Chapter 21: The Global Capital Market: Performance and Policy Problems Multiple Choice Questions 1.

What are three things to measure for in evaluating the performance of the capital markets? A. Level of Intertemporal Trade, International Trade, Portfolio Diversification . Level of Portfolio Diversification, alanced !apital Accounts, "lo#al Inflation !. Level of Portfolio Diversification, Intertemporal Trade, $fficienc% of &oreign $'change D. (nshore)(ffshore Interest *ate Parit%, Level of Portfolio Diversification, +ta#ilit% of $urocurrenc% ,arket $. (nshore)(ffshore Interest *ate Parit%, Interest Parit% and &oreign $'change, alanced !apital Accounts Ans-er. ! /. In the Interest Parit% !ondition, *t)*0t 1 2$et31)$t45$t3't, -here *t)*0t is the interest rate differential and 2$et31)$t45$t is the e'pected change in the e'change rate, -hat does 't stand for if it potentiall% is a market efficient difference #et-een the t-o? A. ,arket inefficienc% . *isk premium !. &orecast error D. Tracking error $. $'cessive volatilit% Ans-er. 6. As a countr% #egins to li#erali7e its capital account, -hat -ould %ou e'pect to happen to the difference #et-een the interest rates for similar assets in this countr% and another countr% -ith open capital markets? A. It -ould get larger. . It -ould get smaller. !. It -ould sta% the same. D. 8one of the a#ove. $. 8ot enough information. Ans-er.

9:

;.

If %ou are offered a gam#le in -hich %ou -in <:: dollars 65= of the time and %ou lose <:: dollars <5= of the time, -hat is %our e'pected pa%off and %our #ehavior given that %ou are a risk)lover? A. ><::, take the gam#le . )>1/<, take the gam#le !. )>1/ , %ou are indifferent D. ><::, decline the gam#le $. )>1/<, decline the gam#le Ans-er.

<.

The t-o t%pes of trade, intertemporal and pure asset s-ap ????? perfect su#stitutes, #ecause A. are@ the% #oth offer considera#le pa%off and are eAual in the long run. . are@ the% #oth involve the smoothing out of current and future consumption. !. are not@ asset s-apping is immediate and involves onl% assets, -hile intertamporal trade takes t-o time periods and involves #oth assets and goods5services. D. oth and !. $. could possi#l% #e, as different economic states occur at different points in time. Ans-er. $

B.

A shado- price is A. a time)lagged varia#le that is onl% apparent after the current period. . something that has to do -ith trees out the -indo-. !. a price neither in nor determined #% a market. D. the discounted price of a foreign asset in the home countr%. $. the marginal utilit% of future consumption. Ans-er. !

91

C.

&or the follo-ing Auestion assume the follo-ing facts. 1. alance of Pa%ments 1 : prior to the transactions. /. Person A 2-ho lives in the Dnited +tates4 purchases an airplane from ritish Air-a%s for >1<:,:::. 6. Person A pa%s -ith a check from his account at &irst Dnion ank in the Dnited +tates. ;. ritish air-a%s, since it -ill need dollars in 1 month, deposits the check at the ank of $ngland. <. ank of $ngland deposits the >1<:,::: at !ommon-ealth ank, -hich is located in the Dnited +tates. Due to the transactions a#ove, -hat are the effects on the #alance of pa%ments? A. )>1<:,::: due to import of good 2current account de#it4 . 3>1<:,::: due to import of good 2current account credit4 !. )>1<:,::: due to deposit of ank of $ngland 2capital account de#it4 D. 3>1<:,::: due to deposit of ank of $ngland 2capital account credit4 $. 8o effect 21<:,::: current account de#it and 1<:,::: capital account credit4. Ans-er. $

=.

&or the follo-ing Auestions ,assume the follo-ing facts. 1. alance of Pa%ments 1 : prior to the transactions. /. Person A 2-ho lives in the Dnited +tates4 purchases an airplane from ritish Air-a%s for >1<:,:::. 6. Person A pa%s -ith a check from his account at &irst Dnion ank in the Dnited +tates. ;. ritish Air-a%s, #ecause it -ill need dollars in 1 month, deposits the check at the ank of $ngland. <. ank of $ngland deposits the >1<:,::: at !ommon-ealth ank, -hich is located in the Dnited +tates. Due to the transactions a#ove, -hat are the effects on the reserve at the &ed? A. 8o effects at all. . &act 6 is a decrease of >1<:,:::, &act < is an increase of >1<:,:::, a net effect of : !. &act 6 is an increase of >1<:,:::, &act < is a decrease of >1<:,:::, a net effect of : D. oth &act 6 and &act < result in increases of >1<:,:::, a net effect of 3 >6::,::: $. oth &act 6 and &act < result in decrease of >1<:,:::, a net effect of ) >6::,::: Ans-er.

