Chapter 7 Why Do Financial Institutions PDF

Chapter 7
Why Do Financial Institutions Exist?
 Answers to End-of-Chapter Questions
1. Financial intermediaries can take advantage of economies of scale and thus lower transaction costs.
For example, mutual funds take advantage of lower commissions because the scale of their purchases
is higher than for an individual, while banks’ large scale allows them to keep legal and computing
costs per transaction low. Economies of scale which help financial intermediaries lower transaction
costs explains why financial intermediaries exist and are so important to the economy.
2. Financial intermediaries develop expertise in such areas as computer technology so that they can
inexpensively provide liquidity services such as checking accounts that lower transaction costs for
depositors. Financial intermediaries can also take advantage of economies of scale and engage in
large transactions that have a lower cost per dollar of investment.
3. No. If the lender knows as much about the borrower as the borrower does, then the lender is able to
screen out the good from the bad credit risks and so adverse selection will not be a problem. Similarly,
if the lender knows what the borrower is up to, then moral hazard will not be a problem because the
lender can easily stop the borrower from engaging in moral hazard.
4. Standard accounting principles make profit verification easier, thereby reducing adverse selection and
moral hazard problems in financial markets, hence making them operate better. Standard accounting
principles make it easier for investors to screen out good firms from bad firms, thereby reducing the
adverse selection problem in financial markets. In addition, they make it harder for managers to
understate profits, thereby reducing the principal-agent (moral hazard) problem.
5. The lemons problem would be less severe for firms listed on the New York Stock Exchange because
they are typically larger corporations which are better known in the marketplace. Therefore it is easier
for investors to get information about them and figure out whether the firm is of good quality or is a
lemon. This makes the adverse selection-lemons problem less severe.
6. Smaller firms that are not well known are the most likely to use bank financing. Since it is harder for
investors to acquire information about these firms, it will be hard for the firms to sell securities in the
financial markets. Banks that specialize in collecting information about smaller firms will then be the
only outlet these firms have for financing their activities.
7. Because there is asymmetric information and the free-rider problem, not enough information is
available in financial markets. Thus there is a rationale for the government to encourage information
production through regulation so that it is easier to screen out good from bad borrowers, thereby
reducing the adverse selection problem. The government can also help reduce moral hazard and
improve the performance of financial markets by enforcing standard accounting principles and
prosecuting fraud.
8. Yes. The person who is putting her life savings into her business has more to lose if the business
takes on too much risk or engages in personally beneficial activities that don’t lead to higher profits.
So she will act more in the interest of the lender, making it more likely that the loan will be paid off.
9. Yes, this is an example of an adverse selection problem. Because a person is rich, the people who are
most likely to want to marry him or her are gold diggers. Rich people thus may want to be extra careful
to screen out those who are just interested in their money from those who want to marry for love.
10. True. If the borrower turns out to be a bad credit risk and goes broke, the lender loses less because
the collateral can be sold to make up any losses on the loan. Thus adverse selection is not as severe
a problem.
11. The free-rider problem means that private producers of information will not obtain the full benefit of
their information producing activities, and so less information will be produced. This means that there
will be less information collected to screen out good from bad risks, making adverse selection problems
worse, and that there will be less monitoring of borrowers, increasing the moral hazard problem.
12. The separation of ownership and control creates a principal-agent problem. The managers (the agents)
do not have as strong an incentive to maximize profits as the owners (the principals). Thus the
managers might not work hard, might engage in wasteful spending on personal perks, or might
pursue business strategies that enhance their personal power but do not increase profits.
13. Because one information resource can be used in providing several services, thus lowering the cost
for each.
14. Conflicts of interest arise because higher profits might arise in providing one kind of service if the
service provider misuses, provides false information, or conceals information when providing another
kind of service.
15. Conflicts of interest lead to a substantial reduction in the quality of information so that asymmetric
information problems become worse, which prevents financial markets from channeling funds into
productive investment opportunities. The result is that financial markets become less efficient.
16. a. Research analysts in investment banks might distort their research to please issuers of securities
so underwriters in the investment bank can get their business.
b. Investment banks might engage in spinning, a form of kickback in which they allocate hot, but
underpriced, IPOs to executives in return for their companies’ future business.
17. Spinning makes financial markets less efficient because it might influence executives to not use the
lowest cost investment bank when issuing securities. The result would be a higher cost of capital and
hence lower efficiency.
18. a. Clients may be able to pressure auditors into skewing their opinions in order to get fees for other
accounting services.
b. Auditors may be auditing information systems or structuring (tax and financial) advice put in
place by their non-audit counterparts within the firm, and thus may be reluctant to criticize this
advice or systems.
c. Auditors may provide overly favorable opinions in order to solicit or retain business.
19. Sarbanes-Oxley requires CEOs and CFOs to certify the financial statements and disclosures of the
firm and requires disclosure of off-balance sheet transactions and relationships with special purpose
entities. This mandatory disclosure improves the quality of information, but has the disadvantage of
being costly. Sarbanes-Oxley also substantially increases supervisory oversight with the PCAOB
which can help stop conflicts of interest in the accounting industry. Also by making the audit committee
independent of management, audits are likely to be more reliable, an important benefit. However,
Sarbanes-Oxley may reduce economies of scope available to accounting firms by preventing them
from providing auditing and consulting services to the same client.
20. The Global Settlement has increased disclosure of analysts’ recommendations which can help
increase information in financial markets. Also it requires increased disclosure of potential conflicts
of interest that can help the market to constrain them. The Global Settlement also bans spinning
which can encourage executives to choose high cost investment banks to underwrite their securities,
and so banning spinning makes it more likely that lower cost and more efficient underwriting takes
place. The fines imposed by the Global Settlement also provide incentives for investment banks to
avoid exploiting conflicts of interest in the future. The negative side of the Global Settlement is that
it separates activities and so may mean that economies of scope in information production are lost.
The Global Settlement also requires that part of the $1.4 billion fine be used to fund independent
research, but it is not clear that the quality of this research will be high.
 Quantitative Problems
1. You are in the market for a used car. At a used car lot, you known that the blue book value for the
cars you are looking at is between $20,000 and $24,000. If you believe the dealer knows as much
about the car as you, how much are you willing to pay? Why? Assume that you only care about the
expected value of the car you buy and that the car values are symmetrically distributed.
Solution: You are willing to pay the average price. If the distribution of car values is symmetric,
you are willing to pay $22,000 for a randomly selected car.
2. Now, you believe the dealer knows more about the cars than you. How much are you willing to pay?
Why? How can this be resolved in a competitive market?
Solution: You are willing to pay the average price upfront: $22,000. However, the dealer will know
this, and only sell you a car worth between $20,000 and $22,000. But you know this. So
you will only pay $21,000. And so on. This ends with you paying $20,000, and the car
being worth $20,000.
This is OK for you, but the dealer can never sell cars worth more than $20,000. The
resolution, of course, is to get more information. This may include a test drive, mechanical
inspection, warranty, etc.
3. You wish to hire Ricky to manage your Dallas operations. The profits from the operations depend
partially on how hard Ricky works, as follows:
Probabilities
Profit  $10,000 Profit  $50,000
Lazy Worker 60% 40%
Hard Worker 20% 80%
If Ricky is lazy, he will surf the Internet all day, and he views this as a zero cost opportunity.
However, Ricky would view working hard as a “personal cost” valued at $1,000. What fixed-
percentage of the profits should you offer Ricky? Assume Ricky only cares about his expected
payment less any “personal cost.”
Solution: Let P be the percent of profits you pay Ricky.
If Ricky is lazy, his expected payment is
0.60  10,000 P  0.40  50,000 P  26,000 P
If Ricky works hard, his expected payment is
0.20  10,000 P  0.80  50,000 P  1,000  42,000 P  1,000
To induce Ricky to work hard, you need
42,000 P  1,000  26,000 P
16,000 P  1,000
P  0.0625
So, offer Ricky 6.25% of the profits, and this should induce him to work hard.
4. You own a house worth $400,000 on a river. If the river floods moderately, the house will be
completely destroyed. This happens about once every 50 years. If you build a seawall, the river
would have to flood heavily to destroy your house, and this only happens about once every 200 years.
What would be the annual premium for an insurance policy that offers full insurance? For a policy
that only pays 75% of the home value? What are your expected costs with and without a seawall?
Do the different policies provide an incentive to be safer (build the seawall)?
Solution: With full insurance:
Without a seawall, the expected loss is
400,000  0.02  8,000
With a seawall, the expected loss is
400,000  0.005  2,000
The insurance company will charge the expected loss as a premium. Your expected cost
under either scenario each year is the premium.
With partial insurance:
Without a seawall, the expected loss is
300,000  0.02  6,000
With a seawall, the expected loss is
300,000  0.005  1,500
The insurance company will charge the expected loss as a premium. Your expected cost
each year is:
Without a seawall:
[0.02  (300,000  400,000)  0.98 (0)]  6,000  8,000
With a seawall:
[0.005  (300,000  400,000)  0.98 (0)]  1,500  2,000
Unfortunately, neither insurance policy is better or worse. Although the premiums under
the partial insurance policy are lower, the expected cost each year is the same as with full
insurance. In either scenario, you will build the seawall if the annual cost of building and
maintaining a seawall is less than $6,000/year.
Chapter 8
1. Asymmetric information problems (adverse selection and moral hazard) are always present in
financial transactions but normally do not prevent the financial system from efficiently channeling
funds from lender-savers to borrowers. During a financial crisis, however, asymmetric information
problems intensify to such a degree that the resulting financial frictions lead to flows of funds being
halted or severely disrupted, with harmful consequences for economic activity.
2. When an asset-price bubble bursts and asset prices realign with fundamental economic values, the
resulting decline in net worth means that businesses have less skin in the game and so have incentives
to take on risk at the lender’s expense. In addition, lower net worth means there is less collateral and
so adverse selecton increases. The bursting of an asset-price bubble therefore makes borrowers less
credit-worthy and causes a contraction in lending and spending. The asset price bust can also lead to a
deterioration in financial institutions’ balance sheets, which causes them to deleverage, further
contributing to the decline in lending and economic activity.
3. An unanticipated decline in the price level leads to firms real burden of indebtedness increasing while
there is no increase in the real value of their assets. The resulting decline in a firm’s net worth
increases adverse selection and moral hazard problems facing lenders, making it more likely a
financial crisis will occur in which financial markets do not work efficiently to get funds to firms
with productive investment opportunities.
4. A decline in real estate prices lowers the net worth of households or firms that are holding real estate
assets. The resulting decline in net worth means that businesses or businesses have less at risk and so
have incentives to take on risk at the lender’s expense. In addition, lower net worth means there is
less collateral and so adverse selection increases. The decline in real estate prices can thus make
borrowers less credit-worthy and cause a contraction in lending and spending. The real estate decline
can also lead to a deterioration in financial institutions’ balance sheets, which causes them to
deleverage, further contributing to the decline in lending and economic activity.
5. If financial institutions suffer a deterioration in their balance sheets and they have a substantial
contraction in their capital. They will have fewer resources to lend, and lending will decline. The
contraction in lending then leads to a decline in investment spending, which slows economic activity.
When there are simultaneous failures of financial institutions, there is a loss of information
production in financial markets and a direct loss of banks’ financial intermediation. In addition, a
decrease in bank lending during a banking crisis decreases the supply of funds available to borrowers,
