Financial Instruments, Financial Markets, and Financial Institutions Problems and Solutions 1. As the end of the month approaches, you realize that you probably will not be able to pay the next month s rent. Describe both an informal and a formal financial instrument that you might use to solve your dilemma. Informal borrow from family or friends. Formal obtain a loan from a bank. 2. Firms enter into contracts with banks in which, for a fee, the bank agrees to make a loan whenever the firm demands it. These agreements are called lines of credit. a. What characteristics of the contract and of the bank would cause the firm to pay more or less for the bank s commitment? b. What characteristics of the contract and of the firm would cause the bank to charge more for the commitment? a. The firm would pay more for a larger line of credit or for a line of credit from a bank that is more likely to be able to follow through with the contract and loan money when the firm needs it. If there were any limits on when the firm could demand a loan, the firm would pay less for the line of credit. b. The bank would charge more to a firm with a lower credit rating. It would also charge more for a larger line of credit. 3. The Chicago Mercantile Exchange has announced the introduction of a financial instrument that is based on rainfall in the state of Illinois. The standard agreement states that for each inch of rain over and above the average rainfall for a particular month, the seller will pay the buyer $1,000. Who could benefit from buying such a contract? Who could benefit from selling it? Instructor s Manual t/a Cecchetti: Money, Banking, and Financial Markets 1
Someone who benefits from above average rainfall could sell the contract, and someone who is harmed by above average rainfall should buy the contract. Crops can benefit from additional rainfall during certain times of the year, but may be harmed by too much rain at other times, so, depending on the season, farmers could be buying or selling derivatives. Hydroelectric companies could also sell the contracts, while people who benefit from dry weather like golf course operators would buy them. 4. Most young people face substantial uncertainty about their future incomes. Describe the characteristics of a financial instrument that would allow you to sell your future income risk. Would anyone be willing to buy such a security? Why or why not? A college student could sell a security that promises payment of a certain percentage of his income if the income is above a specified level. It is unlikely that anyone would be willing to buy such a security because of the perceived small likelihood that the student would follow through with the contract and make future payments. 5. Consider an annuity that makes monthly payments for as long as someone lives. Describe what happens to the purchase price of the annuity as a. the age of the purchaser goes up. b. the size of the monthly payment rises. c. the health of the purchaser improves. a. The number of expected monthly payments declines so the price of the annuity falls. b. The price of the annuity rises. c. The purchaser is expected to live longer; the number of expected monthly payments rises so the price of the annuity rises. 6. You are the director of a major art museum with a substantial endowment. You have very few works by European Renaissance artists and would like to purchase some. You know that only a few of these paintings are available at auction each year, so building your collection will be a slow and laborious process. The risk you face is that the prices of the paintings will rise so rapidly that you will run out of resources before you can assemble a collection that meets your standards. Design a financial instrument that would allow you to transfer this risk to someone else. Describe the instrument s properties. You could enter into a contract with a group of people in which you make fixed payments to them and they are required to purchase certain paintings. This Instructor s Manual t/a Cecchetti: Money, Banking, and Financial Markets 2
contract would be expensive to write because of its detail and complexity, but it would allow you to protect yourself from a rapid rise in the prices of the paintings. 7. Consider the investment returns on holding stock. Which of the following would be more valuable to you, stocks that rise in value when your income rises or stocks that rise in value when your income falls? Why? Stocks that rise in value when your income falls are more valuable because they pay off when you need it the most (when your marginal utility is high). 8. If you wish to purchase mortgage-backed securities, you will discover that you have an interesting option that results from the fact that borrowers can pay off their mortgages early without incurring a penalty. To understand how it works, imagine that there are 1000 identical 30-year fixed-rate mortgages in a pool. The asset-backed securities give you the option of the payments that come from the first 200 to be paid off, the next 200, and so on. How will the value of these mortgage-backed securities vary depending on which group you purchase? The security that includes shares of the payments from the first group of mortgages to be paid off will be most valuable. Because of interest, the total value of the payments made on mortgages that are paid off later will be higher, but a security that is backed by the first group of mortgages will have larger payments over a shorter period. Securities backed by mortgages that are paid off later are also less valuable because there is a higher risk of default. 