9/

9.

&or the follo-ing Auestion, assume the follo-ing facts. 1. !hase 2-hich is located in the Dnited +tates4 has a /:E reserve reAuirement imposed #% the government. /. ank of "erman% has no reserve reAuirements. 6. oth #anks ma% invest at an =E interest rate. ;. oth #anks have fi'ed costs of >6 per deposit made. What is the difference #et-een the minimum interest rates each #ank can offer and still make a profit if the deposit is ><:: for 1 %ear? A. : F #oth #anks can offer the same rate . 1E !. 1.BE D. .;E $. /:E Ans-er. ! $'planation for the ans-er. ,inimum !hase rate. *evenue from deposit. 2<::0.=40.:=)6 1 /9 ,inimum rate it can offer 1 /95<:: 1 <.=E ,inimum ank of "erman% rate. *evenue from deposit. 2<::40.:=)6 1 6C ,inimum rate it can offer 1 6C5<:: 1 C.;E Difference in rates. 1.BE

1:.

+uppose %ou are offered a gam#le in -hich %ou -in >1,::: half the time #ut lose >1,::: half the time. +ince in this case %ou are as likel% to -in as to lose the >1,:::, the average pa%off on this gam#le F its e'pected value) is. :.<0>1,::: 3 :.<0 2)>1,:::4 1 :. Dnder such circumstances. A. 8o one -ill take the gam#le. . *isk averse individuals -ill take the gam#le. !. *isk lovers -ill take the gam#le. D. *isk neutral individuals -ill take the gam#le. $. 8ot enough information. Ans-er. !

96

11.

+uppose %ou are offered a gam#le in -hich %ou -in >1::,::: half the time #ut lose >1::,::: half the time. +ince in this case %ou are as likel% to -in as to lose the >1::,:::, the average pa%off on this gam#le F its e'pected value) is. :.<0>1::,::: 3 :.<0 2)>1::,:::4 1 :. Dnder such circumstances. A. 8o one -ill take the gam#le. . *isk averse individuals -ill take the gam#le. !. *isk lovers -ill take the gam#le. D. *isk neutral individuals -ill take the gam#le. $. 8ot enough information to ans-er. Ans-er. !

1/.

&or most practical matters, economists assume that A. individuals are risk neutral. . individuals are risk lovers. !. individuals are risk averse. D. most individuals are risk lovers. $. most individuals are risk neutral. Ans-er. A

16.

People -ho are risk averse A. value a collection of assets onl% on the #asis of their e'pected returns. . value a collection of assets onl% on the #asis of the risk of that return. !. value a collection of assets not onl% on the #asis of its e'pected returns, #ut also on the #asis of the risk of that return. D. 8o clear cut criteria e'ist. $. 8one of the a#ove. Ans-er. !

1;.

The idea of risk aversion A. is at odds -ith the idea of insurance. . help e'plain the profita#ilit% of insurance companies. !. has nothing to do -ith insurance companies. D. helps e'plain the losses suffers #% the insurance industr%. $. helps e'plain -h% insurance companies in the long run are 7ero profit companies. Ans-er.

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1<.

*isk aversive people A. -ill never hold #onds denominated in several different currencies #ecause of transaction costs. . -ill al-a%s hold #onds denominated in several different currencies #ecause of transaction costs. !. ma% hold #onds denominated in several different currencies. D. ma% hold #onds denominated in several different currencies onl% if satisf%ing the -ell kno-n interest part% condition . $. -ill hold onl% domestic #onds #ecause of the home #ias effect. Ans-er. !

1B.

In general, for a risk averse individual A. a portfolio -hose return fluctuates -idel% from %ear to %ear is more desira#le than one that offers the same average return -ith onl% mild %ear)to)%ear fluctuations. . a portfolio -hose return fluctuates -idel% from %ear to %ear is less desira#le than one that offers the same average return -ith onl% mild %ear)to)%ear fluctuations. !. a portfolio -hose return fluctuates -idel% from %ear to %ear is more desira#le. D. a portfolio -hose return fluctuates less from %ear to tear is more desira#le. $. 8one of the a#ove. Ans-er.

1C.

"enerall%, for a risk)loving individual, A. a portfolio -hose return fluctuates -idel% from %ear to %ear is more desira#le than one that offers the same average return -ith onl% mild %ear)to)%ear fluctuations. . a portfolio -hose return fluctuates -idel% from %ear to %ear is less desira#le than one that offers the same average return -ith onl% mild %ear)to)%ear fluctuations. !. a portfolio -hose return fluctuates -idel% from %ear to %ear is more desira#le. D. a portfolio -hose return fluctuates less from %ear to tear is more desira#le. $. 8one of the a#ove. Ans-er. A

9<

1=.