which leads to higher interest rates, which increases asymmetric information problems and lead to a
further contraction in lending and economic activity.
6. A failure of a major financial institution which leads to a dramatic increase in uncertainty in financial
markets, makes it hard for lenders to screen good from bad credit risks. The resulting inability of
lenders to solve the adverse selection problem makes them less willing to lend, which leads to a
decline in lending, investment, and aggregate economic activity.
7. Credit spreads measure the difference between interest rates on corporate bonds and Treasury bonds
of similar maturity that have no default risk. The rise of credit spreads during a financial crisis (as
occurred during the Great Depression and again during 2007–2009) reflects the escalation of
asymmetric information problems that make it harder to judge the riskiness of corporate borrowers
and weaken the ability of financial markets to channel funds to borrowers with productive investment
opportunities.
8. Bank panics occur because of asymmetric information which results in depositoors being unable to
tell whether their bank is a good bank or might be insolvent when the financial system is subject to a
large negative shock. If they worry that some banks might be insolvent and can’t tell which, they
will want to be first in line to get their money out of the bank and so this can lead to a bank run.. The
run on banks can force banks to sell assets quickly to raise funds, that is banks will engage in fire
sales, and the resulting fall in prices may cause other banks to become insolvent. The resulting
contagion can lead to multiple bank failures and a full scale panic.
9. With fewer banks operating, information about the creditworthiness of borrowers will shrink, so that
there will be more severe moral hazard and adverse selection problems.
10. With restrictions lifted or new financial products, financial institutions often go on a lending spree
and expand their lending at a rapid pace. Unfortunately, the managers of these financial institutions
may not have the expertise to manage risk appropriately in these new lines of business, leading to
overly risky lending. In addition, regulation and government supervision may not keep up with the
new activities, further leading to excessive risk taking. When loans eventually go sour, this causes a
deterioration in financial institution balance sheets, a decrease in lending and therefore a decrease in
economic activity.
11 Weak regulation and supervision mean that financial institutions will take on excessive risk because
market discipline is weakened by the existence of a government safety net. When the risky loans
eventually go sour, this causes a deterioration in financial institution balance sheets, which then
means that these institutions cut back lending and economic activity declines.
12. Both the Great Depression and the 2007-2009 crisis were preceded by sharp increases in asset prices.
During the two episodes, credit spreads widened, the availability of credit shrank, and economic
activity sharply declined. The two episodes differ in the source of asset price increases: during the
Great Depression, rising stock prices were the trigger, whereas in the recent crisis a housing bubble
was the primary trigger. During the Great Depression, many bank failures lead to a bank panic,
causing more banks to fail. During the recent crisis, even though the banking system was hit hard and
bank failures did occur, they were much less pronounced, and no bank panic occurred. Finally,
although both episodes resulted in significant declines in GDP and increases in unemployment, this
was much more pronounced during the Great Depression, when unemployment peaked at 25% (as
opposed to the recent crisis, in which the unemployment rate reached 10.2%). In part, this is the result
of Federal Reserve policymakers trying much more aggressively to contain the financial crisis and
reverse the decline in economic activity during the recent crisis than was true during the Great
Depression.
13. The use of data mining to give households numerical credit scores which can be used to predict defaults
and the use of computer technology to bundle together many small mortgage loans cheaply and
package them into securities. Together both enable the origination of subprime mortgages, which
then can be sold off as securities.
14. Because the agent for the investor, the mortgage originator, has little incentive to make sure that the
mortgage is a good credit risk.
15. False. Financial engineering may create financial products that are so complex that it can be hard to
value the cash flows of the underlying assets for a security or to determine who actually owns these
assets. In other words, the increased complexity of structured products can actually destroy information,
thereby making asymmetric information worse in the financial system and increasing the severity of
adverse selection and moral hazard problems.
16. The decline in housing prices led to many subprime borrowers finding that their mortgages were
“underwater,” When this happened, struggling homeowners had tremendous incentives to walk away
from their homes and just send the keys back to the lender. Defaults on mortgages shot up sharply,
causing losses to financial institutions which then deleveraged, causing a collapse in lending.
17. The shadow banking system is composed of hedge funds, investment banks, and other nondepository
financial firms that are not subject to the tight regulatory frameworks of traditional banks. Due to the
light regulation, they had lower capital requirements (if any at all) and were able to take on
significantly more risk than other financial firms. They are important because a large amount of funds
flowed through the shadow banking system to support low interest rates, which fueled some of the
housing bubble. Because of their large presence in financial markets, when credit markets began
tightening, funding from the shadow banking system decreased significantly, which further reduced
access to needed credit.
18. During a financial crisis, asset prices fall, oftentimes very rapidly and unexpectedly. This leads to the
expectation that asset prices may fall further in the future, and increases the uncertainty over the
value of assets put up as collateral. As a result, firms accepting collateral assets require larger and
larger haircuts, or discounts on the value of collateral in expectation of future lower values. This
requires firms to put up increasingly more collateral for the same loans over time. Due to the falling
asset prices and rising haircuts, it becomes a “buyers market” for these rapidly falling assets; any
firms needing to raise funds quickly would then be forced to sell assets at a fraction of their original
worth.
19. Regulation and supervision end up being weak because powerful domestic business interests want it
that way so they can take more risk, allowing them to earn higher returns, but pass off the losses to
the taxpayer if the loans go sour.
20. The global financial crisis lead to a sharp contraction in the economies of Europe that led to a decline
in tax revenue and government efforts to boost their economies by increasing spending and lowering
taxes. In addition, many governments had to absorb losses of banks. The result was that budget
deficits surged raising doubts about the ability of European governments to pay back their sovereign
debt, causing a collapse in sovereign debt prices and a surge in their interest rates.
21. A sovereign debt crisis can cause governments to pursue austerity to balance their budgets, leading to
highly contractionary fiscal policy. In addition, losses on sovereign debt held by financial institutions
weakens their balance sheets and can be a factor in causing a financial crisis as discussed in the text.
Chapter 11
1. The money markets can be characterized as having securities that trade in one year or less, are of
large denomination, and are very liquid.
2. Money market securities have an original maturity of less than one year, so the bond would not be
considered a money market security.
3. Banks have higher costs than the money market owing to the need to maintain reserve requirements.
The lower cost structure of the money markets, coupled with the economies of scale resulting from
high volume and large-denomination securities, allows for higher interest rates.
4. Term securities have a specific maturity date. Demand securities can be redeemed at any time. A six-
month certificate of deposit is a term security. A checking account is a demand security.
5. Following the Great Depression, regulators were primarily concerned with stopping banks from failing.
By removing interest-rate competition, bank risk was substantially reduced. The problem with these
regulations was that when market interest rates rose above the established interest-rate ceiling,
investors withdrew their funds from banks.
6. The U.S. government sells large numbers of securities in the money markets to support government
spending. Over the past several decades, the government has spent more each year than it has
received in tax revenues. It makes up the difference by borrowing. Part of what it borrows comes
from the money markets.
7. Businesses both invest and borrow in the money markets. They borrow to meet short-term cash flow
needs, often by issuing commercial paper. They invest in all types of money market securities as an
alternative to holding idle cash balances.
8. Merrill Lynch initially felt that it could better service it’s regular customers by making it easier to buy
and sell securities from an account held at the brokerage house. The brokerage could offer a market
interest rate on these funds by investing them in the money markets.
9. Life insurance companies can invest for the long term because the timing for their liabilities is known
with reasonable accuracy. Property and casualty insurance companies cannot predict the natural
disasters that cause large payouts on policies.
10. Treasury bills are usually viewed as the most liquid and least risky of securities because they are
backed by the strength of the U.S. government and trade in extremely large volumes.
11. In competitive bidding for securities, buyers submit bids. A noncompetitive bidder accepts the
average of the rate paid by the competitive bidders.
12. Federal funds are sold by banks to other banks. They are used to invest excess reserves and to raise
reserves if a bank is short.
13. The Federal Reserve cannot directly set the federal funds rate of interest. It can influence the interest
rate by adding funds to or withdrawing reserves from the economy.
14. Large businesses with very good credit standings sell commercial paper to raise short-term funds.
The most common use of these funds it to extend short-term loans to customers for the purchase of
the firm’s products.
15. Banker’s acceptances substitute the creditworthiness of a bank for that of a business. When a
company sells a product to a company it is unfamiliar with, it often prefers to have the promise of a
bank that payment will be made.
1. What would be your annualized discount rate % and our annualized investment rate % on the
purchase of a 182-day Treasury bill for $4,925 that pays $5,000 at maturity?
$5,000 $4,925 360
Solution: Discount Rate    0.02967  2.967%
$5,000 182
$5,000  $4,925 365
Investment Rate    0.03054  3.054%
$4,925 182
2. What is the annualized discount rate % and your annualized investment rate % on a Treasury bill that
you purchase for $9,940 that will mature in 91 days for $10,000?
$10,000  $9,940 360
$10,000 91
$10,000  $9,940 365
Investment Rate    0.02421  2.421%
$9,940 91
3. If you want to earn an annualized discount rate of 3.5%, what is the most you can pay for a 91-day
Treasury bill that pays $5,000 at maturity?
$5,000  A 360
Solution:   .035 $5,000  A  44.24
$5,000 91
A  $4,955.76
4. What is the annualized discount rate % and investment rate % on a Treasury bill that you purchase for
$9,900 that will mature in 91 days for $10,000?
$10,000  $9,900 360
$10,000 91
$10,000  $9,900 365
Investment Rate    0.04052  4.052%
$9,900 91
5. The price of 182-day commercial paper is $7,840. If the annualized investment rate is 4.093%, what
will the paper pay at maturity?
Solution: Let B  what will be paid at maturity
[( B  $7,840) / ($7,840)]  (365 / 182)  0.04093
[( B  $7,840) / ($7,840)]  2.0055  0.04093
( B  $7,840)  2.0055  320.89
B  $7,840  160
B  $8,000
6. How much would you pay for a Treasury bill that matures in 182 days and pays $10,000 if you
require a 1.8% discount rate?
Solution: Let C  what you would pay
[($10,000  C ) /($10,000)]  (360 /182)  0.018
[($10,000  C ) /($10,000)]  1.978  0.018
[($10,000  C )]  0.018  $10,000  1.978
$10,000  C  91
C  $9,909
7. The price of $8,000 face value commercial paper is $7,930. If the annualized discount rate is 4%,
when will the paper mature? If the annualized investment rate % is 4%, when will the paper mature?
Solution: Let N  when the paper matures
Discount Rate:
[($8,000  $7,930) / $8,000)]  (360 / N )  0.04
($70 / $8,000)  (360 / N )  0.04
($0.00875)  (360 / N )  0.04
(360 / N )  0.04  (1/ $0.00875)
(360 / N )  4.571429
N  78.75  79days
Investment Rate:
[($8,000  $7,930) /($7,930)]  (365 / N )  0.04
($70 / $7,930)  (365 / N )  0.04
(365 / N )  0.04  (1/ 0.008827)
365 / N  4.53155
N  80.55  81days
8. How much would you pay for a Treasury bill that matures in one year and pays $10,000 if you
require a 3% discount rate?
Solution: Let C  what you would pay
[$10,000  C ) /($10,000)]  (360 /182)  0.03
[($10,000  C ) /($10,000)]  0.03  (182 / 360)
$10,000  C  151.67
C  $9,848.33
9. The annualized discount rate on a particular money market instrument is 3.75%. The face value is
$200,000 and it matures in 51 days. What is its price? What would be the price if it had 71 days to
maturity?
Solution: Let B  the price with 51 days to maturity
[($200,000  B) / ($200,000)]  (360 / 51)  0.0375
[($200,000  B)  (360 / 51)  0.0375  $200,000
($200,000  B)  (360 / 51)  $7,500
($200,000  B)  $7,500  (51 / 360)
$200,000  B  $1,062.50
B  $198,937.50
If 71 days to maturity, then B  $198,520.83.
10. The annualized yield is 3% for 91-day commercial paper and 3.5% for 182-day commercial paper.
What is the expected 91-day commercial paper rate 91 days from now?
Solution: Let A  the expected 91-day rate, 91 days from now.
Assume that the 182-day rate is the average of the current 91-day rate and the expected
91-day rate.
(3  A) / 2  3.5
3 A  7
A4
11. In a Treasury auction of $2.1 billion par value 91-day T-bills, the following bids were submitted:
Bidder Bid Amount Price

