Question.3043 - Financial Markets and Institutions 1) Explain Interest Rate Swaps and stock options. (10 points) 2) Explain the role that credit default swaps played in the financial crises. (5 points) 3) Explain 4 other things that led up to the financial crises and their impact on the financial markets, housing, prices and GDP. (20 points) 4) Compare and contrast the 3 different theories of money demand (15 points). 5) Given the quantitative theory of money: a) what happens to real GDP if the money supply is cut in half, velocity is stable and prices are sticky? (5 points) b) what happens to prices if the money supply doubles under the classical model assuming that velocity is stable? (5 points) 6) Compare and contrast the independence of the U.S Central Bank (Federal Reserve Bank) and the European Central Bank. Give the pros and cons of an independent central bank (10 points). 7) Explain the 4 tools of monetary policy and how they impact interest rates, financial markets, housing, and GDP (15 points). 8) Give 4 transmission mechanisms and explain how each impacts the financial markets and the overall economy (15 points)
Answer Below:
Financial Markets and Institutions 1) Explain Interest Rate Swaps and stock options. (10 points) Interest rate swaps: Simply speaking “Interest rate swaps” are the exchange of one set of cash flows for another. It is basically an agreement between two parties where one stream of future interest payments is exchanged for another based on a specified principal amount. Most often, interest rate swaps exchange a fixed payment for a floating payment. Floating payment are interest payments which are linked to an interest rate and are fluctuating. Stock Options: Stock options are contracts that convey its holder the right, but not the obligation, to buy or sell stocks of the underlying security at a specified price on or before a given date. Once the date is expired, the option ceases to exist. On the other hand, the seller of the option is obligated to sell (or buy) the shares to (or from) the buyer of the option at the specified price if the buyer requests so. 2) Explain the role that credit default swaps played in the financial crises. (5 points) Credit default swaps (CDS) are derivative instruments which act like an insurance contract. When a buyer purchases a CDS, paying a premium to the seller, he is in return protected against a credit event (like a default) of a company. Simply speaking, the seller of the CDS gives the guarantee of payment in case of any default. As a result, the risk is now transferred to the one willing to take it. At the time of financial crisis, the subprime loans were collectively bundled into a derivative product and sold to investors. In the year 2008, bonds started going bad. By that time, there were CDS not just for traditional corporate debt, but also for mortgage-backed securities, CDOs, and secondary CDOs. When people were optimistic, CDS were cheap; when things went haywire, the price of CDS shot up, and anyone who had sold these swaps was looking at losses on them. So CDS were one way that losses on subprime mortgages triggered write downs at other financial institutions. It got worse as banks started failing, and people who had sold CDS on their debt faced even larger losses. So the most basic problem with CDS is that the insurers selling them sold them at excessively low prices, and they were facing major losses. 3) Explain 4 other things that led up to the financial crises and their impact on the financial markets, housing, prices and GDP. (20 points) First and foremost is the housing bubble which peaked in 2006. The housing prices touched their peak and were invariably high. People were just concentrating on investing in properties – properties which were unrealistically high priced. In order to purchase property / invest in property people took loans from banks based on their future income. Unfortunately when the housing bubble burst in 2007, there were not much takers of the same property and investor’s values got stuck with unsold property in hand. Prices faced a sharp decline thereafter. Secondly there were banks which in order to gain maximum market share and expand operations, believed in subprime loans category and went liberal with loan granting exercise. Subprime loans are loans which are granted to consumers at a higher interest rate due to their risky profile. These subprime loans were later collectively sold to financial institutions structured as derivative products. Ultimately, when the consumers were unable to pay the loan, the impact was collectively seen on the financial institutions which were carrying nothing but junk papers. The credit rating agencies were another reason behind the financial crisis. The credit ratings are companies which give rating to particular loans based on the borrowers background and profile check. The credit ratings also gave ratings to derivative products of subprime loans and were unable to judge them correctly and gave good ratings due to which it was easier to sell these products in the market. Critics have argued that credit rating agencies and investors failed to accurately price the risk involved with mortgage-related financial products. Last but not the least, the governments also failed to play its role by not adjusting its regulatory practices to address problems of newly developed financial markets. 4) Compare and contrast the 3 different theories of money demand (15 points). The different theories of money demand are: 1. Classical Quantity Theory of Money 2. Keynes’Liquidity Preference Theory 3. Friedman’s Modern Quantity Theory of Money. Quantity theory of money is a classical theory that related the amount of money in the economy to nominal income. It states the changes in the quantity of money tend to affect the purchasing power of money inversely. This also meant that although a change in the quantity of money may eventually affect all prices, it does not and cannot affect all prices in the same manner, to the same degree or at the same time. Irving Fisher developed this theory with the following equation: MV = PY; Where, M is the quantity of money (or money supply), V is velocity, which serves as the link between money and output, P is the price level, Y is aggregate output (aggregate income), PY is the total amount of spending on final goods and services produced in the economy. The Keynes Liquidity preference theory, rejects the notion that velocity is constant. This theory emphasizes on three reasons behind why people hold money: a) transactions demand b) precautionary demand c) speculative demand Lastly, the Friedman’s quantity theory of money stated that the money demand is influenced by the same factors that influence the demand for any asset. The theory of asset demand indicates that the demand for money should be a function of the resources available to individuals (their wealth) and the expected returns on other assets relative to the expected return on money. 