) a rise in risk aversion
iv) a reduction in liquidity in the secondary market
The main participations are the government and corporations. The main buyers are the usual
pension and insurance companies. The government is trying to raise finance. This is debt. A
regular bond is a fixed interest, so there is less concern about changing interest rates. The
liquidity should ensure that cost of funds is lower than a less liquid debt alternative. Pension and
insurance funds are generally trying to match assets to liabilities. Assuming no default, funds will
be delivered at a set day in the future.
The supply and demand should show a decrease in demand for rising inflation expectations and
high yields; an expansion in supply and higher yields; an increase in demand for relatively low risk
government bonds and lower yields; and, a reduction in demand and an increase in yield for less
liquidity. A good answer will explain the mechanism fully and will address the link between the
price and the yield. #
Question 4
Discuss some of the ways in which Chaos Theory can be of use in understanding behaviour of
financial markets.
Set out some of the main features of Chaos Theory such as:
Holistic system behaviour
Occurrence of self similar patterns in nature
Use of fractal geometry
Self organisation Turrin, Balusof
The butterfly effect
Discuss the usefulness to the understanding of behaviour in financial markets.
This can be in terms of overall methodology and approach as well as specific events.
Question 5
Critically analyse the UK government’s decision to provide economic support to the financial
services industry.
An answer to this question should assess the role of the financial services within the whole
economy. There should be a discussion of the central role of credit in the economy, covering
working capital and long-term investment; there should be some historical perspective that
references 1930s, banking, and the credit contraction. Other elements that could be part of a good
answer include, an assessment of the costs on supportive measures and the effect these may
have on the economy; arguments for or against support of other industries; the political economy
of financial services influence; the regulatory framework that allowed the financial collapse to
happen; an assessment of the short-term vs long-term costs of intervention.
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EC381: Financial & Capital Markets (MS)
May 2015
Question 6
“The 2007-8 crisis in the financial markets of major capitalist economies was solely brought about
by the crisis in the US sub prime mortgage market. “ Critically evaluate and discuss
Identify the significance of the defaults in the US sub prime market.
Longer term causes eg
Deregulation of national financial markets 1980s
• Global competition amongst financial institution
• Changing view of risk
• US trade imbalance
• Absence of international regulatory bodies
• Imbalances in global financial flows
Liberalisation of international flows, money and goods
More immediate causes eg
• Changing view of risk,
• Remuneration systems for operatives in financial institutions ,
• Use of whole sale money markets rather than traditional sources of loan-able funds
• Resale of debt in an unprecedented manner exasperating systemic contagion
• Speculation, phenomenal size of activity
• Asset price bubbles bursting
• Toxic assets
• US Subprime defaults
• Leverage unwinding positions
Poor information on the size of potential defaults leading to greater difficulty in maintaining
confidence
• Cyclical economic downturn
Develop a discussion of the main reasons for the onset of the crisis in the financial markets
evaluating the initial statement.
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EC381: Financial & Capital Markets (MS)
May 2015