1 $500 million $0.9940
2 $750 million $0.9901
3 $1.5 billion $0.9925
4 $1 billion $0.9936
5 $600 million $0.9939
If only these competitive bids are received, who will receive T-bills, in what quantity, and at what price?
Bidders 1, 4, and 5 will receive T-bills in the amount requested all at .9936.
12. If the Treasury also received $750 million in non-competitive bids, who will receive T-bills, in what
quantity, and at what price?
Solution: All competitive bids are accepted at the highest yield paid to competitive bids. Thus, all
$750 million will be accepted at .9936.
Chapter 12
Answers to End-of-Chapter Questions
1. Investors use capital markets for long-term investment purposes. They use money markets, which
have lower yields, primarily for temporary or transaction purposes.
2. The primary capital market securities are stocks and bonds. Most of these are purchased and owned
by households.
3. The primary market is for securities being issued for the very first time, and the issuer receives the
funds paid for the security. The secondary market is for securities that have been issued previously
but are being traded among investors.
4. The par value is the amount the issuer will pay the holder when the bond matures. The coupon interest
rate is multiplied times the par value to determine the interest payment the issuer must make each year.
The maturity date is when the issuer must pay the holder the par value.
5. Treasury bills mature in less than 1 year, Treasury notes mature in 1 to 10 years, and Treasury bonds
mature in 10 to 30 years.
6. The risk that a bond’s price will change due to changes in market interest rates is called interest rate risk.
7. Agencies that issue securities include Ginnie Mae (formerly the Government National Mortgage
Association), the Federal Housing Administration, the Veterans Administration, the Federal National
Mortgage Association, and the Student Loan Marketing Association. The first four fund mortgage
loans and the last funds college student loans.
8. Firms like having the flexibility to adjust their capital structure by paying off debt they no longer
need. They also need to pay off debt to remove restrictive covenants. Call provisions permit both
these actions at the issuer’s discretion.
9. A sinking fund contains funds set aside by the issuer of a bond to pay for the redemption of the bond
when it matures. Because a sinking fund increases the likelihood that a firm will have the funds to
pay off the bonds as required, investors like the feature. As a result, interest rates are lower on
securities with sinking funds.
10. The list of terms of a bond is known as the indenture.
11. Capital market securities may be sold in a public offering or in a private placement. In a public
offering, investment bankers register the security with the SEC and market it through a network of
brokerage houses. In a private placement, the firm or an investment banker sells the securities to a
very limited number of investors, who each buy a large quantity.
1. A bond pays $80 per year in interest (8% coupon). The bond has 5 years before it matures at which
time it will pay $1,000. Assuming a discount rate of 10%, what should be the price of the bond
(Review Chapter 3)?
Solution: $924.18
2. A zero coupon bond has a par value of $1,000 and matures in 20 years. Investors require a 10%
annual return on these bonds. For what price should the bond sell? (Note: Zero coupon bonds do not
pay any interest.) (Review Chapter 3)?
Solution: $148.64
3. Consider the two bonds described below:
Bond A Bond B
Maturity 15 yrs 20 yrs
Coupon Rate 10% 6%
(Paid semiannually)
Par Value $1,000 $1,000
a. If both bonds had a required return of 8%, what would the bonds’ prices be?
b. Describe what it means if a bond sells at a discount, a premium, and at its face amount
(par value). Are these two bonds selling at a discount, premium, or par?
c. If the required return on the two bonds rose to 10%, what would the bonds’ prices be?
Solution:
a. Bond A  $1,172.92
Bond B  $802.07
b. Bond A is selling at a premium
Bond B is selling at a discount
c. Bond A  $1,000
Bond B  $656.82
4. A 2-year $1,000 par zero-coupon bond is currently priced at $819.00. A 2-year $1,000 annuity is
currently priced at $1,712.52. If you want to invest $10,000 in one of the two securities, which is a
better buy? You can assume
a. the pure expectations theory of interest rates holds,
b. neither bond has any default risk, maturity premium, or liquidity premium, and
c. you can purchase partial bonds.
Solution: With PV  $819; FV  $1,000; PMT  0; and N  2, the yield to maturity on the two-year
zero-coupon bonds is 10.5% for the two-year annuities. PV  $1,712.52; PMT  0;
FV  $2,000; and N  2 gives a yield to maturity of 8.07%. The zero-coupon bonds are
the better buy.
5. Consider the following cash flows. All market interest rates are 12%.
Year 0 1 2 3 4
Cash Flow 160 170 180 230
a. What price would you pay for these cash flows? What total wealth do you expect after 2½ years
if you sell the rights to the remaining cash flows? Assume interest rates remain constant.
b. What is the duration of these cash flows?
c. Immediately after buying these cash flows, all market interest rates drop to 11%. What is the
impact on your total wealth after 2½ years?
Solution:
160 170 180 230
a. Price      $552.67
1.12 1.12 1.12 1.124
2 3
180 230
Expected Wealth  160  (1.12)1.5  170  (1.12)5    $733.69
1.12 1.121.5
5
160 170 180 230

(1)  (2)  (3) 
b. Duration  1.12 1.12 2
1.12 3
1.12 4
 2.50
552.67
180 230
c. Expected Wealth  160  (1.11)1.5  170  (1.11).5    $733.74
1.11 1.111.5
.5
Since you are holding the cash flows for their duration, you are essentially immunized from interest
rate changes (in this simplistic example).
6. The yield on a corporate bond is 10% and it is currently selling at par. The marginal tax rate is 20%.
A par value municipal bond with a coupon rate of 8.50% is available. Which security is a better buy?
Solution: The equivalent tax-free rate  taxable interest rate  (1  marginal tax rate). In this case,
0.10  (1  0.20)  8%. The corporate bond offers a lower after-tax yield given the
marginal tax rate, so the municipal bond is a better buy.
7. If the municipal bond rate is 4.25% and the corporate bond rate is 6.25%, what is the marginal tax
rate assuming investors are indifferent between the two bonds?
Solution: The equivalent tax-free rate  taxable interest rate  (1  marginal tax rate). In this case,
0.0425  0.0625  (1  X), or X  32%.
8. M&E Inc. has an outstanding convertible bond. The bond can be converted into 20 shares of common
equity (currently trading at $52/share). The bond has 5 years of remaining maturity, a $1,000 par
value, and a 6% annual coupon. M&E’s straight debt is currently trading to yield 5%. What is the
minimum price of the bond?
Solution: The price must exceed the straight bond value or the value of conversion (you will see
why in the next question).
If converted, the debt is worth $52  20  $1,040.
Assuming a 5% YTM is correct, the price of straight debt is computed as:
PMT  60; N  5; FV  1000; I  5
Compute PV; PV  1,043.29
The bond must be trading for at least $1,043.29.
9. Assume the debt in the previous question is trading at 1,035. How can you earn a riskless profit from
this situation (arbitrage)?
Solution:
Cash
a. Short 20 shares of M&E at $52/share.
$1,0470 *
($1,0.35)
b. Purchase a convertible bond.
$5
c. Convert the bond to shares, and use to close short position.
Assuming these transactions are completed simultaneously, you make a riskless profit of $5.
*Typically, small investors cannot short stock and have use of the proceeds—the broker retains it as
collateral. So, this doesn’t quite work. But the idea is correct.
10. A 10-year, 1,000 par value bond with a 5% annual coupon is trading to yield 6%. What is the current
yield?
Solution: The current price of the bond is computed as follows:
PMT  50; N  10; FV  1000; I  6
Compute PV; PV  926.40
The current yield  50/926.40  5.4%
11. A $1,000 par bond with an annual coupon has only 1 year until maturity. Its current yield is
6.713% and its yield to maturity is 10%. What is the price of the bond?
Solution:
a. CY  0.06713  Coupon/Price, or Coupon  0.06713  Price
b. Price  (Coupon  1000)/1.10.
Substituting from (1), Price  (0.06713  Price  1000)/1.10
Solve for price; Price  $968.17
12. A 1-year discount bond with a face value of $1,000 was purchased for $900. What is the yield to
maturity? What is the yield on a discount basis?
Solution: 900  1000/(1  YTM), or YTM  11.11%

YDB  (1000 – 900)/1000  (360/365)  9.86%
13. A 7-year, $1,000 par bond has an 8% annual coupon and is currently yielding 7.5%. The bond can
be called in 2 years at a call price of $1,010. What is the bond yielding, assuming it will be called
(known as the yield to call)?
Solution: The current price of the bond is computed as follows:
PMT  80; N  7; FV  1000; I  7.5
Using this, the yield to call is calculated as follows:
PMT  80; N  2; FV  1010; PV  1,026.48
Compute I; I  7.018%
14. A 20-year $1,000 par value bond has a 7% annual coupon. The bond is callable after the 10th year
for a call premium of $1,025. If the bond is trading with a yield to call of 6.25%, the bond’s yield
to maturity is what?
Solution: The current price of the bond is computed using the yield to call as follows:
PMT  70; N  10; FV  1025; I  6.25
Using this, the yield to maturity is calculated as follows:
PMT  70; N  20; FV  1000; PV  1,068.19
Compute I; I  6.39%
15. A 10-year $1,000 par value bond has a 9% semiannual coupon and a nominal yield to maturity of
8.8%. What is the price of the bond?
Solution: The price of the bond is computed as follows:
PMT  45; N  20; FV  1000; I  8.8
16. Your company owns the following bonds:
Bond Market Value Duration

A $13 million 2
B $18 million 4
C $20 million 3
If general interest rates rise from 8% to 8.5%, what is the approximate change in the value of the
portfolio?
Solution: Portfolio duration  2  (13/51)  4  (18/51)  3  (20/51)  3.09
  Value  Duration  (i/(1  i))  Original Value
  Value  3.09  (0.005/1.08)  $51 million  $729,583
Chapter 13.

