Chapter 3 Financial Instruments, Financial Markets, and Financial Institutions Conceptual and Analytical Problems As the end of the month approaches, you realize that you probably will not be able to pay the next month’s rent. Describe both an informal and a formal financial instrument that you might use to solve your dilemma. Answer: Informal—borrow from family or friends. Formal—obtain a loan from a bank. While we often associate informal financial arrangements with poorer countries where financial systems are less developed, informal arrangements often coexist within the most developed financial systems. What advantages might there be to engaging in informal arrangements rather than utilizing the formal financial sector? Answer: Informal financial arrangements are prevalent among certain ethnic groups in the United States, where community ties are strong. (See for example P. Bond and R Townsend (1996) “Formal and Informal Financing in a Chicago Ethnic Neighborhood” Economic Perspectives, Federal Reserve Bank of Chicago, July.) Information and monitoring costs can be lower than for formal loans, as the parties to the arrangement are generally known to each other and social and cultural factors will ensure the arrangements are honored. In addition, informal arrangements are often more flexible than standardized formal loans. If higher leverage is associated with greater risk, explain why the process of deleveraging (reducing leverage) can be destabilizing. Answer: The problem arises if too many institutions try to reduce their leverage at the same time. A large number of institutions selling assets will push down asset prices. With asset values falling relative to liabilities, net worth falls, increasing leverage and prompting further asset sales, potentially destabilizing those markets. The Chicago Mercantile Exchange has announced the introduction of a financial instrument that is based on rainfall in the state of Illinois. The standard agreement states that for each inch of rain over and above the average rainfall for a particular month, the seller will pay the buyer $1,000. Who could benefit from buying such a contract? Who could benefit from selling it? Answer: Someone who benefits from above average rainfall could sell the contract, and someone who is harmed by above average rainfall should buy the contract. Crops can benefit from additional rainfall during certain times of the year, but may be harmed by too much rain at other times; so, depending on the season, farmers could be buying or selling derivatives. Hydroelectric companies could also sell the contracts, while people who benefit from dry weather – like golf course operators – would buy them. You wish to buy an annuity that makes monthly payments for as long as you live. Describe what happens to the purchase price of the annuity if (1) your age at the time of purchase goes up, (2) the size of the monthly payment rises, and (3) your health improves. Answer: The number of expected monthly payments declines so the price of the annuity falls. The price of the annuity rises as each payment is larger. The purchaser is expected to live longer; the number of expected monthly payments rises so the price of the annuity rises. Which of the following would be more valuable to you: a portfolio of stocks that rises in value when your income rises or a portfolio of stocks that rises in value when your income falls? Why? Answer: A portfolio of stocks that rises in value when your income falls is more valuable because it pays off when you need it the most (when your marginal utility is high). Has the distinction between direct and indirect forms of finance become more or less important in recent times? Why? Answer: The distinction has become less important. The increasing sophistication of the financial system has led to greater institutionalization, so that even direct finance transactions usually involve a financial institution to some extent. Designated market makers, who historically have provided liquidity (that is, have stood by ready to buy and sell) in markets for specific stocks, have declined in importance. Explain this decline in terms of technology and global economic integration. Answer: Advances in technology have made it possible for investors from around the world to trade via electronic exchanges and communications networks. Large numbers of electronic buyers and sellers create sufficient liquidity to replace the activities previously provided by the designated market makers. However, complete elimination of these market makers would require near-foolproof software to match the buy and sell orders. Instead, there have been numerous examples of headline-making market disturbances associated with electronic trading mishaps. The design and function of financial instruments, markets, and institutions are tied to the importance of information. Describe the role played by information in each of these three pieces of the financial system. Answer: The design and function of financial instruments, markets, and institutions are tied to the importance of information. Financial instruments summarize essential information about the borrower. Financial markets aggregate information from many sources and communicate it widely. Financial institutions produce information to screen and monitor borrowers. Suppose you need to take out a personal loan with a bank. Explain how you could be affected by problems in the interbank lending market such as those seen during the 2007-2009 financial crisis. Answer: The strains in the interbank market pushed up interbank lending rates, which increases the cost of funds to banks and would likely lead to an increase in the rate on your personal loan. If your bank is having trouble obtaining short-term funding in the interbank market, it may decide to hold more cash and reduce lending, impacting your ability to secure a loan at all. Advances in technology have facilitated the widespread use of credit scoring by financial institutions in making their lending decisions. Credit scoring can be defined broadly as the use of historical data and statistical techniques to rank the attractiveness of potential borrowers and guide lending decisions. In what ways might this practice enhance the efficiency of the financial system? Answer: The use of credit scoring techniques standardizes the assessment of loan applicants and reduces information costs. This allows financial institutions to lend to a broader range of borrowers and facilitates the creation of asset-backed securities based on these loans. Lending practices based on more objective criteria reduce subjectivity and discrimination in lending decisions, leading