"enerall%, for a risk neutral individual, A. a portfolio -hose return fluctuates -idel% from %ear to %ear is more desira#le than one that offers the same average return -ith onl% mild %ear)to)%ear fluctuations. . a portfolio -hose return fluctuates -idel% from %ear to %ear is less desira#le than one that offers the same average return -ith onl% mild %ear)to)%ear fluctuations. !. a portfolio -hose return fluctuates -idel% from %ear to %ear is more desira#le. D. a portfolio -hose return fluctuates less from %ear to tear is more desira#le. $. 8ot enough information. Ans-er. $

19.

"enerall%, A. a portfolio -hose return fluctuates -idel% from %ear to %ear is more desira#le than one that offers the same average return -ith onl% mild %ear)to)%ear fluctuations. . a portfolio -hose return fluctuates -idel% from %ear to %ear is less desira#le than one that offers the same average return -ith onl% mild %ear)to)%ear fluctuations. !. a portfolio -hose return fluctuates -idel% from %ear to %ear is more desira#le. D. a portfolio -hose return fluctuates less from %ear to tear is more desira#le. $. 8ot enough information Ans-er. $

/:.

Investment #anks in the Dnited +tates are A. regular #anks speciali7ing in investment proGects. . not #anks at all #ut institutions -hich speciali7e in under-riting sales of stocks and #onds. !. special arms of the D.+. government for D.+. #anks operating outside the D.+. D. regular #anks speciali7ing in investment proGects, #ut allo-ed to offer limited domestic transactions. $. 8one of the a#ove. Ans-er.

9B

/1.

&irst oston !orporation, "oldman +achs, and La7ard &reres are e'amples of A. commercial #anks. . corporations. !. non)#ank financial institutions, such as insurance companies, pension funds, and mutual funds. This includes investment #anks, -hich speciali7e in under-riting sales of stocks and #onds #% corporations and in some cases governments. D. central #anks and other government agencies $. 8one of the a#ove. Ans-er. !

//.

!iticorp, ,organ "uarant%, and ankers Trust are e'amples of A. commercial #anks. . corporations. !. non)#ank financial institutions, such as insurance companies, pension funds, and mutual funds. This includes investment #anks, -hich speciali7e in under-riting sales of stocks and #onds #% corporations and in some cases governments. D. central #anks and other government agencies. $. 8one of the a#ove. Ans-er. A

/6.

A countr% can control A. fi'ed e'change rates onl%. . monetar% polic% oriented to-ard domestic goal.s !. freedom of international capital movements. D. An% t-o of the a#ove three. $. (nl% A and . Ans-er. D

/;.

Dnder a gold standard, countries control A. fi'ed e'change rates onl%. . monetar% polic% oriented to-ard domestic goals. !. freedom of international capital movements. D. (nl% A and !. $. (nl% A and . Ans-er. D

9C

/<.

After the retton Woods period, countries chose to control A. fi'ed e'change rates onl% . monetar% polic% oriented to-ard domestic goals. !. freedom of international capital movements. D. (nl% and !. $. (nl% A and . Ans-er. D

/B.

Dnder the unified $uro regime, the $uropean countries control A. fi'ed e'change rates onl%. . monetar% polic% oriented to-ard domestic goals. !. freedom of international capital movements. D. (nl% and !. $. (nl% A and !. Ans-er. $

/C.

Which one of the follo-ing possi#ilities is true? A. ,uch of eurocurrenc% trading occurs in $urope. . ,uch of eurocurrenc% trading occurs in the Dnited +tates. !. $urocurrenc% trading occurs ever%-here e'cept the Dnited +tates. D. $urocurrenc% trading occurs ever%-here e'cept $urope. $. 8one of the a#ove. Ans-er. !

/=.

$urodollars are A. dollar deposits located in the Dnited +tates. . dollar deposits located in $urope. !. dollar deposits located outside $urope. D. dollar deposits located outside the united +tates. $. dollar deposits located outside #oth $urope and the Dnited +tates. Ans-er. D

/9.

$uro#anks are A. all $uropean anks. . all non)American #anks. !. #anks that accept deposits denominated in $urocurrencies e'cluding $urodollars. D. #anks that accept deposits denominated in $urocurrencies including $urodollars. $. 8one of the a#ove. Ans-er. D

9=

6:.

The leading center of $urocurrenc% trading is A. 8e- Hork !it%. . !hicago. !. London. D. Paris. $. &rankfurt. Ans-er. !

61.

The &edIs *egulation J A. placed a ceiling on the interest rates D.+. #anks could pa% on time deposits to foreigners. . placed a ceiling on the interest rates D.+. #anks could pa% on time deposits. !. placed a ceiling on the amount D.+. residents can deposits in $uro #anks. D. placed a ceiling on the amount foreign residents can deposits in domestic American #anks. $. 8one of the a#ove. Ans-er.