1. The value of any asset is the present value of its future cash flows. The value of a bond is the PV of
the interest payments plus the PV of the final payment. Stocks are valued the same way. The price is
the PV of the cash flows that stock is expected to generate for the investor.
2. There are two cash flows from stock, periodic dividends, and a future sales price. Dividends are
frequently changed when firm earnings either rise or fall. The future sales price is also difficult to
estimate, since it depends on the dividends that will be paid at some date even farther in the future.
Bond cash flows also consist of two parts, periodic interest payments and a final maturity payment.
These payments are established in writing at the time the bonds are issued and cannot be changed
without the firm defaulting and being subject to bankruptcy. Stock prices tend to be more volatile,
since their cash flows are more subject to change.
3. Organized exchanges have a physical building where business is conducted. They generally have a
governing board that establishes rules for trading. The organized exchanges tend to have larger firms
listed on them than trade over the counter.
4. NASDAQ is a computer network that allows traders to monitor stocks traded on the over-the-counter
market. It provides current bid and ask prices on about 4000 actively traded securities.
5. Stocks do not mature, do not pay a fixed amount every period, and often give holders the right to vote
on management issues.
6. At least 7 of the 30 firms are involved in high-technology products or services. This has increased the
volatility of the Dow index in recent years as these firms were added.
Ebay, Inc. went public in September of 1998. The following information on shares outstanding was listed
in the final prospectus filed with the SEC1.
In the IPO, the Ebay issued 3,500,000 new shares. The initial price to the public was $18.00 per share.
The final first-day closing price was $44.88.
1. If the investment bankers retained $1.26 per share as fees, what was the net proceeds to Ebay?
What was the market capitalization of new shares of Ebay?
Solution: Net Proceeds to Ebay  (18.00  1.26)  3,500,000  $58,590,000.00
Market Cap  44.88  3,500,000  $157,080,000
2. Two common statistics in IPOs are underpricing and money left on the table. Underpricing is defined
as percentage change between the offering price and the first day closing price. Money left on the
table is the difference between the first day closing price and the offering price, multiplied by the
number of shares offered. Calculate the underpricing and money left on the table for Ebay. What does
this suggest about the efficiency of the IPO process?
Solution: Underpricing  ((44.88  18.00)/18.00)  149.33%

MLOT  (44.88  18.00)  3,500,000  $94,080,000
3. The shares of Misheak, Inc. are expected to generate the following possible returns over the next 12
months:
1
This information is summarized from http://www.sec.gov/Archieves/edgar/data/1065088/0001012870-98-002475.txt
Return Probability
5% 0.10
5% 0.25
10% 0.30
15% 0.25
25% 0.10
If the stock is currently trading at $25/share, what is the expected price in one year. Assume that the
stock pays no dividends.
Solution: The expected return over the next 12 months is calculated as:
0.05  0.10  0.05  0.25  0.10  0.30  0.15  0.25  0.25  0.10  0.10
This suggests that the expected price is $25  (1.10)  $27.50
4. Suppose Soft People, Inc. is selling at $19.00 and currently pays an annual dividend of $0.65 per
share. Analysts project that the stock will be priced around $23.00 in one year. What is the expected
return?
Solution:
23.00  0.65  19.00
Expected return   24.47%
19.00
5. Suppose Microsoft, Inc. was trading at $27.29 per share. At that time, It pays an annual dividend of
$0.32 per share, and analysts have set a 1-year target price around $33.30 per share. What is the
expected return on this stock?
Solution:
33.30  0.32  27.29
Expected return   0.2319  23.2%
27.29
6. LaserAce is selling at $22.00 per share. The most recent annual dividend paid was $0.80. Using the
Gordon Growth model, if the market requires a return of 11%, what is the expected dividend growth
rate for LaserAcer?
Solution:
D0 (1  g ) 0.80(1  g )
P0  , or 22.00  . Solving, g  7.1%
ke  g 0.11  g
7. Huskie Motor’s just paid an annual dividend of $1.00 per share. Management has promised
shareholders to increase dividends a constant rate of 5%. If the required return is 12%, what is the
current price per share?
Solution:
D0 (1  g ) 1.00(1  0.05)
P0    $15.00
ke  g 0.12  0.05
8. Suppose Microsoft, Inc. is trading at $27.29 per share. It pays an annual dividend of $0.32 per share,
which is double its last year’s dividend of $0.16 per share. If this trend is expected to continue, what
is the required return on Microsoft?
Solution:
D0 (1  g ) 0.32(1  1)
P0  27.29  , or ke  102%.
ke  g ke  1
This seems a bit high. Perhaps investors don’t believe this trend will continue forever, or this isn’t the
correct valuation model for Microsoft!
9. Gordon & Co.’s stock has just paid its annual dividend $1.10 per share. Analysts believe that Gordon
will maintain its historic dividend growth rate of 3%. If the required return is 8%, what is the
expected price of the stock next year?
Solution:
D1 (1  g ) 1.133(1.03)
P1    $23.34
ke  g 0.08  0.03
10. Macro Systems just paid an annual dividend of $0.32 per share. Its dividend is expected to double for
the next four years (D1 through D4), after which it will grow at a more modest pace of 1% per year.
If the required return is 13%, what is the current price?
Solution:
0.64 1.28 2.56 5.12 5.12(1  0.01) 1
P0        $32.91
1.13 1.13 1.13 1.13
2 3 4
0.13  0.01 1.134
11. Nat-T-Cat Industries just went public. As a growing firm, it is not expected to pay a dividend for the
first five years. After that, investors expect Nat-T-Cat to pay an annual dividend $1.00 per share
(i.e., D6  1.00), with no growth. If the required return is 10%, what is the current stock price?
Solution:
D6 (1  g ) 1.00(1.00)
P5    $10.00
ke  g 0.10  0.00
so,
P0  P5 /(1.10)5  $6.21
12. Analysts are projecting that CB Railways will have earnings per share of $3.90. If the average
industry ratio is about 25, what is the current price of CB Railways?
Solution:
Price  3.90  25  $97.50
13. Suppose Microsoft, Inc. reported earnings per share around $0.75. If Microsoft is in an industry with
a ratio ranging from 30 to 40, what is a reasonable price range for Microsoft?
Solution: Microsoft’s price should be between $0.75  30 to $0.75  40, or $22.50 to $30.00.
14. Consider the following security information for four securities making up an index:
Price
Shares
Security time  0 time  1 Outstanding
1 8 13 20 million
2 22 25 50 million
3 35 30 120 million
4 50 55 75 million
What is the change in the value of the index from time  0 to time  1 if the index is calculated using
a value-weighted arithmetic mean?
Solution: For a value-weighted arithmetic mean, the change is calculated as follows:
First, the market value at time  0 is calculated as:
Price Shares Market

Security time  0 time  1 Outstanding Value
1 8 13 20 million $ 160
2 22 25 50 million $1,100
3 35 30 120 million $4,200
4 50 55 75 million $3,750
$9,210
The change is then calculated as:

 13  8 160 25  22 1100 30  35 4200 55  50 3750 
 8  9210  22  9210  35  9210  50  9210   0.0027
 
Index1  Index0  1.0027
15. An index had an average (geometric) mean return over 20 years of 3.8861%. If the beginning index
value was 100, what was the final index value after 20 years?
Solution:
The actual return over the 20 years is (1.038861)20  2.143625
So, the final index value is 214.3625
16. Compute the price of a share of stock that pays a $1 per year dividend and that you expect to be able
to sell in one year for $20, assuming you require a 15% return.
Solution:
$1/(1  0.51)  $20/(1  0.15)  $18.26
17. The projected earnings per share for Risky Ventures, Inc. is $3.50. The average PE ratio for the
industry composed of Risky Ventures closest competitors is 21. After careful analysis, you decide
that Risky Ventures is a little more risky than average, so you decide a PE ratio of 23 better reflects
the market’s perception of the firm. Estimate the current price of the firm’s stock.
Solution:
23  $3.5  $80.50
Chapter 17
1. The rank from most to least liquid is (c), (b), (a), (d).
2. No, because the bank president is not managing the bank well. The fact that the bank has never incurred
costs as a result of a deposit outflow means that the bank is holding a lot of reserves that do not earn
any interest. Thus the bank’s profits are low, and stock in the bank is not a good investment.
3. No. When you turn a customer down, you may lose that customer’s business forever, which is
extremely costly. Instead, you might go out and borrow from other banks, corporations, or the Fed to
obtain funds so that you can make the customer’s loan. Alternatively, you might sell negotiable CDs
or some of your securities to acquire the necessary funds.
4. Because when a deposit outflow occurs, a bank is able to borrow reserves in these overnight loan
markets quickly; thus, it does not need to acquire reserves at a high cost by calling in or selling off
loans. The presence of overnight loan markets thus reduces the costs associated with deposit outflows,
so banks will hold fewer excess reserves.
5. You should want to make short-term loans. Then, when these loans mature, you will be able to make
loans at higher interest rates, which will generate more income for the bank.
6. False. If an asset has a lot of risk, a bank manager might not want to hold it even if it has a higher
return than other assets. Thus a bank manager has to consider risk as well as the expected return
when deciding to hold an asset.
7. True. Banks can now pursue new loan business much more aggressively than in the past because when
they see profitable loan opportunities, they can use liability management to acquire new funds and
expand the bank’s business.
8. Because the off-balance sheet activities mentioned in this chapter which generate fees have become
a more important part of a bank’s business.
9. Interest expenses have large fluctuations because interest rates fluctuate so much; provisions for loan
losses fluctuate a lot because when the economy turns down or a particular sector of the economy
deteriorates, the potential for loan losses rises dramatically.
10. Because ROE, the return on equity, tells stock holders how much they are earning on their equity
investment, while ROA, the return on assets, only provides an indication how well the bank’s assets
are being managed.
11. The net interest margin measures the difference between interest income and expenses. It is important
because it indicates whether asset and liability management is being done properly so that the bank
earns substantial income on its assets and has low costs on its liabilities.
12. ROE will fall in half.
13. To lower capital and raise ROE, holding its assets constant, it can pay out more dividends or buy back
some of its shares. Alternatively, it can keep its capital constant but increase the amount of its assets
by acquiring new funds and then seeking out new loan business or purchasing more securities with
these new funds.
14. The benefit is that the bank now has a larger cushion of bank capital and so is less likely to go broke
if there are losses on its loans or other assets. The cost is that for the same ROA, it will have a lower
ROE, return on equity.
15. It can raise $1 million of capital by issuing new stock. It can cut its dividend payments by $1 million,
thereby increasing its retained earnings by $1 million. It can decrease the amount of its assets so that
the amount of its capital relative to its assets increases, thereby meeting the capital requirements.
1. The balance sheet of TriBank starts with an allowance for loan losses of $1.33 million. During
the year, TriBank charges off worthless loans of $0.84 million, recovers $0.22 million on loans
previously charged off, and charges current income for $1.48 million provisions for loan losses.
Calculate the end of year allowance for loan losses.
Solution: 1.33 M  0.84 M  0.22 M  1.48 M  $2.19 M
2. X-Bank reported an ROE of 15% and an ROA of 1%. How well capitalized in this bank?
Solution: ROE  ROA  EM