9. The foreign exchange market, in which dollars can be exchanged for euros or yen, is an over-the-counter market. Describe the costs and benefits of this form of market organization. It can be easier to make mistakes in an over-the-counter market, but over-the-counter markets can still function during events like those of September 11, 2001 because they are not in one central physical location. 10. Define a primary financial market and explain why very few people ever have any contact with one. A primary financial market is where new financial instruments are issued. This is where bonds and stocks are sold for the first time. Most people are not in a position to purchase new issues, both because they do not have the necessary wealth and because they do not have access to the investment bankers who are marketing them. Instead, we make purchases in secondary markets. 11. The Wall Street Journal has a daily listing of what are called money rates or interest rates on short-term securities. Locate it in a recent issue of the paper by Instructor s Manual t/a Cecchetti: Money, Banking, and Financial Markets 3
looking at the index on page 1 of the Money and Investing section. The most important money rates are the prime rate, the federal funds rate, and the Treasury bill rate. Describe each of these instruments and report the current rate quoted in the paper. The prime rate is the base rate for corporate loans offered by at least 75% of the 30 largest banks in the U.S. The federal funds rate is the rate at which banks lend reserves to each other overnight. The Treasury bill rate is the discount from face value of short-term government securities. On March 31, 2004, the prime rate was 4%, the federal funds rate was 1% and the rate for 13-week T-bills was 0.945%. 12. Trading on private information is illegal. Why? What would happen to the financial markets if you could trade on information that is not public? Financial markets pool and communicate information about the issuers of securities. If the information is not correct or not widely available, prices will be wrong and resources will not be allocated to their most efficient uses. In addition, if market participants are allowed to trade on private information, the markets will not be perceived as fair. 13. You are asked for advice by the government of a small, poorly developed country that wants to increase its rate of economic growth. You notice that the country has no financial markets. What advice would you give? Developing financial markets is an essential component of economic growth. The prices generated in the financial markets will help to direct resources to their most efficient resources, which will foster economic growth. To support the development of financial markets, the government needs to create laws requiring accurate disclosure of information, prohibiting trading on information that is not public, and ensuring that borrowers pay back lenders. These laws need to be strictly enforced. 14. List the six types of financial institutions and describe a transaction that you might have that involves each one. a. Depository Institutions take deposits and make loans. b. Insurance Companies accept premiums, which they invest in securities and real estate (their assets) in return for promising compensation to policyholders should certain events occur (their liabilities). Life insurers protect against the risk of untimely death; property and casualty insurers protect against personal injury loss and losses from theft, accidents, and fire. Instructor s Manual t/a Cecchetti: Money, Banking, and Financial Markets 4
c. Pension Funds invest individual and company contributions into stocks, bonds, and real estate (their assets) in order to provide payments to retired workers (their liabilities). d. e. f. Securities Firms: Brokers, Investment Banks (underwriters), and Mutual Fund Companies: Brokers and Investment Banks issue stocks and bonds to corporate customers, trade them, and advise customers. All these activities give customers access to the financial markets. Mutual fund companies pool the resources of individuals and companies and invest them in portfolios of bonds, stocks, and real estate. Customers own shares of the portfolios, so they face the risk that the assets will change in value. But portfolios are less risky than individual securities, and individual savers can purchase smaller units than they could if they went directly to the financial markets. Finance Companies raise funds directly in the financial markets in order to make loans to individuals and firms. Finance companies tend to specialize in particular types of loans, such as mortgage, automobile, or certain types of business equipment. While their assets are similar to a bank s, their liabilities are very different. Government Sponsored Enterprises are federal credit agencies that provide loans directly for farmers and home mortgages, as well as guarantee programs that insure the loans made by private lenders. The government also provides retirement income and medical care to the elderly through Social Security and Medicare - functions performed privately by pension funds and insurance companies. 15. The design and function of financial instruments, markets, and institutions are tied to the importance of information. Describe the role of information in each of these three pieces of the financial system. Financial instruments summarize essential information about the borrower. Financial markets aggregate information from many sources and communicate it widely. Financial institutions produce information to screen and monitor borrowers. Instructor s Manual t/a Cecchetti: Money, Banking, and Financial Markets 5