Question: Describe a put option on interest rate

> Explain how banks become exposed to exchange rate risk.

> What are the two ways in which a bank should diversify its loans? Why? Is international diversification of loans a viable strategy for dealing with credit risk? Defend your answer.

> Consider how economic conditions affect the credit risk premium. Do you think the credit risk premium will likely increase or decrease during this semester? How do you think the yield curve will change during this semester? Offer some logic to support yo

> As economic conditions change, how do banks adjust their asset portfolio?

> What is a bank’s gap, and what does it attempt to determine? Interpret a negative gap. What are some limitations of measuring a bank’s gap?

> Explain how the value at risk (VaR) method can be used to determine whether a bank has adequate capital.

> Explain how the uniform capital requirements can discourage banks from taking excessive risk.

> Briefly describe the Glass-Steagall Act, and then explain how the related regulations have changed since it was enacted.

> Describe the U.S. government’s efforts to infuse capital in all of the very large banks during the credit crisis.

> Explain the government’s dilemma regarding whether it should rescue American International Group (AIG) during the credit crisis.

> Lehman Brothers continued to report positive earnings throughout the spring of 2008, even though mortgage valuations were clearly declining. Nevertheless, some institutional investors were concerned that Lehman Brothers might have been overstating its ea

> How did Basel III change capital and liquidity requirements for banks?

> How did the Financial Reform Act of 2010 change the reserve requirements of the FDIC’s Deposit Insurance Fund?

> During some crises, investors shift their funds out of the stock market and into money market securities for safety, even if they do not fear that interest rates will rise. Explain how and why these actions by investors affect the yield curve. Is the shi

> Explain how the Financial Reform Act is intended to prevent some problems that contributed to the credit crisis.

> Explain how the TARP was expected to help resolve problems during the credit crisis.

> Explain how bank regulation can be more effective when there is consolidation of banks and securities firms.

> Should the Fed have the power to rescue firms such as Bear Stearns that are not commercial banks?

> Provide examples of off-balance sheet activities. Why are regulators concerned about them?

> Explain how the accounting method applied to mortgage-backed securities made it more difficult for banks to satisfy capital requirements during the credit crisis of 2008–2009.

> Explain how the conversion of securities firms to a bank holding company (BHC) structure might reduce their risk.

> Explain how the Sarbanes-Oxley (SOX) Act improved the transparency of banks. Why might the act have a negative impact on some banks?

> Describe the Financial Services Modernization Act of 1999. Explain how it affected commercial bank operations, and how it changed the competitive landscape among financial institutions.

> How are banks’ balance sheet decisions regulated?

> Assume that (1) investors and borrowers expect that the economy will weaken and that inflation will decline, (2) investors require a small liquidity premium, and (3) markets are partially segmented and the Treasury currently has a preference for borrowin

> Describe the process of borrowing from the Federal Reserve. What rate is charged, and who sets it? Why do banks commonly borrow in the federal funds market rather than through the Federal Reserve?

> Define federal funds, the federal funds market, and the federal funds rate. Who sets the federal funds rate? Why is the federal funds market more active on Wednesday?

> Compare and contrast the retail CD and the negotiable CD.

> Explain how banks use credit default swaps.

> Explain how some mortgage operations by some commercial banks (along with other financial institutions) played a major role in instigating the credit crisis that began in 2008.

> Explain the dilemma faced by banks when determining the optimal amount of capital to hold. A bank’s capital is less than 10 percent of its assets. How do you think this percentage would compare to that of manufacturing corporations? How would you explain

> Why do banks invest in securities, even though loans typically generate a higher return? How does a bank decide the appropriate percentage of funds that should be allocated to each type of asset? Explain.

> Seattle Bank just took speculative positions by borrowing Canadian dollars and converting the funds to invest in Australian dollars. Explain a possible future scenario that could adversely affect the bank’s performance.

> Assume that Switzerland has a very strong economy, placing upward pressure on both its inflation and interest rates. Explain how these conditions could place pressure on the value of the Swiss franc and determine whether the franc’s value will rise or fa

> Explain how foreign exchange derivatives could be used by U.S. speculators to speculate on the expected appreciation of the Japanese yen.