to a more efficient allocation of resources. Commercial banks, insurance companies, investment banks, and pension funds are all examples of financial intermediaries. For each of these, give an example of a source of their funds and an example of their use of funds. Answer: Commercial banks receive deposits in checking and savings accounts and borrow from other entities. The funds they receive are used to make loans and purchase government securities. Insurance companies receive premium payments, which they invest in securities or other assets to earn income until claims are paid. Investment banks charge fees for advising clients on mergers and acquisitions and for preparing new stock and bond issues for the market. They may use funds to participate in some of the initial public offerings they distribute. Pension funds receive regular contributions from companies providing for retirement promises. These funds are invested in assets that will later be used to pay retirement benefits to company employees. Life insurance companies tend to invest in long-term assets such as loans to manufacturing firms to build factories or to real estate developers to build shopping malls and skyscrapers. Automobile insurers tend to invest in short-term assets such as Treasury bills. What accounts for these differences? Answer: Automobile insurers generally need to have funds readily available when a policyholder makes a claim, and Treasury bills are highly liquid. Life insurance companies have liabilities with a much longer horizon. A life insurance policy is expected to pay off in 30 years, say, so that assets with longer horizons correspond to their longer-term liabilities. In general, insurers can limit their risks by matching the terms of their liabilities with the terms of their assets. For each pair of instruments below, use the criteria for valuing a financial instrument to choose the one with the highest value. A U.S. Treasury bill that pays $1,000 in six months or a U.S. Treasury bill that pays $1,000 in three months. A U.S. government Treasury bill that pays $1,000 in three months or commercial paper issued by a private corporation that pays $1,000 in three months. An insurance policy that pays out in the event of serious illness or one that pays out when you are healthy, assuming you are equally likely to be ill or healthy. Explain each of your choices briefly. Answer: The T-bill that pays out in three months, as the sooner the payment the more valuable. The T-bill is more valuable as the likelihood of the U.S government honoring its debts is higher than a private corporation. The insurance policy that pays out when you are ill, as this is when the payment is most needed. Joe and Mike purchase identical houses for $200,000. Joe makes a down payment of $40,000 while Mike only puts down $10,000; for each individual, the down payment is the total of his net worth. Assuming everything else equal, who is more highly leveraged? If house prices in the neighborhood immediately fall by 10 percent (before any mortgage payments are made), what would happen to Joe’s and Mike’s net worth? Answer: Mike is more highly leveraged as he has financed a larger part of his asset with borrowing (95 percent compared with Joe’s 80 percent). Assuming they have no other assets or liabilities, if house prices fall by 10 percent, Joe’s net worth would still be $20,000 but Mike’s would be negative. He would owe $190,000 on his mortgage for a house worth $180,000. Everything else being equal, which would be more valuable to you – a derivative instrument whose value is derived from an underlying instrument with a very volatile price history or one derived from an underlying instrument with a very stable price history? Explain your choice. Answer: The primary use of derivatives is to transfer risk from one party to another. The more volatile the price of the instrument upon which the derivative is based, the higher the risk, everything else being equal. Therefore, the derivative based on the more volatile underlying asset should have more value to you. For example, an option to buy a particular asset as some date in the future at a pre-determined price would have little value if the price of that asset never changed over time. You decide to start a business selling covers for smart phones in a mall kiosk. To buy inventory, you need to borrow some funds. Why are you more likely to take out a bank loan than to issue bonds? Answer: Issuing bonds is a form of direct finance and would require finding a buyer who would be willing to bear the information and monitoring costs associated with the loan. For a small, unknown business, these costs would usually be prohibitive. In the case of a bank loan, the lending institution becomes the counterparty to the transaction. These financial institutions overcome problems associated with asymmetric information by using their expertise to screen loan applicants and use standardized loan contracts to reduce transaction costs. Splitland is a developing economy with two distinct regions. The northern region has great investment opportunities, but the people who live there need to consume all of their income to survive. Those living in the south are better off than their northern counterparts and save a significant portion of their income. The southern region, however, has few profitable investment opportunities and so most of the savings remain in shoeboxes and under mattresses. Explain how the development of the financial sector could benefit both regions and promote economic growth in splitland. Answer: In the absence of financial markets, resources are not being allocated to the best investment opportunities available – in this case, to the northern region. The introduction of a financial intermediary, for example, could channel the available savings from the southerners to the most productive investment opportunities that are available in the northern region. The presence of the intermediary would reduce the information costs that may have prevented the southerners lending directly to the northerners in the past. The southerners would benefit by earning a return on their savings while the northern region would benefit from the increased investment. Splitland would benefit from higher economic growth as the available resources are allocated more efficiently. What would you expect to happen to investment and growth in the economy if the U.S. government decided to abolish the Securities and Exchange Commission? Answer: The role of the Securities and Exchange Commission (SEC) is to protect investors by working to insure that all investors have access to certain knowledge about companies. (See