0.15  0.01  EM
EM  15  assets/equity
So equity/assets  6.66%. This is a well-capitalized bank.
3. In mid-1978, Wiggley S&L issued a standard 30-year fixed rate mortgage at 7.8% for $150,000.
36 months later, mortgage rates jumped to 13%. If the S&L sells the mortgage, how much of a
loss is expected?
Solution: When issued, the required payment is:
PV  $150,000, I  7.8/12, N  360, FV  0
Compute PMT.
PMT  $1,079.81 After 36 months, the mortgage balance is:
PMT  $1,079.81, I  7.8/12, N  324, FV  0
Compute PV. PV  $145,764.43
However, at current rates, the remaining cash flows are worth:
PMT  $1,079.81, I  13/12, N  324, FV  0
Compute PV. PV  $96,637.64
Wiggley S&L expects to take a loss of $49,126 if it sells the mortgage.
4. Refer to the previous question. In 1981 Congress allowed S&Ls to sell mortgages at a loss and to
amortize the loss over the remaining life of the mortgage. If this were used for the previous question,
how would the transaction have been recorded? What would be the annual adjustment? When would
that end?
Solution: The sale would be recorded as:
Debit Credit
Cash $96,638 Mortgage $145,764
Capitalized Loss $49,126
Then, each year for the next 27 years (ending in 2007!), the loss would be written off:
Debit Credit
Loss Expense $1,819.48 Capitalized Loss $1,819.48
5. For the upcoming week, Nobel National Bank plans to issue $25 million in mortgages and purchase
$100 million 31-day T-bills. New deposits of $35 million are expected, and other sources will
generate $15 million in cash. What is Nobel’s estimate of funds needed?
Solution: $25 M  $100 M  $35 M  $15 M  $75 M
6. A bank with $100 million in demand deposits estimates that net daily deposits are, on average,
$100 million with a standard deviation of $5 million. The bank wants to maintain a minimum of 8%
of deposits in reserves at all times. What is the highest expected level of deposits during the month?
What reserves do they need to maintain? Use a 99% confidence level.
Solution: The highest that demand deposits will reach, with 99% confidence, is $100 M  3 
$5 million, or $115 million. To maintain 8% as reserves against this possibility,
they must maintain $115 M  0.08  $9.2 million.
A better approach would be to increase/decrease reserves as deposits are received/withdrawn,
rather than maintain $9.2 million against the possibility of $115 M in deposits.
7. NewBank started its first day of operations with $6 million in capital. $100 million in checkable
deposits is received. The bank issues a $25 million commercial loan and another $25 million in
mortgages, with the following terms:
 mortgages: 100 standard 30-year, fixed-rate with a nominal annual rate of 5.25% each for
$250,000.
 commercial loan: 3-year loan, simple interest paid monthly at 0.75%/month.
If required reserves are 8%, what does the bank balance sheets look like? Ignore any loan
loss reserves.
Assets Liabilities
Required Reserves $ 8 million Checkable Deposits $100 million
Excess Reserves $48 million Bank Capital $ 6 million
Loans $50 million
8. NewBank decides to invest $45 million in 30-day T-bills. The T-bills are currently trading at $4,986.70
(including commissions) for a $5,000 face value instrument. How many do they purchase? What does
the balance sheet look like?
Solution: The bank can purchase $45 M/$4,986.70, which is about 9,024 T-bills. The actual cost is
$44,999,980.80.
After the transaction, the balance sheet is:
Assets Liabilities
Excess Reserves $ 3 million Bank Capital $ 6 million
T-bills $45 million
Loans $50 million
9. On the 3rd day of operations, deposits fall by $5 million. What does the balance sheet look like? Are
there any problems?
Solution: The cash leaving the bank comes from reserves, first excess and then required. Following
the outflow, the balance sheet is:
Assets Liabilities
T-bills $45 million Bank Capital $ 6 million
Loans $50 million
With $95 million in deposits, the 0.08  $95 M is required in reserves, or $7.6 million.
The bank is short $1.6 million.
10. To meet any shortfall in the previous question, NewBank will borrow the cash in the fed funds market.
Management decides to borrow the needed funds for the remainder of the month (now 29 days). The
required yield on a discount basis is 2.9%. What does the balance sheet look like after this
transaction?
Solution:
Assets Liabilities
Required Reserves $7.6 million Checkable Deposits $ 95 million
T-bills $ 45 million Fed Funds Borrowed $1.6 million
Loans $ 50 million Bank Capital $ 6 million
11. The end of the month finally arrives for NewBank, and it receives all the required payments from its
mortgages, commercial loan, and T-bills. How much cash was received? How are these recorded?
Solution: The required monthly mortgage payments are:
PV  25 M, I  5.25/12, N  360, FV  0
Compute PMT. PMT  $138,050.93
The loan payment is: $23 M  0.0075  $187,500.
These are recorded as:
Debit Credit
Cash $325,551 Interest Income $296,875
Loans $ 28,676
The T-bills paid: 9,024  $5,000  $45,120,000. This is recorded as:
Debit Credit
Cash $45,120,000 T-bills $44,999,980.80
Interest Income $ 120,019.20
12. NewBank also pays off its fed funds borrowed. How much cash is owed? How is this recorded?
Solution:
$F  $1.6 M 360
  0.029
F 29
F  $1,603,746.53
This is recorded as:
Debit Credit
Fed Funds $1,600,000 Cash $1,603,746.53
Interest Expense $ 3,746.53
13. What does the month-end balance sheet for NewBank look like? Calculate this before any income tax
consideration.
Solution:
Assets Liabilities
Required Reserves $ 7.6 million Checkable Deposits $ 95 million
Excess Reserves $43.84 million Bank Capital $6.41 million
Loans $49.97 million
14. Calculate NewBank’s ROA and NIM for its first month. Assume that net interest equals EBT, and
that NewBank is in the 34% tax bracket.
Solution:
Interest income $416,894
Interest expense $ 3,747
NIM $413,147
Income tax $140,470
Net income $272,677
ROA  272,677/101.41 M  0.2688% (monthly)
15. Calculate NewBank’s ROE and final balance sheet including its tax liabilities.
Solution:
Assets Liabilities
Excess Reserves $43.84 million Taxes Payable $140,470
Loans $49.97 million Bank Capital $ 6.27 million
ROA  272,677/6,269,530  4.35% (monthly)
16. If NewBank was required to establish a loan loss reserve at 0.25% of the loan value for commercial
loans, how is this recorded? Recalculate NewBank’s ROE and final balance sheet including its tax
liabilities.
Solution: The establishment of the loan loss reserve is:
Debit Credit
Loan Loss Expense $62,500 Loan Loss Reserve $62,500
The new income is:
Interest income $416,894
Interest expense $ 3,747
NIM $413,147
Loan loss expense $ 62,500
Taxable income $350,647
Income tax $119,220
Net Income $231,427
The new balance sheet is:
Assets Liabilities
Excess Reserves $43.84 million Taxes Payable $119,220
Loans $49.97 million Loan Loss Reserve $ 62,500
Bank Capital $ 6.23 million
ROE  231,427/6,228,280  3.71% (monthly)
17. If NewBank’s target ROE is 4.5%, how much net fee income must it generate to meet this target?
Solution: The required net income  0.045  $6 M  $270,000.

Working backwards, we get:
Taxable income $409,091

Income tax $139,091
Net Income $270,000
Since the taxable income was previously $350,647, this means that $58,444 in net fee
income (fees generated less expenses) is needed to meet the target.
18. After making payments for three years, one of the mortgage borrowers defaults on the mortgage.
NewBank immediately takes possession of the house and sells it at auction for $175,000. Legal
fees amount to $25,000. If no loan loss reserve was established for the mortgage loans, how is this
event recorded?
Solution: The required monthly mortgage payments are:
PV  250,000, I  5.25/12, N  360, FV  0
The remaining balance on the mortgage after 36 payments is:
PMT  $1,380.51, I  5.25/12, N  360 – 6, FV  0
Compute PV. PV  $238,845.64
The transaction is recorded as:
Debit Credit
Cash 150,000.00 Loan $238,845.64
Loan Loss Expense $88,845.64
Chapter 18
1. Answers will vary.
2. There would be adverse selection because people who might want to burn their property for some
personal gain would actively try to obtain substantial fire insurance policies. Moral hazard could also
be a problem because a person with a fire insurance policy has less incentive to take measures to
prevent a fire.
3. Chartering banks is the bank regulation that helps reduce the adverse selection problem because
it attempts to screen proposals for new banks to prevent risk-prone entrepreneurs and crooks
from controlling them. It will not always work because risk-prone entrepreneurs and crooks have
incentives to hide their true nature and thus may slip through the chartering process.
4. Regulations that restrict banks from holding risky assets directly decrease the moral hazard of risk
taking by the bank. Requirements that force banks to have a large amount of capital also decrease the
banks’ incentives for risk taking because banks now have more to lose if they fail. Such regulations
will not completely eliminate the moral hazard problem because bankers have incentives to hide their
holdings or risky assets from the regulators and to overstate the amount of their capital.
5. The benefits of a too-big-to-fail policy are that it makes bank panics less likely. The costs are that
it increases the incentives of moral hazard by big banks who know that depositors do not have
incentives to monitor the bank’s risk-taking activities. In addition, it is an unfair policy because it
discriminates against small banks.
6. Because off-balance-sheet activities do not appear on bank balance sheets, they cannot be dealt
with by simple bank capital requirements, which are based on bank assets, such as a leverage ratio.
Banking regulators have dealt with this problem by imposing an additional risk-based bank capital
requirement that banks set aside additional bank capital for different kinds of off-balance-sheet
activities.
7. Because with higher amounts of capital, banks have more to lose if they take on too much risk. Thus
capital requirements make it less likely that banks will take on excessive risk.
8. Bank supervision involves bank examinations in which examiners assess six areas of the bank
represented in the CAMELS rating (capital adequacy, asset quality, management, earnings, liquidity,
and sensitivity to market risk). A low score on the CAMELS rating allows the supervisors to declare a
bank to be a “problem bank,” making it more subject to frequent examinations and to sanctions
to reduce the amount of risk taking it is engaged in. Bank examiners also check that the bank is
following the rules and regulations and is not holding securities or loans that are too risky. All of these
measures help ensure that banks are not taking on too much risk, and thus promote a safer
and sounder banking system.
9. The Bank Insurance Fund of the FDIC was recapitalized by allowing it to borrow more from the
Treasury and by raising insurance premiums. The bill reduced the scope of deposit insurance by
limiting brokered deposits and by limiting the too-big-to-fail doctrine by forcing the FDIC to use the
least cost method of closing failed banks except under unusual circumstances. The bill has prompt
corrective action provisions that require the FDIC to intervene earlier with stronger actions when
banks move into one of the weaker of the five classifications based on bank capital. The limiting of
deposit insurance and prompt corrective action should reduce moral hazard risk-taking on the part
of banks. The bill instructs the FDIC to come up with risk-based premiums which will increase the
premium cost when the banks take on more risk, thus helping to reduce the moral hazard problem. The
bill also mandates increased reporting requirements and annual examinations to prevent the banks
from taking on too much risk. It also enhances regulation of foreign banks in the U.S. to keep them
from operating in the U.S. if they are taking on too much risk.
10. With the advent of new financial instruments, a bank that is quite healthy at a particular point in time
can be driven into insolvency extremely rapidly from risky trading in these instruments. Thus, a focus
on bank capital at a point in time may not be effective in indicating whether a bank will be taking on
excessive risk in the near future. Therefore, to make sure that banks are not taking on too much risk,
bank supervisors now are focusing more on whether the risk-management procedures in banks keep
them from excessive risk taking that might make a future bank failure more likely.
11. More public information about the risks incurred by banks and the quality of their portfolio helps
stockholders, creditors, and depositors to evaluate and monitor banks and pull their funds out if the
banks are taking on too much risk. Thus, in order to prevent this from happening banks are likely to
take on less risk and this make bank failures less likely.
12. Eliminating or limiting the amount of deposit insurance would help reduce the moral hazard of
excessive risk taking on the part of banks. It would, however, make bank failures and panics more
likely, so it might not be a very good idea.
13. In general, yes. A national banking system will enable banks to diversify their loan portfolios better,
thus decreasing the likelihood of bank failures. In addition it may make banks and hence the economy
more efficient and will help increase banks’ profitability which will make them healthier.
14. The economy would benefit from reduced moral hazard; that is, banks would not want to take on
too much risk because doing so would increase their deposit insurance premiums. The problem is,
however, that it is difficult to monitor the degree of risk in bank assets because often only the bank
making the loans knows how risky they are.
15. Market-value accounting for bank capital would let the deposit insurance agency know quickly if
a bank was falling below its capital requirement so that it could be closed down before it led to
substantial losses for the insurance agency. Also it would help keep banks from operating with
negative capital when the moral hazard problem becomes especially severe and the bank takes on
excessive risk. However, making accurate market-value calculations of bank capital is a complex
task since it would require some estimates and approximations. However, even if not fully accurate,
if market-value accounting provides a more accurate assessment of bank capital than historical-cost
accounting, it would lead to lower losses from the deposit insurance agency.
1. Consider a failing bank. A deposit of $150,000 is worth how much if the FDIC uses the payoff
method? The purchase and assumption method? Which is more costly to tax payers?
Solution: Under the payoff method, large deposits pay better than $0.90/dollar. In this case, the
$150,000 is worth better than $150,000  0.90  $135,000. Under the purchase and
assumption policy, the bank is completely absorbed, and all accounts are worth their
full value.
Upfront, the second method will have a lower cost to the insurance fund. However, if
depositors fear loss under the payoff method, they are less likely to maintain account
balances in excess of $100,000 in a single bank.
2. Consider a bank with the following balance sheet:
Assets Liabilities
T-bills $45 million
Mortgages $40 million
Commercial Loans $10 million
Calculate the bank’s risk-weighted assets.