> Assume that the yield curves in the United States, France, and Japan are flat. If the U.S. yield curve suddenly becomes so positively sloped, do you think the yield curves in France and Japan would be affected? If so, how?

> Explain the exchange rate system that existed during the 1950s and 1960s. How did the Smithsonian Agreement in 1971 revise it? How does today’s exchange rate system differ from the earlier system?

> Explain how the failure of a large commercial bank could cause a worldwide swap credit crisis.

> Explain how an equity swap could allow Marathon Insurance Company to capitalize on expectations of a strong stock market performance over the next year without altering its existing portfolio mix of stocks and bonds.

> Describe the possible roles of securities firms in the swap market.

> Explain the types of cash flow characteristics that would cause a firm to hedge interest rate risk by swapping floating-rate payments for fixed payments. Why would some firms avoid the use of interest rate swaps, even when they are highly exposed to int

> Explain why some companies that issue bonds engage in currency swaps. Why do they not simply issue bonds in the currency that they would prefer to use for making payments?

> Explain why some companies that issue bonds engage in interest rate swaps in financial markets. Why do they not simply issue bonds that require the type of payments (fixed or variable) that they prefer to make?

> Explain basis risk as it relates to a currency swap.

> Markus Company purchases supplies from France once a year. Would Markus be favorably affected if it establishes a currency swap arrangement and the dollar strengthens? What if it establishes a currency swap arrangement and the dollar weakens?

> Describe a call option on interest rate futures. How does it differ from purchasing a futures contract?

> If liquidity and interest rate expectations are both important for explaining the shape of a yield curve, what does a flat yield curve indicate about the market’s perception of future interest rates?

> How do speculators use put options? Describe the conditions under which their strategy would backfire. What is the maximum loss that could occur for a purchaser of a put option?

> How do speculators use call options? Describe the conditions under which their strategy would backfire. What is the maximum loss that could occur for a purchaser of a call option?

> Explain the use of circuit breakers.

> Explain systemic risk as it relates to the futures market. Explain how the Financial Reform Act of 2010 attempted to improve the monitoring of systemic risk in the futures market and other markets.

> Describe stock index futures. How could they be used by a financial institution that is anticipating a jump in stock prices but does not yet have sufficient funds to purchase large amounts of stock? Explain why stock index futures may reflect investor ex

> How might a savings and loan association use Treasury bond futures to hedge its fixed-rate mortgage portfolio (assuming that its main source of funds is short-term deposits)? Explain how prepayments on mortgages can limit the effectiveness of the hedge.

> Describe the practice of cross hedging and explain when this strategy might be used.

> Describe the general characteristics of a futures contract. How does a clearinghouse facilitate the trading of financial futures contracts?

> Explain how circuit breakers are used to reduce the likelihood of a large stock market crash.

> Use the loanable funds framework to explain how European economic conditions might affect U.S. interest rates.

> Explain how the Securities and Exchange Commission attempts to prevent violations of SEC regulations.

> Briefly describe the structure and role of the Securities and Exchange Commission (SEC).

> What are electronic communication networks (ECNs)?

> Describe the roles of market makers.

> Under what conditions might investors consider short selling a specific stock?

> Explain how margin requirements can affect the potential return and risk from investing in a stock. What is the maintenance margin?

> Why are trading halts sometimes imposed on particular stocks?

> Describe the January effect.

> Explain why investor sentiment can affect stock prices.

> Explain how the value of the dollar affects stock valuations.

> Offer an argument for why a political regime that favors a large government will cause interest rates to be higher. Offer at least one example of why a political regime that favors a large government will cause interest rates to be lower [Hint: Recognize

> How are the interest rate, the required rate of return on a stock, and the valuation of a stock related?

> Describe the dividend discount valuation model. What are some limitations when using this model?

> Explain the difference between weak-form, semistrong-form, and strong-form efficiency. Which of these forms of efficiency is most difficult to test? Which is most likely to be refuted? Explain how to test weak-form efficiency in the stock market.