www.sec.gov for further details.) If the SEC were abolished, it would be more difficult for investors to make good, well-informed decisions. Capital markets would likely function less efficiently to the detriment of investment and growth. Use Core Principle 3 from Chapter 1 to suggest some ways in which the problems associated with the shadow banking sector during the 2007-2009 financial crisis might be mitigated in the future. Answer: Core Principle 3 states that information is the basis for decisions. Many of the problems in the shadow banking sector during the financial crisis arose because investors and trading partners lacked information about activities of the shadow banks. Measures to improve the transparency of shadow banking activities, through increased regulation of these institutions, for example, could help mitigate the problems that arose. What risks might financial institutions face by funding long-run loans such as mortgages to borrowers (often at fixed interest rates) with short-term deposits from savers? Answer: If savers decide to withdraw in large numbers from the financial institution, the institution may not have sufficient funds readily available for them if the funds had been lent out as a 30-year mortgage, for example. (Assume the mortgage is held on the balance sheet of the institution in question.) Moreover, long-term mortgage loans are often made at fixed interest rates while rates on short-term deposits fluctuate with the market. The financial institution faces the risk that interest rates will rise, requiring higher interest rates to be paid to continue to attract deposits while the payments received from the mortgage loans stay the same. As the manager of a financial institution, what steps could you take to reduce the risks referred to in Problem 21? Answer: Some strategies include pooling mortgages into mortgage-backed securities and selling them or using derivative instruments to transfer the risk associated with interest rate increases. This could be done, for example, by purchasing a derivatives instrument that paid off when interest rates rose. Give two examples of how greater financial inclusion might benefit a small farmer who previously did not have access to modern finance. Answer: Access to savings instruments offered by the financial system facilitates the management of risk. Participation in the financial system creates information that can help judge the creditworthiness of a potential borrower and so can help the farmer borrow from a financial institution. How might broader access to finance benefit a country where access was previously very limited? Answer: Greater access to finance can boost economic growth by lowering transaction costs, facilitating the channeling of savings to the most productive uses and enabling greater specialization. Data Exploration The broadest stock index in the United States is the Wilshire 5000. Plot this index (FRED code: WILL5000PR) over the period from 1971 to the present. Answer: The requested data plot is: Wilshire Associates, Wilshire 5000 Price Index© [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000PR, August 9, 2016. Plot the percent change from a year ago of the Wilshire 5000 (FRED code: WILL5000PR). Discuss the behavior of changes in the index before, during, and after recession periods, which are indicated by the vertical, shaded bars on the graph. Answer: It is common for the index to fall prior to or coincident with the onset of recession and then to rise in advance of or coincident with the onset of economic expansion. However, large swings in the index occur more frequently than recessions, so they are a useful, but imperfect, device for anticipating business cycle changes. For example, the index plunge in 1987 was not followed by a recession. Similarly, the recovery after the 2001 recession includes a sustained decline of the index. During this period, accounting irregularities at failed companies like Enron and WorldCom raised concerns about the well-being of the U.S. corporate sector more generally even as the economy grew. Finally, note that one of the largest index swings was associated with the financial crisis of 2007-2009. The requested data plot is: Wilshire Associates, Wilshire 5000 Price Index© [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000PR, August 9, 2016. Do changes in stock values affect the wealth of households? Beginning in 1971, plot on a quarterly basis the percent change from a year ago of the Wilshire 5000 (FRED code: WILL5000PR) and the percent change from a year ago of household net worth (FRED code: TNWBSHNO). Compare the two lines.
Answer: The percentage swings in household net worth are smaller in amplitude than those in the stock index. They usually move together (we say they are “positively correlated”), but not always (consider the late 1970s). Stocks make up only part of household wealth, the biggest component of which is housing. Note the record plunge in household wealth in the 2007-2009 financial crisis, which witnessed the largest decline in the value of housing since the 1930s in addition to the plunge of the stock index. The requested data plot is: Wilshire Associates, Wilshire 5000 Price Index© [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000PR, August 9, 2016. The Dow Jones Industrial Average is a well-known index of equity prices, but includes only 30 stocks. Consider a much broader measure of the stock market -- the market value of corporate equities in nonfinancial corporations (FRED code: MVEONWMVBSNNCB) – which sums the price of each stock times the number of outstanding shares. After plotting it, comment on its pattern since the mid-1990s. Answer: The indicated data plot is: The most volatile periods have occurred since the late 1990s. The first episode reflects the “Dot.Com” bubble that emerged in the 1990s and burst spectacularly at the start of the new millennium. The second episode reflects the impact of the 2007-2009 financial crisis. While stock prices rebounded after each episode, the inflation-adjusted value of outstanding equities did not rise above the peak of the Dot.Com bubble in 2000 until the second quarter of 2014. In Data Exploration Problem 3, you looked at changes in household net worth. In Data Exploration Problem 4 you examined stock market wealth. Aside from stock market wealth, what other assets contribute to household net worth? Answer: While the value of housing and financial assets like equities and bonds are very important for household wealth, other components include bank deposits and the value of personal items such as automobiles indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075