6/.

Which of the follo-ing statements is true? A. ank failure is limited to #anks that have mismanaged their assets. . ank failure is limited to #anks that have invested in real estate. !. ank failure is limited to #anks that have invested in government #onds. D. ank failure is limited to a fe- #anks. $. ank failure is not limited to #anks that have mismanaged their assets. Ans-er. $

66.

Which of the follo-ing statements is true? A. ank failures inflict serious financial harm on individual depositors. . ank failures do not inflict serious financial harm on individual depositors. !. ank failures inflict not onl% serious financial harm on individual depositors, #ut also harm the macroeconomic sta#ilit% of the econom%. D. ank failures inflict serious financial harm on individual depositors, #ut fortunatel% do not harm the macroeconomic sta#ilit% of the econom%. $. 8one of the a#ove. Ans-er. !

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6;.

Which of the follo-ing statements is true? A. anks -ith cautious investment strategies never fail if unconfirmed rumors of financial trou#le #egin circulating. . anks -ith cautious investment strategies never fail if rumors of financial trou#le #egin circulating. !. anks -ith cautious investment strategies ma% fail if unconfirmed rumors of financial trou#le #egin circulating. D. anks -ith cautious investment strategies ma% fail if rumors of financial trou#le #egin circulating. $. 8one of the a#ove. Ans-er. !

6<.

Which of the follo-ing statements is true for the Dnited +tates? A. The &ederal Deposit Insurance !orporation 2&DI!4 insures #ank deposits against losses up to >1::,:::. . The &ederal Deposit Insurance !orporation 2&DI!4 insures #ank deposits against floods up to >1::,:::. !. The &ederal Deposit Insurance !orporation 2&DI!4 insures #ank deposits against losses up to >1:,:::. D. The &ederal Deposit Insurance !orporation 2&DI!4 insures #ank deposits against natural disaster up to >1::,:::. $. 8one of the a#ove. Ans-er. A

6B.

Which of the follo-ing statements is true for the Dnited +tates? A. anks are reAuired to make contri#utions to the &DI! to cover the cost of #ank deposits insurance. . anks are not reAuired to make contri#utions to the &DI! to cover the cost of #ank deposits insurance. !. The states are not reAuired to make contri#utions to the &DI! to cover the cost of #ank deposits insurance for #anks -ith their main #ranch in that state. D. The states are reAuired to make contri#utions to the &DI! to cover the cost of #ank deposits insurance for #anks -ith their main #ranch in that state. $. The specific municipalit% -here the main #ranch of the #ank is located is reAuired to make contri#utions to the &DI! to cover the cost of #ank deposit insurance. Ans-er. A

1::

6C.

Which of the follo-ing statements is true for the Dnited +tates? A. The &DI! does not provide insurance for deposits for +avings and Loans 2+KL4 associations. . The &DI! does provide insurance for deposits for +avings and Loans 2+KL4 associations, #ut onl% up to ><:,:::. !. The &DI! does provide insurance for deposits for +avings and Loans 2+KL4 associations up to >1::,:::. D. The &DI! does provide insurance for deposits for +avings and Loans 2+KL4 associations up to >1<:,:::. $. 8one of the a#ove. Ans-er. !

6=.

anks in the Dnited +tates A. face rules against lending too large a fraction of their assets to a single private customer onl%. . face rules against lending too large a fraction of their assets to a single private customer or to a single foreign government #orro-er. !. face rules against lending too large a fraction of their assets to a single foreign government #orro-er onl%. D. Although a good idea, #anks are not restricted at all as far as -hom the% lend mone% to as long as other safeguards e'ist. $. ecause this is a #ad idea, #anks are not restricted at all as far as -hom the% lend mone% to as long as other safeguards e'ist. Ans-er.

69.

anks in the Dnited +tates A. cannot hold common stocks. . can hold common stocks. !. cannot hold common stocks of companies the% do #usiness -ith. D. cannot hold common stocks of companies that have their headAuarters in the same state. $. 8one of the a#ove. Ans-er. A

;:.

anks in the Dnited +tates A. are prevented from holding assets that are Ltoo risk%.M . are not prevented from holding assets that are Ltoo risk%.M !. are encouraged not to hold assets that are Ltoo risk%.M D. are not encouraged not to hold assets that are Ltoo risk%.M $. 8one of the a#ove. Ans-er. A

1:1

;1.

In the Dnited +tates, the follo-ing agencies have the right to e'amine the #ankIs #ooks. A. &ed and the &DI!. . &DI! and the (ffice of the !omptroller of the !urrenc%. !. &ed and the office of the !omptroller of the !urrenc%. D. oth and !. $. (nl% the &ed. Ans-er. D

;6.

