We discussed two leading reasons for the decline in the number of banks in the U.S. over the last five decades. One of them is merger, what is the other one? (a) What are the main reasons for banks to merge? In particular, they are trying to overcome what costs through mergers? 2. Securitization is an important innovation for the financial market. Please give two examples for the areas where the securitization process has happened. Explain the advantage and potential disadvantage for one (and only one) of the two examples you give. 3. In what sense is credit default swaps a tool for insurance? Discuss from the perspective of buyers of the CDS. 4. (Bonus credit) Suppose that a bond with a face value F pays a coupon Ct for t = 1, . . . , M years, with M as its maturity. The coupon payments Ct follows a schedule of Ct = C0d t-1 . Write out an equation and calculate the explicit value (i.e. getting rid of the . . .) for its price in a competitive asset market. (a) Now suppose there is another “bond” with infinite years of payments Ct = C0d t-1 and no face value. In order for it to have a price (i.e. not an infinitely large price), what minimal conditions do you have to impose on the interest rates and the parameter d?
1. We discussed two leading reasons for the decline in the number of banks in the U.S. over the last five
decades. One of them is merger, what is the other one?
(a) What are the main reasons for banks to merge? In particular, they are trying to overcome what
costs through mergers?
2. Securitization is an important innovation for the financial market. Please give two examples for the
areas where the securitization process has happened. Explain the advantage and potential disadvantage
for one (and only one) of the two examples you give.
3. In what sense is credit default swaps a tool for insurance? Discuss from the perspective of buyers of
the CDS.
4. (Bonus credit) Suppose that a bond with a face value F pays a coupon Ct for t = 1, . . . , M years, with
M as its maturity. The coupon payments Ct follows a schedule of Ct = C0d
t−1
. Write out an equation
and calculate the explicit value (i.e. getting rid of the . . .) for its price in a competitive asset market.
(a) Now suppose there is another “bond” with infinite years of payments Ct = C0d
t−1 and no face
value. In order for it to have a price (i.e. not an infinitely large price), what minimal conditions
do you have to impose on the interest rates and the parameter d?
5. Fees are an important way how banks can generate income.
(a) First from the bank’s perspective, why do banks want to collect fees on events such as bounced
checks, or overdraft from checking accounts, apart from generating income?
(b) You can imagine that depositors are not so happy with these fees. The 2010 Dodd-Frank Act
creates a new Consumer Financial Protection Bureau (CFPB) within the Federal Reserve. The
new agency will monitor credit card fees and interest rates. With the Great Recession in the
backdrop, explain why the CFPB wants to step in and regulate the fees. (Hint: Connect to how
the government regulates/deregulates the competition in the banking industry.)
6. On March 22nd, 2019 the three-month Treasuries yields and the ten-year Treasuries yields just got
inverted for the first time in a long while, as the following figure indicated. Recall the term structure
of the interest rate.
1
Figure 1: Inverted yield curve
(a) Draw a figure for an inverted yield curve and explain briefly the figure.
(b) Many people think the inversion between yield curves, in particular a short-run one and the
ten-year T-bills, is a good indicator for recession. Explain why.
7. Take the recent 2008 Great Recession as an example. Consider the five risks we have talked about in
class: liquidity risk, credit risk, interest-rate risk, market risk, and economic risk.
(a) Which ones are idiosyncratic risks and which ones are aggregate risks?
(b) Could you please explain how different kinds of risks banks face interact with each other? Please
be succinct.
8. Let us finish the example of stock and bond returns in class. Again, assume that stocks have a 50-50%
chance of either 22% return or -6% return, and bonds have a fixed 2% return all the time. Assume
that the household allocates s share of their wealth in stocks.
(a) Calculate the average return of this household’s asset allocation, denoted as mean;
(b) Calculate the variance of this household’s asset allocation, denoted as var;
(c) (Bonus credit) Assume that the household would like to maximize the average return, but also
minimize the risk. Could you please propose an objective function for this household to maximize
over in order to achieve a balance between the two goals? How would you solve for the optimal
s? (Hint: You do not have to derive an exact solution for s, just show the steps.)
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