Econ 353 Money, Banking, and Financial Institutions

Spring 2006
Final Exam

Name____________________________________

The duration of the exam is 2 hours.

The exam consists of 10 problems and it is worth 100 points.
Please write in the space provided. If necessary, write on the back of the page.
Please ask me if you have any questions.
To receive full credit you have to carefully explain all your answers and show all
your work.

General advice: If you get stuck in the early parts of a problem, do not stop there. You
can receive substantial partial credit by explaining how you would solve the rest of
problem if you had the necessary answers from its previous parts.
1. (20 points) Determine whether each of the statements below is True or False:
US banking system is called dual because banks can be chartered either by
the state level or the federal level authorities.
True.
Bank branching regulations reduced the amount of competition in the
banking sector and hurt bank customers.
True.
Hedge funds typically have very low-risk portfolios because they engage in
sophisticated hedging strategies.
False.
All defined-benefit pension plans are fully funded because there is no way
to change benefits after they were defined.
False.
Federal Reserve is the most independent central bank in the world.
False.
Contractionary monetary policy is associated with higher interest rates.
True.
Eurodollars is the term used to denote the dollar-denominated deposits held
by foreign banks in the US.
False.
The presence of the lender of last resort induces banks to pursue safer
investment strategies.

False.
2. (10 points) Suppose that the following yield curve is observed today:
Yield to Maturity (%)

6
5.5
5

Term to Maturity (years)

a. Assuming that the expectations hypothesis is true, determine the current

yield on 1-year bonds, 2-year bonds, 3-year bonds, and 4-year bonds?
There are no calculations involved. These rates are obtained directly from the
graph:
1-year bonds 5%,
2-year bonds 5.5%,
3-year bonds 5.5%,
4-year bonds 5%.

b. Assuming that the expectations hypothesis is true, determine the yield on

1-year bonds one year from today, two years from today, and three years
from today? Would you be able answer this question without assuming
that the expectations hypothesis is true?
Expectations hypothesis says that the (yearly) interest rate on a two-year bond is the
average of this years interest rate on a one-year bond and the next years interest
rate on a one-year bond (the first part of the subscripts denotes the maturity of the
instrument (1-year, 2-year, and 3-year, and so on), the second part in parentheses
denotes the time period (t-today, t+1 a year from today, t+2 two years from
today, and so on)):

Yield on a two-year bond today: i2(t)=( i1(t) + i1(t+1))/2=(5+ i1(t+1))/2=5.5%; where i1(t+1)
is the unknown yield on 1-year bond one year from now. Solving for it we get
i1(t+1)=6%.
Similarly, the (yearly) yield on a three-year bond is the average of the yields on oneyear bonds today, a year from today, and two years from today:
Yield on a three-year bond today: i3(t)=( i1(t) + i1(t+1) + i1(t+2))/3=(5+6+ i1(t+2))/3=5.5%;
where i1(t+2) is the unknown yield on a 1-year bond two years from now. Solving for
it we get i1(t+2)=5.5%.
Yield on a four-year bond today: i3(t)=( i1(t) + i1(t+1) + i1(t+2) + i1(t+3))/4=(5+6+5.5+
i1(t+3))/4=5%; where i1(t+3) is the unknown yield on a 1-year bond three years from
now. Solving for it we get i1(t+3)=3.5%.
It is not possible to solve this part without assuming that expectations hypothesis is
true.
3. (5 points) Which of the following 1-year, $1,000 face-value securities has highest
yield to maturity?
i. A 10 percent coupon bond selling for $1,000;
ii. A 8 percent coupon bond selling for $1,000;
iii. A 6 percent coupon bond selling for $1,000;
iv. A 6 percent coupon bond selling for $1,100
Clearly, i offers higher yield to maturity than both ii and iii because the price is
the same, but coupon rate is higher in i. At the same time, iii offers higher yield
than iv because you can buy it cheaper than iv (youll have higher capital gain).
So, i offers highest yield to maturity.
4. (10 points) The Federal Reserve Open Market Committee released the following
statement after its February 2, 2005 meeting:
The Federal Open Market Committee decided today to raise its target for the
federal funds rate by 25 basis points to 2-1/2 percent.
The Committee believes that, even after this action, the stance of monetary
policy remains accommodative and, coupled with robust underlying growth in
productivity, is providing ongoing support to economic activity. Output
appears to be growing at a moderate pace despite the rise in energy prices,
and labor market conditions continue to improve gradually. Inflation and
longer-term inflation expectations remain well contained.
The Committee perceives the upside and downside risks to the attainment of
both sustainable growth and price stability for the next few quarters to be
roughly equal. With underlying inflation expected to be relatively low, the

