Questions:
1. Predict what will happen to interest rates on a corporation's bonds if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future.
2. What was the Glass-Steagall Act?
3. Rank the following securities in terms of their risk level from most risky to least risky: a) US treasury bond
b) A rated corporate bond
c)"Junk" bond
d) Aa rated corporate bond
e) US treasury note
4. What is the primary role for each of the following agencies?
a) Federal Reserve
b) FDIC
c) Office of the Comptroller of the Currency
d) NCUA
e) CFPB
5. Investors perceive a 20% likelihood that USAirways will go bankrupt and default on its debt. Suppose that the interest rate on a 15 year treasury bond is 3%. What would the interest rate on USAirways bonds need to be in order to make investors indifferent between them and Treasury bonds?
6. Categorize each of the following as a reason that the FDIC or the Fed was created a) To insure the stability of the banking system
b) To insure the credibility of bank deposits
c) To prevent bank runs
7. Suppose you have an asset which pays 20% if the economy is strong, 2% if the economy is average but loses 5% if the economy goes into recession. Further you know that there is a 20% chance for a strong economy, 70% chance for average growth and a 10% chance for a recession. What is the expected return on this investment?
8. What can cause a sound bank to fail? (Hint: what do I mean by a "sound" bank?)
9. Suppose you purchase a call option on a stock. The strike price is $75 and the option contract costs $3. What is your total profit (or loss) in dollars if the trading price of the stock is: a.) $50 e.) $75
b.) $60 f.) $78
c.) $70 g.) $80
d.) $72 h.) $85
10. What is the response to the moral hazard problem of deposit insurance?
Excel Problem: For this problem, you must produce your graphs using excel.
11. With the underlying outcome price on the x-axis and the security-holder's outcome on the y-axis graph the payoffs for the following derivatives: a) call option with exercise price of $50 and option price of $3 b) put option with exercise price of $50 and option price of $3 c) futures contract to buy at $50 and contract price of $3 d) auto insurance with $300 premium and $500 deductible
12.The point of this game is that diversification is a good thing. It is also a justification for expected value pricing.
The game consists of bond buyers, bond insurers, and two types of bond issuers: risky and safe. The game unfolds in two stages. In the first stage risky bond issuers are able to insure their bonds against default. In the second stage the bonds are sold to bond buyers. The market interest rate is 6%.
In the first stage, the Risky Issuers need to issue a bond to finance their operations. They have a 15% chance of default. They have the option to insure the bond against default. If they purchase insurance they pay an insurance premium (a fee) to the insurer. Then if the bond issuer defaults on the bond then the insurer will pay to the buyer the principle amount of the bond ($100).
The insurer and the risky bond issuer need to negotiate/calculate a fair price for the insurance. Considering the information given, what price should bond issuer pay for this insurance premium?
In the second stage of the game, the bond issuers turn around and try to sell the bonds to the bond buyers. There are two types of bonds. First, some bond issuers are risk free. Second, are the risky bonds which may or may not be insured against default.
The Bond Buyers have $100 to invest. The market interest rate is 6%. If they buy a riskless bond they will earn the full interest. Considering the information given, what interest rate should a bond buyer pay for a risk-less bond?
If they purchase a risky bond and it does not default, then they will receive the full negotiated interest. If they purchase an uninsured risky bond and it default, then they will receive nothing. Considering the information given, what interest rate should a bond buyer pay for an uninsured risky bond?
If they purchase an insured risky bond and it defaults then they will get their principle ($100) from the insurance company but no interest. Considering the information given, what interest rate should a bond buyer pay for an insured risky bond?