In the Dnited +tates, #anks A. cannot #e forced to sell assets that the #ank e'aminer deems too risk%. . can #e forced to sell assets that the #ank e'aminer deems too risk%. !. can #e forced to sell assets that the #ank e'aminer deems too risk% onl% after a court order. D. can #e forced to sell assets that the #ank e'aminer deems too risk% onl% after #oth e'aminers from the &ed and from the &DI! agree. $. 8one of the a#ove. Ans-er.

;;.

In the Dnited +tates, #anks A. ma% not #e forced #% #ank e'aminer to adGust their #alance sheets #% -riting off loans the e'aminer thinks -ill not #e repaid. . ma% #e forced #% the #ank e'aminer to adGust their #alance sheets #% -riting off loans the e'aminer thinks -ill not #e repaid. !. ma% #e forced #% the #ank e'aminer to adGust their #alance sheets #% -riting off loans the e'aminer thinks -ill not #e repaid onl% if the &ed and the &DI! e'aminers agree. D. ma% #e forced #% the #ank e'aminer to adGust their #alance sheets #% -riting off loans the e'aminer thinks -ill not #e repaid onl% if the &ed and the (ffice of the !omptroller of the !urrenc% e'aminers agree. $. oth ! and D. Ans-er.

1:/

Essay Questions 1. What are the three t%pes of transactions #et-een the residents of different countries? 1. /. 6. /. Trades of goods and services for goods or services. Trades of goods and services for assets. Trades of assets for assets.

Ans-er.

What are the three t%pes of gains from international transactions #et-een the residents of different countries? 1. /. 6. "ains due to comparative advantage and economies of scale. "ains due to inter)temporal trade, -hich is the e'change of goods and services for claims to future goods and services, -hich is for assets. "ains due to trades of assets for assets, such as the e'change of real estate located in London for D.+. Treasur% #onds.

Ans-er.

6.

No- can international trade in assets make #oth countries #etter off?

Ans-er. % allo-ing them to reduce the riskiness of the return on their -ealth and #% allo-ing the t-o parties to diversif% their portfolios, i.e., to divide their -ealth among a -ider spectrum of assets, and thus reduce the amount of mone% placed on one specific asset. ;. $'plain To#inIs idea of LDonIt put all %our eggs in one #asket.M

Ans-er. The idea of diversification advanced #% To#in in his Attitude To-ards *isk and Portfolio DiversificationIs paper. <. Wh% is it useful to make a distinction #et-een de#t and eAuit% instruments?

Ans-er. +ee page B;: and !hapter //. De#t instruments such as #onds and #ank deposits are repaid regardless of economic circumstances. $Auit% instruments, such as a share of stock, have a pa%off that is linked to economic performances. No-ever, remem#er the possi#ilit% of #ankruptc% and the real return, -hich is su#Gect to domestic currenc% fluctuations.

1:6

B.

Who are the main actors in the international capital market? !ommercial #anks. !orporations. 8on)#ank financial institutions, such as insurance companies, pension funds, and mutual funds. This includes investment #anks, -hich speciali7e in under-riting sales of stocks and #onds #% corporations and in some cases governments. !entral #anks and other government agencies.

Ans-er. 1. /. 6.

;. C.

Descri#e the role of offshore #anking and of offshore currenc% 2eurocurrencies4 trading.

Ans-er. +ee pages B;6)B;C. oth have mushroomed due to increased international trade, increased multinational corporations, and glo#ali7ation. +tudents should also emphasi7e #anksI desire to escape domestic government regulations and ta'es on financial activities and political concerns from holding deposits in the countr% that issued them, -hich increases default concerns on the part of the foreign investors, etc. =. What do %ou e'pect -ould #e the effects of 9511 on the si7e of the $urocurrenc% markets?

Ans-er. Will increase due to fear that foreign deposits in the Dnited +tates -ill #e fro7en unless coordinated efforts #% all countries. 9. $'plain -h% a London $uro#ank has a competitive advantage over a #ank in 8eHork in attracting dollar deposits.

Ans-er. It can pa% more #ecause the London #ank is not su#Gect to an% reserve reAuirements 2neither American nor ritish4, -hereas the 8e- Hork #ank is su#Gect to D.+. reserve reAuirements. 1:. ,an% o#servers #elieve that the largel% unregulated nature of glo#al #anking activit% leaves the -orld financial s%stem vulnera#le to #ank failure on a massive scale. Is this a real threat? If so, -hat measures have governments taken to reduce it?

Ans-er. +ee pages B;C F B<;.

1:;

11.

L ank failure ma% not #e limited to #anks that have mismanaged their assets.M $'plain -h%.