5) Given the quantitative theory of money: a) What happens to real GDP if the money supply is cut in half, velocity is stable and prices are sticky? (5 points) If the money supply is cut by half, in the long run the price levels will also cut by half and it would have nil impact on the GDP. However, in the short run, the price level will fall down and so the real GDP. The sudden drop in the money supply means that people no longer hold as much cash as they want. Cash holdings will be accumulated and demand for everything else would drop. In other words, aggregate demand falls. Once the price level has dropped by half (causing the real value of the money supply to increase back to its original level), the monetary imbalance is rectified and aggregate demand recovers. In the meantime, however, the economy suffers a recession marked by deflation and high unemployment. b) What happens to prices if the money supply doubles under the classical model assuming that velocity is stable? (5 points) According to quantity theory of money, if the amount of money in an economy doubles, price levels also double, causing inflation (the percentage rate at which the level of prices is rising in an economy). 6) Compare and contrast the independence of the U.S Central Bank (Federal Reserve Bank) and the European Central Bank. Give the pros and cons of an independent central bank (10 points). Though overtime the independence of the Federal Reserve has increased, the European central bank is considered as one of the most independent banks globally. In establishing the European System of Central Banks, policymakers endowed it with a high degree of independence from the governments of the member states and the European Union. There are some structural differences: 1) The budgets for the regional banks in the Fed are established by the Board of Governors, while the national central banks in Europe are the ones who finance the Executive Board. 2) While the majority voting in the 12-member FOMC goes to the seven-member Board of Governors, the 15 national central banks in the ECB collectively have a majority in the Governing Council (counterpart to the FOMC made up of the 15 national central bank presidents and the 6-member Executive Board). 3) The ECB is less involved in the supervision and regulation of financial institutions than the Fed is. In terms of independence, the Fed has more goal independence while the ECB is more politically independent. The Fed is free to pursue both low unemployment and low inflation, while the ECB is mandated to ensure price stability. The ECB is less susceptible to political whims, however, since any change in the ECB’s structure or management would require a unanimous change to the Maastricht Treaty by all signatories (highly unlikely) whereas a change to the Fed’s organization and structure could be passed by a simple majority in Congress. Pros of an independent central bank: 1. Independent central bank has longer-run objectives, politicians don't: 2. Avoids political business cycle 3. Less likely deficits will be inflationary Cons of an independent central bank: 1. Fed may not be accountable 2. Hinders coordination of monetary and fiscal policy 3. Fed has often performed badly 7) Explain the 4 tools of monetary policy and how they impact interest rates, financial markets, housing, and GDP (15 points). The four tools of monetary policy are: 1) Open market operations (OMOs) - are the purchase and sale of securities in the open market by a central bank. This a key tool used by the Federal Reserve in the implementation of monetary policy. The short-term objective for open market operations is to adjust the supply of reserve balances so as to keep the federal funds rate around the target established initially. Purchases inject money into banking system and stimulate growth while sales of securities do the opposite. 2) Changing the reserve ratio - reserve requirements are the %age of deposits that institutions must hold in reserve and are not supposed to lend. Increasing the reserve ratios reduces the volume of deposits that can be supported by a given level of reserves and reduces the money stock, ultimately raising the cost of credit. On the other hand, decreasing the reserve ratio leaves depositories initially with excess reserves, which can induce an expansion of bank credit and deposit levels and a decline in interest rates. 3) Changing the discount rate – another major monetary policy implementation tool. The discount is the rate charged to commercial banks and other depository institutions on loans from their central bank. Typically, higher discount rates indicate that more restrictive monetary policies are in store, while a lower rate might signal a less restrictive move. 4) The use of term auction facility (TAF) – another monetary policy program used by the Federal Reserve to help increase liquidity in the U.S. credit markets. As per TAF, the Fed auctions set amounts of collateral-backed short-term loans to depository institutions. Participants bid with a minimum bid set at an overnight indexed swap rate relating to the maturity of the loans. TAF allows financial institutions to borrow funds at a rate that is below the discount rate. 8) Give 4 transmission mechanisms and explain how each impacts the financial markets and the overall economy (15 points) The transmission channels are as follows: ? Interest rate channel: This is the most important monetary mechanism. A reduction in long-term interest rates leads to growth of business investment and consumer spending on durable goods. This leads to a shift in the demand curve and eventually reflects in aggregate supply and prices. ? Asset price channel: Expansionary monetary policy leads to higher equity prices and makes investment more attractive. This leads to increase in wealth and consumption and pushes the aggregate demand curve. ? Exchange rate channel: This channel works through both the aggregate demand and supply side. On demand side, interest rate is lowered by monetary expansion which brings about a real depreciation in domestic currency. Exports thus rise and aggregate demands get stronger. On the supply side, expansion on monetary policy increases prices of imports and thus raises inflation. ? Monetary and credit aggregates: Basic notion is that the monetary policy will have an effect on price and output through credit rationing steps. An expansionary monetary policy increases firm’s net worth and reduces perceived loan risks. This makes banks willing to supply more credit thus financing a rise in aggregate demand.More Articles From Finance
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