Solution: Reserves and T-bills have a zero weight. So, $56 million has zero weight.
Mortgages carry a 50% weight. RW Assets  $40 million  0.50  $20 million.
Commercial loans carry a 100% weight. RW Assets  $10 million.
Total risk-weighted assets  $30 million.
3. Consider a bank with the following balance sheet:
Assets Liabilities
T-bills $45 million
Commercial Loans $50 million
The bank commits to a loan agreement for $10 million to a commercial customer. Calculate the bank’s
capital ratio before and after the agreement. Calculate the bank’s risk-weighted assets before and after
the agreement.
Solution: Before the agreement, the capital ratio  6/106  5.66%. Since the loan agreement has no
accounting transaction, the capital ratio is the same after.
For risk-weighted assets:
Reserves and T-bills have a zero weight. So, $56 million has zero weight.
After the loan agreement, risk-weighted assets:
Reserves and T-bills have a zero weight. So $56 million has zero weight.
Commercial loan commitments are at 100%. RW Assets  $10 million
The actual risk-weighted assets for the loan commitment may vary depending on the terms
of the commitment and other factors. However, under the idea of risk-weighted assets, the
$10 million would be correct.
4. Oldhat Financial started its first day of operations with $9 million in capital. $130 million in
checkable deposits are received. The bank issues a $25 million commercial loan and another
$50 million in mortgages, with the following terms:
 mortgages: 200 standard 30-year, fixed-rate with a nominal annual rate of 5.25% each
for $250,000
 commercial loan: 3-year loan, simple interest paid monthly at 0.75%/month
If required reserves are 8%, what does the bank balance sheet look like? Ignore any loan loss reserves.
How well capitalized is the bank?
Solution:
Assets Liabilities
Required Reserves $10.4 million Checkable Deposits $130 million
Excess Reserves $53.6 million Bank Capital $ 9 million
Loans $75 million
The bank is well capitalized, at 9/139  6.47%
5. Calculate the risk-weighted assets and risk-weighted capital ratio of Oldhat’s first day.
Solution: Reserves have a zero weight. So, $64 million has zero weight.
Residential mortgages carry a 50% weight. RW Assets  $25 million.
The capital ratio  9/50  18%.
6. The next day, terrible news hits the mortgage markets, and mortgage rates jump to 13%. What is
the market value of Oldhat’s mortgages? What is Oldhat’s “market value” capital ratio?
Solution: When issued, the required payment is:
PV  $250,000, I  5.25/12, N  360, FV  0
After the rate increase, the mortgages are worth:
PMT  $1,380.51, I  13/12, N  360, FV  0
Compute PV. PV  $124,797.56, or a loss of about 50% of value.
The new “market value” balance sheet is:
Assets Liabilities
Excess Reserves $53.6 million Bank Capital $16 million
Loans $50 million
However, the loss would not be immediately recognized. No actual accounting transaction
would take place.
7. Bank regulators force Oldhat to sell its mortgages to recognize the fair market value. What is the
accounting transaction? How does this affect its capital position?
Solution: The sale of each mortgage would be recorded as:
Debit Credit
Cash $124,798 Mortgages $250,000
Loss $125,202
After the fact, the actual balance sheet is:
Assets Liabilities
Excess Reserves $78.6 million Bank Capital $16 million
Loans $25 million
Now, the true state of the bank’s position is realized.
8. Congress allowed Oldhat to amortize the loss over the remaining life of the mortgage. If this
technique was used in the sale, how would the transaction have been recorded? What would be the
annual adjustment? What does Oldhat’s balance sheet look like? What is the capital ratio?
Solution: The sale of each mortgage would be recorded as:
Debit Credit
Cash $124,798 Mortgages $250,000

Capitalized Loss $125,202
Then, each year for the next 30 years, the loss would be written off:
Debit Credit
Loss (Expense) $4,173.40 Capitalized Loss $4,173.40
After the fact, the actual balance sheet is now:
Assets Liabilities
Excess Reserves $78.6 million Bank Capital $ 9 million
Capitalized Loss $25 million
Loans $25 million
The bank is again well capitalized, at 9/139  6.47%
9. Oldhat decides to invest the $78.6 million in excess reserves in commercial loans. What will be
the impact on its capital ratio? Its risk-weighted capital ratio?
Solution: With the commercial loan, the balance sheet is now:
Assets Liabilities
Required Reserves $ 10.4 million Checkable Deposits $130 million
Excess Reserves $ 0 million Bank Capital $9 million
Capitalized Loss $ 25 million
The bank is still well capitalized, at 9/139  6.47%.

For risk-weighted:
Reserves have a zero weight. So, $10.4 million has zero weight.
The remaining balance sheet is at 100%, or $128.6 million.
The risk-weighted capital ratio  9/128.6  7%.
10. The bad news about the mortgages is featured in the local newspaper, causing a minor bank run.
$6 million is deposits are withdrawn. Examine the bank’s condition.
Solution: The balance sheet is now:
Assets Liabilities
Capitalized Loss $ 25 million
The bank is still well capitalized, at 9/133  6.76%.

However, the required reserve ratio is 8%, or $9.92 million. The bank is roughly
$5.5 million short.
11. Oldhat borrows $5.5 million in the overnight fed funds market. What is the new balance sheet for
Oldhat? How well capitalized is the bank?
Solution: The balance sheet is now:
Assets Liabilities
Excess Reserves $ 0 million Fed funds borrowed $ 5.5 million
Capitalized Loss $ 25 million Bank Capital $ 9 million
The bank is still well capitalized, at 9/138.5  6.5%
Chapter 19
1. Agricultural and other interests in the U.S. were quite suspicious of centralized power and thus
opposed the creation of a central bank.
2. a. Office of the Controller of the Currency;

b. the Federal Reserve;
c. state banking authorities and the FDIC;
d. the Federal Reserve.
3. False. Although there are many more banks in the United States than in Canada, this does not
mean that the American banking system is more competitive. The reason for the large number of U.S.
banks is anticompetitive regulations such as restrictions on banking.
4. New technologies such as electronic banking facilities are frequently shared by several banks, so
these facilities are not classified as branches. Thus they can be used by banks to escape limitations to
offering services in other states and, in effect, to escape limitations from restrictions on branching.
5. Because becoming a bank holding company allows a bank to:

a. circumvent branching restrictions since it can own a controlling interest in several banks even if
branching is not permitted, and
b. engage in other activities related to banking that can be highly profitable.
6. International banking has been encouraged by giving special tax treatment and relaxed branching
regulations to Edge Act corporations and to international banking facilities (IBFs); this was done to
make American banks more competitive with foreign banks. The hope is that it will create more
banking jobs in the United States.
7. IBFs encourage American and foreign banks to do more banking business in the United States,
thus shifting employment from Europe to the United States.
8. No, because the Saudi-owned bank is subject to the same regulations as the American-owned bank.
9. The elimination of reserve requirements would decrease the size of money market mutual funds
because banks could then offer higher interest rates on their deposits; funds would flow out of money
market mutual funds into banks.
10. The rise of inflation and the resulting higher interest rates on alternatives to checkable deposits meant
that banks had a big shrinkage in this low-cost way of raising funds. The innovation of money
market mutual funds also meant that the banks lost checking account business. The abolishment of
Regulation Q and the appearance of NOW accounts did help decrease disintermediation but raised the
cost of funds for American banks, which now had to pay higher interest rates on checkable and other
deposits. Foreign banks were also able to tap a large pool of domestic savings, thereby lowering their
cost of funds relative to American banks.
11. True. Higher inflation helped raise interest rates which caused the disintermediation process to occur
and which helped create money market mutual funds. As a result banks lost cost advantages on the
liabilities side of their balance sheets and this has led to a less healthy banking industry. However,
improved information technology would still have eroded the banks’ income advantages on the assets
side of their balance sheet, so the decline in the banking industry would still have occurred.
12. The growth of the commercial paper market and the development of the junk bond market meant
that corporations were now able to issue securities rather than borrow from banks, thus eroding the
competitive advantage of banks on the lending side. Securitization has enabled other financial
institutions to originate loans, again taking away some of the banks’ loan business.
13. Uncertain. The invention of the computer did help lower transaction costs and the costs of collecting
information, both of which have made other financial institutions more competitive with banks and
have allowed corporations to bypass banks and borrow directly from securities markets. Therefore,
computers were an important factor in the decline of traditional banking. However, another source
of the decline in the traditional banking industry was the loss of cost advantages for the banks in
acquiring funds, and this loss was due to factors unrelated to the invention of the computer, such as
the rise in inflation and its interaction with regulations which produced disintermediation.
14. Brokerage firms began to engage in the traditional banking business of issuing deposit instruments,
while foreign bank activities in the United States further eroded the competitive position of U.S. banks.
This led to the Federal Reserve’s allowing bank holding companies to enter the underwriting business
through a loophole in Glass-Steagall in order to keep them competitive. Finally, legislation in 1999
was passed to repeal Glass-Steagall.
15. The Gramm-Leach-Bliley Act now opens the door to consolidation, not only in terms of the number
of banking institutions, but also across financial service activities. Banking institutions will become
larger and increasingly complex organizations, engaging in the full gamut of financial services
activities.
Chapter 20
1. Liquidity intermediation, denomination intermediation, ease of diversification, cost advantages,

and the growth of defined contribution pension plans.
2. Liquidity intermediation is allowing investors to redeem their shares at any time, despite long-
term holdings.
3. You may be willing to pay fees for a mutual fund to provide liquidity intermediation,
denomination intermediation, and lower the cost of diversification, but believers in an efficient
market will not pay substantial fees for managers to select specific stocks.
4. An open end mutual fund is continuously issuing new shares as new funds are received. A closed
end fund only issues shares once.
5. Investors have different objectives, goals, and tastes in securities. Mutual funds attempt to offer a
selection of funds to attract as many dollars as possible. Each different fund will have some attribute
that separates it from the others in the family.
6. Index funds are not actively managed. They simply hold the stocks in the index. They usually
have significantly lower fees than actively managed funds.
7. A load fund charges a fee for accepting investments. The fees may be at the beginning of the
investment or may be charged when the funds are withdrawn.
8. A deferred load is a fee charged when money is withdrawn from a fund. They are usually 5% and
fall by 1% for each year the investment is left in the account.
9. Hedge funds typically require very large investments, do not allow withdrawals, and charge very
high fees.
10. Money market interest rates rose in the late 1970s when bank interest rates were capped by
Regulation Q. Investors traded the safety of banks for the high returns offered by MMMFs due
to the types of securities they held.
11. 12b-1 fees pay the mutual fund for marketing and advertising. They are limited to 1% of the fund’s
average net assets per year.
12. Investment managers are usually compensated as a percentage of the funds under management. They
have an incentive to increase total assets, even when this is done at the expense of shareholder return.
13. Late trading is allowing investors to buy or sell shares in a fund after the 4:00 PM closing time when
the fund NAV is set.
14. Market timing occurs when investors take advantage of time zones and the 4:00 PM NAV valuation to
engage in arbitrage trading.
15. Increased disclosure, more independent directors, hardening of the 4:00 PM closing time, and fees for
early fund withdrawals.
1. On January 1st, the shares and prices for a mutual fund at 4:00 PM are:
Stock Shares owned Price