Ans-er. A sound #ank faced -ith the -holesale loss of deposits is likel% to close its door even if the asset side of its #alance sheet is fundamentall% sound #ecause man% #ank assets are illiAuid and cannot #e sold Auickl% to meet deposit o#ligations -ithout su#stantial loss to the #ank. +tudents should stress the atmosphere of financial panic, -hich -ill lead to self) fulfilling e'pectations. 1/. LIt is in the interest of each depositor to -ithdra- her mone% from a #ank if all other depositors are doing the same, even -hen the #ankIs assets are sound.M Discuss. As part of %our ans-er clearl% state -hether the statement is true or false.

Ans-er. True. +tudents should ela#orate on #ank run and stress the atmosphere of financial panic, -hich -ill lead to self)fulfilling e'pectations. 16. LThere is evidence that the string of D.+. #ank closings in the earl% 196:s helped start and -orsen the "reat Depression.M Discuss.

Ans-er. True. +ee the reference to ernanke in the te't#ook and earlier account #% Anna +ch-art7 and ,ilton &riedman. 1;. Descri#e the e'tensive Lsafet% netM that has #een set up in the Dnited +tates in order to reduce the risk of #ank failure. 1. /. 6. ;. <. Deposit insurance *eserve reAuirements !apital reAuirements and asset restrictions ank e'amination Lender of last resort facilities

Ans-er.

1<.

$'plain -h% the &DI! is follo-ing a Ltoo)#ig)to)failM polic% of full% protecting all depositors at the largest #anks.

Ans-er. A trick% Auestion. The &DI! does that although, officiall%, it still applies onl% to the >1::,::: limit. Pro#a#l%, the idea is that the cost to one depositor is un#eara#le relative to the small cost -e all need to pa% as a collective. Also, there are the issues of political pressure and avoiding #laming the government for mismanaging the safeguards. 1B. $'plain the issues involved -ith the &ed acting as a lender of Last *esort 2LL*4.

Ans-er. (n the one hand, LL* ena#les the &ed to avoid panic and distur#ance to proper functioning of financial markets. (n the other hand, using the polic% ma% cause pro#lems of moral ha7ard.

1:<

1C.

$'plain the causes of the D.+. +avings and Loans crisis of the earl% 19=:s.

Ans-er. (n the one hand, allo-ing +KL to make much riskier loans, for e'ample, loans on commercial real estate. (n the other hand, inadeAuate e'amination for the ne- situation and depositors, together -ith increase in interest rates due to increased inflation rate. 1=. $'plain the difficulties in regulating international #anking. 1. 8o deposit insurance, in particular, inter)#ank deposits are unprotected /. A#sence of reserve reAuirements 6. ank e'amination more difficult to enforce ;. 8ot clear -hich group of regulators has responsi#ilit% for monitoring a given #ankIs assets <. 8ot clear -hich central #ank, if an%, is responsi#le for providing Lender of Last *esort assistance

Ans-er.

19.

LThe internationali7ation of #anking has -eakened national safeguards against #anking collapse, #ut at the same time it has made the need for effective safeguards more urgent.M Discuss.

Ans-er. True. +tudents should ela#orate on. 1. 8o deposit insurance, in particular, inter)#ank deposits are unprotected /. A#sence of reserve reAuirements 6. ank e'amination more difficult to enforce ;. 8ot clear -hich group of regulators has responsi#ilit% for monitoring a given #ankIs assets <. 8ot clear -hich central #ank, if an%, is responsi#le for providing Lender of Last *esort assistance. /:. What is the connection #et-een the 1991 film The Godfather, Part III and international #anking?

Ans-er. +ee page B<1. /1. Wh% did the &ed step in to organi7e a rescue for Long Term !apital ,anagement 2LT!,4 in +eptem#er 199=, rather than simpl% letting the trou#le fund fail? Was the &edIs action necessar% or advisa#le?

Ans-er. +ee pages B<6)B<;. To avoid -hat the &ed perceived as a possi#le meltdo-n of international #anking caused #% the crisis in *ussia and -hen Asia and Latin American economies -ere alread% facing a steep economic slo-do-n. The pro#lem is moral ha7ard again.

1:B

//.

No- -ell has the international capital market performed?

Ans-er. International portfolio diversification has increased. +ee also page B<<. /6. $'plain -h%, according to &eldstein and Norioka, one should e'pect that domestic investment rates diverge -idel% from saving rates.

Ans-er. The decisions of corporations to invest and for households to save are different. Thus glo#ali7ation means more and different -a%s to save and invest and increasing the differences #et-een the t-o ratios. /;. $'plain -h% large interest rate differences -ould #e strong evidence of unreali7ed gains from trade.

Ans-er. The difference #et-een onshore and offshore interest rates on similar assets denominated in the same currenc% should #e small if information a#out glo#al investment opportunities is transmitted efficientl%. Data sho- that this is the case for the Dnited +tates, "erman%, Oapan and the 8etherlands. /<. Discuss studies #ased on the interest parit% conditions.