Committee believes that policy accommodation can be removed at a pace that

is likely to be measured. Nonetheless, the Committee will respond to changes
in economic prospects as needed to fulfill its obligation to maintain price
stability.
What can you conclude from this statement about the current target rate for the
federal funds? Why was (or wasnt) it changed? Is it more likely to be increased or
decreased in the future?
The first paragraph says that the target federal funds rate was raised by 0.25%
to 2.5%. The second paragraph says that even after the increase, the rate is
relatively low (accommodative stance of the monetary policy means that the
policy is expansionary, even though rate increase is associated with
contractionary policy). The statement says that this increase will not hurt the
economy, which is growing steadily. Inflation might be a bigger concern (even
though it says that it is contained). The last paragraph says that that there is 5050 percent chance that the rate will be increased again (risks to attainment of
sustainable growth and price stability are roughly equal). In addition, since
inflation is low, no rapid interest rate raise will likely be necessary.
5. (5 points) You purchase a 30-year, $1000 face-value, zero-coupon bond. The
interest rate is 6%. One year later the interest rate has changed to 5% and you
decide to sell the bond. What is your one-year holding period return?
The holding period return is equal to
Return=Coupon payment/Price Paid + Change in Price/Price Paid.
There no coupon payments in this case, so all we have to do is to determine the
change in price.
The price of this bond at the time of purchase has to be equal to the present
value of all future payments. There a single payment of $1,000 which will be
made in 30 years. The present value is equal to PV=Face
value/(1+0.06)30=$1000/(1+0.06)30=$174.11.
The price in one year is going to be PV=Face
value/(1+0.05)29=$1000/(1+0.05)29=$242.94. (The payment is going to be made in
29 years; the interest rate is 5% instead of 6%.)
So the change in price is equal to $242.94-$174.11=$68.84 (capital gain). The
holding period return is therefore:
Return= $68.84/$174.11= 0.3954 (39.54%).

6. (10 points) What are the two main elements of the price of an option and explain
what each of them means?
Option price has two components: (1) intrinsic value and (2) option premium. The
intrinsic value is the value of the option if it is exercised immediately (it cannot be
negative, only in-the-money options have any intrinsic value, at-the-money and out-

of-the-money options have zero intrinsic value). For call options the intrinsic value
is the difference between market price of the underlying asset and the strike price.
For put options it is the difference between the strike price and the market price of
the underlying asset. Option premium reflects the potential for gains in the future.
If the market price will move in the favorable (for option holder) direction, there
will be some gains to be made by exercising the option. Option holders only care
about gains because losses are limited by the ability not to exercise the option.
7. (10 points) Show on a T-account how the following transactions affect the
balance sheet of a central bank:
a. A customer withdraws $1000 from a checking account.
A

|
| Currency +$1000
| Reserves -$1000

b. Central Bank sells $1000 worth of T-Bills.

A
Securities -$1000

|
| Reserves

L
-$1000

c. Central Bank gives a $1000 discount loan.

A
Loans +$1000

|
| Reserves

L
+$1000

8. (5 points) Why countries with more generous deposit insurance can be more
likely to suffer from financial crises?
Insurance creates moral hazard insured have low incentives to behave in a
cautious manner (invest in safe assets). If insurance is more generous, the moral
hazard problem is more pronounced (banks would seek high risk investments
because they know that they would be saved if investments do not work out).

9. (5 points) What is a mutual fund and what is the difference between closed-end
and open-end mutual funds?

Mutual funds issue shares and sell them to individual investors and then invest the
proceeds in the stock market. By accumulating resources of many individual
investors mutual funds are able to substantially reduce the risk by diversifying their
portfolios. In addition, since mutual funds have relatively low transaction costs
because they deal in large quantities of securities. The shares of the open-end funds
can be redeemed at any time at a value tied to the value of the asset portfolio of this
fund. Closed-end funds shares are traded on the stock market (the value of a share
may differ from the value of the underlying asset portfolio, and no additional shares
are being issued/sold).
10. (5 points) What are the arguments against central bank independence?
The main argument against central bank independence is lack of accountability.
central bank officials are not elected and therefore not responsible to voters (as
opposed to politicians). If central bank performs badly there is no way to
replace the management (as opposed to any politician at any time). Lack of
accountability may lead central banked to follow some policies out of selfinterest (as opposed to public interest). In the end it is undemocratic to have a
group of people who are not responsible to anyone to make crucial policy
decisions. In addition, it is often helpful to have all government agencies
coordinate their policies. It may not be possible with an independent central
bank.

11. (5 points) Suppose that the currency-to-deposits ratio is 0.2, the required reserve
ratio is 0.1, and the excess reserves ratio is 0.05. Compute the money (M1)
multiplier and interpret what it means?
The actual money multiplier can be calculated using the formula:
m=[1 + C/D] / [C/D + r + ER/D], where C/D = currency-to-deposits ratio,
r=required reserves ratio, and ER/D=excess reserves ratio. Observe that cash
holding affects multiplier in a more complex way than the excess reserves cash
is not part of deposits but it is part of money (M1). So it slows deposit creation
but contributes to the money aggregate. m= 1.2/0.35=3.43.
It means that for every dollar of new reserves the amount of money (M1) in an
economy grows by more than $3 because commercial banks create deposits with
reserves.
12. (10 points) Assume that the Fed predicts that the following demand for reserves
on the federal funds market: RD=1000 100*i, where RD is the quantity of
reserves demanded (in billions of dollars) and i is the current federal finds rate.
Feds target federal finds rate is 5%. Current supply of reserves is $400 billion.
Explain using a graph what the Fed has to do to achieve its target federal funds
rate?

Setting supply equal to demand we get: RD=1000 100*i = 400 i=6%, which is
1% above target. In order to decrease the rate, the Fed must increase the supply of
reserves. This is done by buying securities. The exact amount of reserves needed can
be calculated from RD=1000 100*5=$500. (We just plugged in the target federal
funds rate of 5% in order to get to the desired supply of reserves.) Since the current
supply is $400, the Fed needs to buy $100 worth of securities (and create the
corresponding amount of reserves).
Federal Funds rate
S2

S1

6
5
D

400

500

Quantity of Reserves

The formulas you may or may not need:

PV=[C/i] * [1 1/(1+i)n],
PV=FV/(1+i)n,
Expected value= value*prob(value) + value*prob(value)+
Variance = (value expected value)2*prob(value) + (value expected
value)2*prob(value) +.
in(t)=( i1(t) + i1(t+1) + i1(t+2) ++ i1(t+n-1))/n.