1 1,000 $ 1.92
2 5,000 $ 51.18
3 2,800 $ 29.08
4 9,200 $ 67.19
5 3,000 $ 4.51
cash n.a. $5,353.40
Stock 3 announces record earnings, and the price of stock 3 jumps to $32.44 in after-market trading.
If the fund (illegally) allows investors to buy at the current NAV, how many shares will $25,000 buy?
If the fund waits until the price adjusts, how many shares can be purchased? What is the gain to such
illegal trades? Assume 5,000 shares are outstanding.
Solution: At 4:00 PM, the NAV is calculated as:
$1,920  $255,900  $81,424  $618,148  $13,530  $5,353.40
NAV 
5,000
 $195.26/share.
$25,000 buys 128.034 shares. Based on the new information, NAV is:
$1,920  $255,900  $90,832  $618,148  $13,530  $5,353.40
NAV 
5,000
 $197.14/share.
$25,000 buys 126.813 shares.
If sale prices are used, the investor buys 128.034 shares. $25,000 enters the fund. After
the price increase (assuming nothing else changes), the fund is worth $1,010,683.40. Each
share is worth $1,010,683.40/5128.034  $197.09. The investor’s shares are now worth
$25,234.20, or a gain of $234.20.
2. A mutual fund charges a 5% upfront load plus reports an expense ratio of 1.34%. If an investor
plans on holding a fund for 30 years, what is the average annual fee, as a percent, paid by the investor?
Solution: 5%/30  0.1667%
The expense ratio is an annual charge, so it remains 1.34%.
The total fees paid are 1.34%  0.1667%  1.5067%.
3. A mutual fund offers “A” shares which have a 5% upfront load and an expense ratio of 0.76%.
The fund also offers “B” shares which have a 3% backend load and an expense ratio of 0.87%. Which
shares make more sense for an investor looking over an 18 year horizon?
Solution: For the “A” shares, the average annual fee is 5%/18  0.76%  1.0378%
For the “B” shares, the average annual fee is 3%/18  0.87%  1.0367%
So, the investor is better off with the “B” shares.
4. A mutual fund reported year-end total assets of $1,508 million and an expense ratio of 0.90%.
What total fees is the fund charging each year?
Solution: The fees are a percent of total assets. In this case, 0.90%  $1,508 million  $13,572,000.
5. A $1 million fund is charging a back-end load of 1%, 12b-1 fees of 1%, and an expense ratio of
1.9%. Prior to deducting expenses, what must the fund value be at the end of the year for investors to
break even?
Solution: With the backend load, the fund value must be (after expenses):
$1 million/0.99  $1,010,101.01
The expense ratio typically includes 12b-1 fees. So, a total of 1.9% will be charged. So,
before expenses, the fund value must be: $1,010,101.01/0.981  $1,029,664.64
6. On January 1st, a mutual fund has the following assets and prices at 4:00 p.m.:

1 1,000 $ 1.97
2 5,000 $48.26
3 1,000 $26.44
4 10,000 $67.49
5 3,000 $ 2.59
Calculate the net asset value (NAV) for the fund. Assume that 8,000 shares are outstanding for the fund.
Solution:
$1,970  $241,300  $26,440  $674,900  $7,770
NAV   $119.05/share
8,000
7. An investor sends the fund a check for $50,000. If there is no front-end load, calculate the new
number of shares and price/share. Assume the manager purchases 1,800 shares of stock 3, and the rest
is held as cash.
Solution: With the $50,000, the value of the fund is now $952,380  50,000  $1,002,380. Shares are
sold at a price of $119.05, or 420 new shares. There are now 8,420 shares outstanding.
The new fund looks like:

1 1,000 $ 1.97
2 5,000 $48.26
3 2,800 $26.44
4 10,000 $67.49
5 3,000 $ 2.59
cash n.a. $ 2408
8. On January 2nd, the prices at 4:00 PM are:

1 1,000 $ 2.03
2 5,000 $51.37
3 2,800 $29.08
4 10,000 $67.19
5 3,000 $ 4.42
cash n.a. $ 2408
Calculate the net asset value (NAV) for the fund.

Solution:
$2,030  $256,850  $81,424  $671,900  $13,260  2,408
NAV   $122.08/share
8,420
9. Assume the new investor then sells the 420 shares. What is his profit? What is the annualized return?
The fund sells 800 shares of stock 4 to raise the needed funds.
Solution: The 420 shares are worth 420  $122.08  $51,273.60, for a profit of $1,273.60.
The one day return is $1,273.60/50,000  2.54%. Annualized, this is 637% in nominal terms,
assuming 250 trading days.
The new fund is:

1 1,000 $ 2.03
2 5,000 $ 51.37
3 2,800 $ 29.08
4 9,200 $ 67.19
5 3,000 $ 4.42
cash n.a. $4,886.40
10. To discourage short-term investing in its fund, the fund now charges a 5% upfront load and a 2%
backend load. The same investor decides to put $50,000 back into the fund. Calculate the new
number of shares outstanding. Assume the fund manager buys back as many round-lot shares of
stock 4 with the cash.
Solution: With the upfront load, 5% is charged as a commission. The actual funds invested are
$50,000  0.95  $47,500.
This represents $47,500/122.08  389.09 new shares.
The manager purchases 700 shares of stock 4.
11. On January 3rd, the prices at 4:00 PM are:

1 1,000 $ 1.92
2 5,000 $ 51.18
3 2,800 $ 29.08
4 9,900 $ 67.19
5 3,000 $ 4.51
cash n.a. $5,353.40
Calculate the new NAV.

Solution:
$1,920  $255,900  $81,424  $665,181  $13,530  $5,353.40
NAV   $121.98/share
8,389.09
12. Unhappy with the results, the new investor then sells the 389.09 shares. What is his profit? What is
the new fund value?
Solution: The 389.09 shares are worth 389.09  $121.98  $47,461.20. This amount comes out of
the fund, leaving the fund with $975,847.20.
The investor must then pay the 2% back-end fee, leaving $47,461.20  0.98  $46,511.98.
This represents a loss of $3,488.02, mostly due to fees.
Chapter 21

1. People carry insurance because they are risk-averse and prefer to know their wealth with certainty.
2. Insurance companies do not want people to use insurance as a form of gambling.
3. Information asymmetry exists when one party to a transaction knows more about the situation than
the other does. Often the person buying insurance knows more about the risk than the insurance
company knows.
4. Adverse selection occurs when a person elects to buy insurance because she knows her risk is greater
than the average. Moral hazard occurs when an insured individual fails to protect against loss because
he knows that the loss is covered by insurance.
5. Insurance companies protect themselves by requiring inspections and medical examinations, insuring
groups rather than individuals, and insisting on a deductible.
6. Independent agents do not represent any particular insurance agency but sell products from a large
number of companies. Exclusive agents sell the products of one company exclusively.
7. Most are stock companies.
8. The law of large numbers means that the greater instances of a given risk the more accurate a prediction
can be made. These predictions are tabulated in actuarial tables.
9. Term life insurance pays a death benefit if the policyholder dies; no other benefit is paid. Whole
policies pay a death benefit but also include a savings program that pays out if the policyholder lives.
10. Losses due to fire, theft, storm, explosion, and neglect are covered by property policies. Casualty
policies protect against harm from product failure or accidents.
11. Reinsurance allocates a portion of the risk to another company in exchange for a portion of the
premium.
12. Defined-benefit plans specify precisely what payment will be made to the plan’s beneficiaries.
Defined-contribution plans specify what funds will be contributed into the plans, but the benefits
depend on the performance of the investments made with those funds.
13. A more sophisticated public, greater awareness of providing for retirement, and a lack of confidence
in Social Security have led to growth in private pension plans.
14. Current workers’ tax payments go to pay the benefits of current retirees.
15. The demographics suggest that more people will be retiring than will be entering the workforce in the
future. With fewer people paying into the plan and more taking out, it could go bankrupt.
1. Research indicates that the 1,000,000 cars in your city experience unrecoverable losses of
$250,000,000 per year from theft, collisions, etc. If 30% of premiums are used to cover expenses,
what premium must be charged to car owners?
Solution: The average loss per car  $250,000,000/1,000,000 cars  $250/car

So, 70% of the premium must equal the payout of $250.
Or, 0.70 Premium  $250
Premium  $250/0.70
Premium  $357.14
2. Assume that life expectancy in the United States is normally distributed with a mean of 73 years and
a standard deviation of 9 years. What is the probability that you will live to be over 100 years old?
Solution: The Z-score is calculated as follows:
100  73 27
Z  3
9 9
The age of 100 years old is 3 standard deviations to the right of the mean. Using a standard
normal probability chart, this suggests that the probability is less than 1%.
3. Your rich uncle dies, leaving you a life insurance policy worth $100,000. The insurance company
also offers you an option to receive $8,225/year for 20 years, with the first payment due today. Which
option should you use?
Solution: Since the options are either $100,000 immediately or $8,225/year, you can calculate the
rate your are “paying” as:
PV  100,000; PMT  8225; N  20; FV  0; Calculator in BEGIN mode.
Calculate I. I  6% (roughly)
With this information, the answer depends on many factors. Do you “need’ the $100,000
today? Can you personally invest the $100,000 at a higher rate with the same level of risk?
Is there any risk that the insurance company will not pay in the future? Etc.
4. A home products manufacturer estimates that the probability of being sued for product defects is
1% per year per product manufactured. If the firm currently manufacturers 20 products, what is the
probability that the firm will experience no lawsuits in a given year?
Solution: The probability of not being sued is 99%. If we assume that the probabilities are
independent, then the probability of no lawsuits over all 20 products is:
0.9920  0.8179, or about 82%.
5. Kio Outfitters estimated the following losses and probabilities from past experience:
Loss Probability
$30,000 0.25%
$15,000 0.75%
$10,000 1.50%
$ 5,000 2.50%
$ 1,000 5.00%
$ 250 15.00%
$ 0 75.00%
What is the probability Kio will experience a loss of $5,000 or greater? If an insurance company
offers a loss policy with $1,500 deductible, what is the most Kio will pay?
Solution: Losses of less than $5,000 occur 95% of the time. So, 5% of the time, losses will be
$5,000 or greater.
With a $1,500 deductible, Kio’s expected losses are:
Loss Probability
$28,500 0.25%
$13,500 0.75%
$ 8,500 1.50%
$ 3,500 2.50%
$ 1,000 5.00%
$ 250 15.00%
$ 0 75.00%
The expected (mean) loss is $475, which is the fair price of insurance.
6. A client needs assistance with retirement planning. Here are the facts:
 The client Dave is 21 years old. He wants to retire at 65.
 Dave has disposable income of $2,000/month.
 The IRA Dave has chosen has an average annual return of 8%.
If Dave contributes half of his disposable income to the account, what will it be worth at 65?
How much would he need to contribute to have $5,000,000 at 65?
Solution: Compute the future value at $1,000 per month:
N  44  12; PMT  1,000; I  8/12; PV  0
Compute FV. FV  $4,858,811
Dave is clearly close to his goal already. To determine what he needs to have the $5 M:
FV  5,000,000; I  8/12; N  528; PV  0
Compute PMT. PMT  $1,029.
7. When opening an IRA account, investors have two options. With a regular IRA account, funds added
are not taxed initially, but are taxed when withdrawn. With a Roth IRA, the funds are taxed initially,
but not when withdrawn. If an investor wants to contribute $15,000 before-tax to an IRA, what will
be the difference after 30 years between the two options. Assume that the investor is currently in the
25% tax bracket, and the IRA will earn 6%/year.
Solution: With the regular IRA, the after-tax final value is:
N  30; I  6; PV  15,000; PMT  0
Compute FV. FV  86,152, or 86,152  (1  0.25)  $64,614 after tax.
With the Roth IRA, the after-tax final value is:
N  30; I  6; PV  15,000  (1  0.25); PMT  0
Compute FV. FV  $64,614.
So, unless an investor expects to lower tax rates in the future, the two are equivalent.
There are other reasons to use a Roth IRA not discussed here.
8. An employee contributes $200 a year (at the end of the year) to her pension plan. What would be the
total contributions and value of the account after 5 years? Assume that the plan earns 15% per year
over the period.
Solution: The total contributions are $200  5  $1,000.