Ans-er. pages B<9)BB:. In general, the formula does not hold and is not a good predictor of future devaluations. $ven -orse, it failed to predict correctl% even the direction in -hich the spot e'change rate -ould change. /B. What is securiti7ation?

Ans-er. The term refers to financial instruments in -hich #ank assets are repackaged in readil% marketa#le forms. These kind of Lderivatives,M although useful for the international investors and the #anks that under-rite them, causes huge pro#lems in government a#ilities to monitor #ank assets and independentl% assess their risk to the soundness of the international #anking s%stem.

1:C

Quantitative Graphin! Problems 1. +uppose %ou are offered a gam#le in -hich %ou -in >1,::: half the time #ut lose >1,::: half the time. If %ou are a risk averter, -ill %ou take the gam#le?

Ans-er. ecause %ou are as likel% to -in as to lose the >1,:::, the average pa%off on this gam#leF its e'pected value))is. :.<0>1,::: 3 :.<0 2)>1,:::4 1 :. If %ou are risk averse, %ou -ill not take the gam#le #ecause, for %ou, the possi#ilit% of losing >1::: out-eighs the possi#ilit% that %ou -ill -in, although #oth outcomes are eAuall% likel%. /. !alculate the e'pected pa%off for the follo-ing cases, -here A1 and A/ are the pro#a#ilities of state 1 and /, respectivel%.
q1 0.5 0.5 0.5 0.6 q2 0.5 0.5 0.5 0.4 payoff if state 1 Payoff if state 2 Expected payoff 1,000 -1000 200 -200 300 -100 1,000 -1000

Ans-er.
q1 0.5 0.5 0.5 0.6 q2 0.5 0.5 0.5 0.4 payoff if state 1 1,000 200 300 1,000 payoff if state 2 -1000 -200 -100 -1000 Expected payoff 0 0 100 200

1:=

6.
q1 0.5 0.5 0.5 0.6 0.7 0.3 0.4

!omplete the follo-ing ta#le

q2 0.5 0.5 0.5 0.4 payoff if state 1 Payoff is state 2 Expected payoff 1,000 0 200 0 -100 100 -1000 200 1100 1000 1070 1200 -100 290 1300 -100 40 1400 -100 500

0.9

Ans-er.
q1 0.5 0.5 0.5 0.6 0.7 0.3 0.1 0.4 q2 0.5 0.5 0.5 0.4 0.3 0.7 0.9 0.6 payoff if state 1 Payoff is state 2 Expected payoff 1,000 -1000 0 200 -200 0 300 -100 100 1,000 -1000 200 1100 1000 1070 1200 -100 290 1300 -100 40 1400 -100 500

1:9

;.

The follo-ing simple t-o)countr% Auestion illustrates ho- countries are made #etter off #% trade in assets. Imagine that there are t-o countries, Nome and &oreign, and that residents of each o-n onl% one asset, domestic land %ielding an annual harvest of ki-i fruit. Assume that the %ield on the land is uncertain. Nalf the time, NomeIs land %ields a harvest of 1:: tons of ki-i fruit at the same time that &oreignIs land %ields a harvest of <: tons. The other half of the time the outcomes are reversed. &oreignIs harvest is 1:: tons, #ut the Nome harvest is onl% <:. A. !alculate the average, for each countr%, of ki-i harvest.

Ans-er. The average for each countr% of ki-i harvest is. :.<01:: 3 :.<0<: 1 C< tons of ki-i fruit. No-ever, note that the inha#itants of the t-o countries never kno- in advance -hether the ne't %ear -ill #ring feast or famine. . 8o- suppose the t-o countries can trade shares in the o-nership of their prospective assets. &urther, assume that a Nome citi7en o-ns a 1: percent share in &oreign land. Ne -ill receive a 1: percent share in &oreign land, and thus receives 1: percent of the annual &oreign ki-i fruit harvest. &urther assume that a &oreign o-ner of a 1: percent share in Nome land is permitted. In this case, a &oreigner is entitled to 1: percent of the Nome harvest. !alculate the e'pected value of ki-i fruit for each investor. Is the investor #etter off?

Ans-er. "ood %ear at Nome. the farmer -ill get 9: toms of ki-i from home and < tons of ki-i from &oreign. ad %ears at home. he -ill get ;< tons of ki-i from his Nome and 1: tons from the &oreign countr%, namel% << tons. The pro#a#ilit% for a good or a #ad %ear is :.<. Thus the e'pected returns -ill no- #e. :.<09< 3 :.< 0 << 1 C< It is not clear -hether the investor is #etter off or not. If he likes to smooth his consumption, he ma% #e #etter off. (ther-ise, it is impossi#le to tell -ithout a particular utilit% function. !. 8o- suppose the t-o countries can trade shares in the o-nership of their prospective assets. &urther assume that a Nome citi7en o-ns a /< percent share in &oreign land. Ne -ill receive a /< percent share in &oreign land and thus receives /< percent of the annual &oreign ki-i fruit harvest. &urther assume that a &oreign o-nership of a /< percent share in Nome land is permitted also. In this case, a &oreigner is entitled to /< percent of the Nome harvest. !alculate the e'pected value of ki-i fruit for each investor.