> In the movie Wall Street, Bud Fox is a broker who conducts trades for Gordon Gekko’s firm. Gekko purchases shares of firms that he believes are undervalued. Various scenes in the movie offer excellent examples of concepts discussed in this chapter. a. B

> Explain how to estimate the beta of a stock. Explain why beta serves as a measure of the stock’s risk.

> Identify the factors that affect a stock portfolio’s volatility and explain their effects.

> Explain the use of the price-earnings (PE) ratio for valuing a stock. Why might investors derive different valuations for a stock when using the price-earnings method? Why might investors derive an inaccurate valuation of a firm when using the price-earn

> What does it mean to “flip” shares? Why would investors want to flip shares?

> Describe a lockup provision and explain why it is required by the lead underwriter.

> Explain the use of a prospectus developed before an IPO. Why does a firm do a road show before its IPO? What factors influence the offer price of stock at the time of the IPO?

> During the credit crisis, U.S. interest rates were extremely low, which enabled businesses to borrow at a low cost. Holding other factors constant, this should have resulted in a higher number of feasible projects, which should have encouraged businesses

> Many financial institutions borrow heavily in the money markets using mortgages and mortgage-backed securities as collateral. Write a short essay about the lessons of the credit crisis to the deficit units and the surplus units that participate in the mo

> Explain the difference between obtaining funds from a venture capital firm and engaging in an IPO. Explain how the IPO may serve as a means by which the venture capital firm can cash out.

> Why do firms engage in IPOs? What is the amount of fees that the lead underwriter and its syndicate charge a firm that is going public? Why are there many IPOs in some periods and few IPOs in other periods?

> What is the danger of issuing too much stock? What is the role of the securities firm that serves as the underwriter, and how can it ensure that the firm does not issue too much stock?

> Describe how the interaction between buyers and sellers affects the market value of a firm and explain how that value can subject a firm to the market for corporate control.

> How does the initial rate on adjustable rate mortgages (ARMs) differ from the rate on fixed-rate mortgages? Why? Explain how caps on ARMs can affect a financial institution’s exposure to interest rate risk.

> What is the general relationship between mortgage rates and long-term government security rates? Explain how mortgage lenders can be affected by interest rate movements. Also explain how they can insulate themselves against interest rate movements.

> Explain how a mortgage company’s degree of exposure to interest rate risk differs from other financial institutions.

> Compare the secondary market activity for mortgages to the activity for other capital market instruments (such as stocks and bonds). Provide a general explanation for the difference in the activity level.

> Is the price of a long-term bond or the price of a short-term security more sensitive to a change in interest rates? Why?

> Assume that breaking news causes bond portfolio managers to suddenly expect much higher economic growth. How might bond prices be affected by this expectation? Explain. Now assume that breaking news causes bond portfolio managers to suddenly anticipate a

> Consider the prevailing conditions for inflation (including oil prices), the economy, the budget deficit, and the Fed’s monetary policy that could affect interest rates. Based on these conditions, do you think interest rates will likely increase or decre

> Explain how bond prices may be affected by money supply growth, oil prices, and economic growth.

> When tensions rise or war erupts in the Middle East, bond prices in many countries tend to decline. What is the link between problems in the Middle East and bond prices? Would you expect bond prices to decline more in Japan or in the United Kingdom as a

> An analyst recently suggested that there will be a major economic expansion that will favorably affect the prices of high-rated fixed-rate bonds, because the credit risk of bonds will decline as corporations improve their performance. Assuming that the e

> Explain the concept of bond price elasticity. Would bond price elasticity suggest a higher price sensitivity for zero-coupon bonds or high-coupon bonds that are offering the same yield to maturity? Why? What does this suggest about the market value volat

> Why can convertible bonds be issued by firms at a higher price than other bonds?

> Are variable-rate bonds attractive to investors who expect interest rates to decrease? Explain. Would a firm that needs to borrow funds consider issuing variable-rate bonds if it expects interest rates to decrease in the future? Explain.

> What are the advantages and disadvantages to a firm that issues low- or zero-coupon bonds?

> Explain how the downgrading of bonds for a particular corporation affects the prices of those bonds, the return to investors who currently hold these bonds, and the potential return to other investors who may invest in the bonds in the near future.

> Explain the conditions that led to the debt crisis in Greece.