The future value of the plan is:
N  5; PMT  200; I  15; PV  0
Compute FV. FV  $1,348.47
9. Paul’s car slid off the icy road causing $2,500 in damage to his car. He was also treated for minor
injuries, costing $1,300. His car insurance has a $500 deductible, after which the full loss is paid.
His health insurance has a $100 deductible and covers 75% of medical cost (total). What was
Paul’s out-of-pocket costs from the incident?
Solution: The car will cost Paul $500. The remaining $2,000 is covered.
Paul will pay $400 of the medical expenses – the $100 deductible plus 25% of the
remaining $1200 of expense.
Chapter 22
1. Regulators felt that investment banking was riskier and had led to bank failures during the Great
Depression.
2. The Glass Steagall Act.
3. When an offering is underwritten, the investment banker purchases the issue at a pre-specified
price. In a best-efforts issue, the investment bankers does not take ownership.
4. Investment bankers offer advice, help with filing documents, and assistance with marketing the
issue.
5. No, an SEC review simply determines if the proper documents have been filed.
6. By forming a syndicate the risk of the issue is spread among many different firms and more
brokers will be attempting to sell the securities.
7. It is better to be fully subscribed because oversubscription indicates that the investment bankers
priced the security too low.
8. The investment banker and the firm may not be able to agree on a price or the issue may be too
small for the investment banker to want to invest the time and effort needed to arrive at a price.
9. In a hostile takeover, the target firm does not want control to pass to the acquiring firm, and so its
management makes every effort to prevent the takeover from happening. In a merger, both sides work
together to expedite the union of the firms.
10. They make a market by standing ready to buy or sell securities.
11. A market order has the broker buy or sell the security at the current market price. A limit order sets a
maximum price for buying the security and a minimum price for selling the security.
12. Yes, selling the security short.
13. Banks object because legislation prevents banks from entering the brokerage business but does not
prevent brokers from entering the banking business.
14. First, the company is not subject to Sarbanes-Oxley regulation. Second, CEOs may feel they have
more time and flexibility to make changes than when faced with quarterly profit expectations from
public shareholders. Additionally, the CEO may be better motivated due to the compensation structure
and both the owners may benefit from favorable tax treatment.
Amazon.com2 issued an initial public offering in May of 1997. Prior to its IPO, the following information
on shares outstanding was listed in the final prospectus:
Percentage of Shares
Number Of Shares Outstanding
Name and Address Beneficially Owned Prior to Offering After Offering
Jeffrey P. Bezos 9,885,000 47.5% 41.4%
c/o Amazon.com, Inc.
1516 Second Avenue, 4th Floor
Seattle, WA 98101
L. John Doerr 3,401,376 16.4 14.3
Kleiner Perkins Caufield & Byers
4 Embarcadero Center, Suite 3520
San Francisco, CA 94111
Tom A. Alberg 195,000 — —
Scott D. Cook 75,000 — —
Patricia Q. Stonesifer 75,000 — —
All directors and executive officers as 15,688,925 72.5 63.5
a group (14 persons)
Total shares outstanding 20,858,702 100.0 —
In the IPO, the firm issued 3,000,000 news shares. The initial price was $18.00 per share with investment
bankers retaining $1.26 as fees. The final first-day closing price was $23.50.
1. What were the total proceeds from this offering? What part was retained by Amazon? What part by
the investment bankers? What percent of the offering is this?
Solution: Total proceeds  3,000,000  $18.00  $54,000,000

To Amazon  3,000,000  $16.74  $50,220,000
To the IB  3,000,000  $1.26  $3,780,000, or 7% of the offer price.
2. Mr. Doerr of Kleiner Perkins Caufield & Byers owned a significant number of shares. What was the
market value of these shares at the end of the first day of trading?
Solution: Market value  3,401,376  $23.50  $79.93 million.
3. What was the market value of Amazon.com following its first day as a publicly-held company?
Solution: Market cap  (20,858,702  3,000,000)  $23.50  $560.68 million.
4. Refer back to the IPO of Ebay presented in the problems for Chapter 11. What were the fees for Ebay
as a percent of funds raised? Does a pattern emerge?
Solution: For Ebay, the offering price was also $18.00, with $1.26 retained by the investment bankers.
Or 7% of the offering price.
2
Information summarized from http://www.sec.gov/Archives/edgar/data/1018724/0000891020-97-000868.txt
5. To verify this further, examine the IPO for Blue Nile, Inc. It can be found on the SEC’s site at:
http://www.sec.gov/Archives/edgar/data/1091171/000089161804001024/v97093b4e424b4.htm
What was the offering price? What percent was retained by the underwriter?
Solution: The offering price can be viewed on the top of the first page. It was $20.50, with $1.435
retained by the underwriter. This represents a fee of $1.435/20.50  7%.
6. For Blue Nile, Inc., what are the expected proceeds to the company? Is this certain? What
assumptions are you making? How would you verify this?
Solution: The expected proceeds are 3,740,000  ($20.50  $1.435)  $71,303,100. The assumption
is that this IPO is a firm commitment offering. If the offering is a best-effort, the proceeds
are not certain. This can be checked in the prospectus. Indeed, in the prospectus, it states,
“On March 9, 2004, the Company’s Board of Directors passed the following resolutions:
 To authorize the officers of the Company to undertake a firm commitment
underwritten public offering of shares of the Company’s common stock
 etc.”
7. You want to buy 100 shares of a stock currently trading at $50 per share. Your brokerage firm allows
margin sales with a 50% opening margin and a maintenance margin of 25%. What does this mean?
If you close your position with the shares at $53.50, what is your return?
Solution: The value of the shares you want to purchase is 100  $50  $5,000. With a 50% opening
margin, you can give your broker $2,500, and your broker will lend you the rest.
A 25% maintenance margin means your equity position cannot fall below 25%. The
question is how low the price can fall before you must deposit additional funds. To find
this, solve for the price X as follows:
100 X  2500
 0.25, or X $33.33.
100 X
If the price falls below $33.33, a margin call will occur.
If you close your position at a price of $53.50, the value of 100  $53.50  $5,350, or a gain
of $350. Since this only required $2,500 from you, the percentage gain is 350/2500  14%.
8. The limit order book for a security is:
Unfilled Limit Orders

Buy Orders Sell Orders
25.12 100 25.36 300
25.20 500 25.38 200
25.23 200 25.41 200
The specialist receives the following, in order:

a. Market order to sell 300 shares
b. Limit order to buy 100 shares at 25.38
c. Limit order to buy 500 shares at 25.30
How, if at all, are these orders filled? What does the limit order book look like after these orders?
Solution: a. is fulfilled with 200 shares @ 25.23 and 100 shares @ 25.20
b. is fulfilled with 100 shares @ 25.36
c. is not filled, and goes into the book
After these, the book looks like:
Unfilled Limit Orders

Buy Orders Sell Orders
25.12 100 25.36 200
25.20 400 25.38 200
25.30 500 25.41 200

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Chapter 7

Why Do Financial Institutions Exist?

 Answers to End-of-Chapter Questions

 Answers to End-of-Chapter Questions

 Answers to End-of-Chapter Questions

Bidder Bid Amount Price

Answers to End-of-Chapter Questions

10. The list of terms of a bond is known as the indenture.

3. Consider the two bonds described below:

160 170 180 230

Solution: 900  1000/(1  YTM), or YTM  11.11%

16. Your company owns the following bonds:

Bond Market Value Duration

Answers to End-of-Chapter Questions

Solution: Underpricing  ((44.88  18.00)/18.00)  149.33%

Price Shares Market

The change is then calculated as:

12. ROE will fall in half.

Solution: 1.33 M  0.84 M  0.22 M  1.48 M  $2.19 M

Solution: ROE  ROA  EM

Solution: $25 M  $100 M  $35 M  $15 M  $75 M

ROE  231,427/6,228,280  3.71% (monthly)

Solution: The required net income  0.045  $6 M  $270,000.

Taxable income $409,091

Answers to End-of-Chapter Questions

1. Answers will vary.

2. Consider a bank with the following balance sheet:

Calculate the bank’s risk-weighted assets.

3. Consider a bank with the following balance sheet:

The bank is well capitalized, at 9/139  6.47%

After the fact, the actual balance sheet is:

Now, the true state of the bank’s position is realized.

Cash $124,798 Mortgages $250,000

After the fact, the actual balance sheet is now:

The bank is again well capitalized, at 9/139  6.47%

The bank is still well capitalized, at 9/139  6.47%.

The bank is still well capitalized, at 9/133  6.76%.

The bank is still well capitalized, at 9/138.5  6.5%

Answers to End-of-Chapter Questions

2. a. Office of the Controller of the Currency;

5. Because becoming a bank holding company allows a bank to:

Answers to End-of-Chapter Questions

1. Liquidity intermediation, denomination intermediation, ease of diversification, cost advantages,

Stock Shares owned Price

Stock Shares owned Price

Stock Shares owned Price

8. On January 2nd, the prices at 4:00 PM are:

Stock Shares owned Price

Calculate the net asset value (NAV) for the fund.

Stock Shares owned Price

11. On January 3rd, the prices at 4:00 PM are:

Calculate the new NAV.

Answers to End-of-Chapter Questions

2. Insurance companies do not want people to use insurance as a form of gambling.

7. Most are stock companies.

Solution: The average loss per car  $250,000,000/1,000,000 cars  $250/car

Solution: The total contributions are $200  5  $1,000.

Answers to End-of-Chapter Questions

2. The Glass Steagall Act.

10. They make a market by standing ready to buy or sell securities.

12. Yes, selling the security short.

Solution: Total proceeds  3,000,000  $18.00  $54,000,000