"ood %ear at Nome. C< 3 1/.< 1 =C.< tons -ith pro#a#ilit% :.< ad %ear at Nome. 6C.< from Nome and /< from &oreign 1 B/.< -ith pro#a#ilit% :.<. The e'pected return is. :.<0=C.< 3 :.<0B/.< 1 C<. Again, this case sho-s smoother consumption relative to parts A or .

11:

D.

8o- suppose the t-o countries can trade shares in the o-nership of their prospective assets -ithout an% restrictions. Assume that the consumers in #oth countries -ould like to totall% smooth their consumption. Descri#e the outcomes.

Ans-er. In this case, Nome residents -ill #u% a <: percent share of the land in &oreign, and the% -ill pa% for it #% giving &oreign residents a <: percent share in Nome land. To understand -h%, think a#out the returns to the Nome and &oreign portfolios -hen #oth are eAuall% divided #et-een titles to Nome and &oreign land. When times are good at Nome 2and therefore #ad in &oreign4, each countr% earns the same return harvest, -hich is C< ever% %ear -ith certaint%. Nalf of the Nome harvest 21:: ton of ki-i fruit4 plus half of the &oreign harvest 2<: tons of ki-i fruit4 or C< tons of fruit. :.<01:: 3 :.<0<:: 1 C<. In the opposite case, #ad times in Nome, good time in &oreign, each countr% still earns C< tons of fruit. Thus, -e have sho-n that if the countries hold portfolios eAuall% divided #et-een the t-o assets, each countr% earns a certain return of C< tons of ki-i fruit. This certain return is e'actl% the same as the average harvest each faced #efore international asset trading -as allo-ed. This trade completel% eliminates the risk faced #% #oth countries -ithout changing average returns. Assuming risk)averse individuals in #oth countries, the t-o countries are #etter off as a result of asset trading. $. 8o- suppose that trade in assets is not allo-ed #ut the t-o countries sign a treat% that guarantee the sending of /< tons of ki-i in good time #% the high output countr% in that season. What -ill #e the outcome of such a treat%? $'plain -h%.

Ans-er. The outcomes -ill #e e'actl% the same as in !ase D a#ove. In other -ords, rather than signing a treat%, Gust leaving the financial markets to function -ill lead us to the desira#le results.

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<.

Does the interest rate parit% hold in each of the follo-ing cases? In case it does not hold , calculate the risk premium. A. *t 1 <, *t0 1 6, $t 1 <, $t31e 1 C . *t 1 B, *t0 1 6, $t 1 <, $t31e 1 C !. *t 1 C, *t0 1 6, $t 1 <, $t31e 1 C D. *t 1 =, *t0 1 6, $t 1 <, $t31e 1 C $. *t 1 <, *t0 1 ;, $t 1 <, $t31e 1 C &. *t 1 <, *t0 1 <, $t 1 <, $t31e 1 C ". *t 1 <, *t0 1 B, $t 1 <, $t31e 1 C N. *t 1 <, *t0 1 6, $t 1 B, $t31e 1 C I. *t 1 <, *t0 1 6, $t 1 C, $t31e 1 C O. *t 1 <, *t0 1 6, $t 1 =, $t31e 1 C P. *t 1 <, *t0 1 6, $t 1 <, $t31e 1 = L. *t 1 <, *t0 1 6, $t 1 <, $t31e 1 9 ,. *t 1 <, *t0 1 6, $t 1 <, $t31e 1 1:

Ans-er.
Case % & C ' E ) * + , . / 0 Rt 5 6 7 ( 5 5 5 5 5 5 5 5 5 Rt* 3 3 3 3 4 5 6 3 3 3 3 3 3 Et 5 5 5 5 5 5 5 6 7 ( 5 5 5 Ee t 1 7 7 7 7 7 7 7 7 7 7 ( 9 10 Ris! P"e#i$# 1.6 2.6 3.6 4.6 0.6 -0.4 -1.4 1.(33333333 2 2.125 1.4 1.2 1

11/

B.

Assume interest parit% holds. !alculate $t31e for each of the follo-ing cases.
Case % & C ' E ) Rt 5 6 7 ( 5 5 Rt* 3 3 3 3 4 5 Et 5 5 5 5 5 5 Ee t
1

Ans-er.

Case % & C ' E )

Rt 5 6 7 ( 5 5

Rt* 3 3 3 3 4 5

Et 5 5 5 5 5 5

Et 1 15 20 25 30 10 5

116