SOLUTIONS MANUAL for Financial Markets and Institutions, 8th Edition By Anthony Saunders, Marcia Cor by StudyGuide

TABLE OF CONTENTS Part 1: INTRODUCTION AND OVERVIEW OF FINANCIAL MARKETS Chapter 1: Introduction Chapter 2: Determinants of Interest Rates Chapter 3: Interest Rates and Security Valuation Chapter 4: The Federal Reserve System, Monetary Policy, and InterestRates Part 2: SECURITIES MARKETS Chapter 5: Money Markets Chapter 6: Bond Markets Chapter 7: Mortgage Markets Chapter 8: Stock Markets Chapter 9: Foreign Exchange Markets Chapter 10: Derivative Securities Markets Part 3: COMMERCIAL BANKS Chapter 11: Commercial Banks Chapter 12: Commercial Banks’ Financial Statements and Analysis Chapter 13: Regulation of Commercial Banks Part 4: OTHER FINANCIAL INSTITUTIONS Chapter 14: Other Lending Institutions Chapter 15: Insurance Companies

Chapter 16: Securities Firms and Investment Banks Chapter 17: Investment Companies Chapter 18: Pension Funds Chapter 19: Fintech Companies Part 5: RISK MANAGEMENT IN FINANCIAL INSTITUTIONS Chapter 20: Types of Risks Incurred by Financial Institutions Chapter 21: Managing Credit Risk on the Balance Sheet Chapter 22: Managing Liquidity Risk on the Balance Sheet Chapter 23: Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet Chapter 24: Managing Risk off the Balance Sheet with Derivative Securities Chapter 25: Managing Risk off the Balance Sheet with Loan Sales and Securitization

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 1 Questions: 1.

a. primary b. primary c. secondary d. secondary e. secondary

a. money market b. money market c. capital market d. capital market e. capital market f. money market g. money market h. money market i. capital market j. money market

3. The capital markets are more likely to be characterized by actual physical locations such as the New York Stock Exchange. Money market transactions are more likely to occur via telephone, wire transfers, and computer trading. 4. According to Figure 1-4, federal funds and repurchase agreements, followed by Treasury bills, negotiable CDs, and commercial paper, had the largest amounts outstanding in 2019. 5. The major instruments traded in capital markets are corporate stocks, mortgages, corporate bonds, Treasury notes and bonds, state and local government bonds, U.S. government owned and sponsored agencies, and bank and consumer loans. 6. According to Figure 1-4, corporate stocks represent the largest capital market instrument in 2019, followed by mortgages, Treasury securities, and corporate bonds. 7. The bank would be most concerned about a depreciation of the yen against the dollar. 8. Financial institutions consist of: Commercial banks - depository institutions whose major assets are loans and major liabilities are deposits. Commercial banks’ loans are broader in range, including consumer, commercial, and real estate loans, than other depository institutions. Commercial banks’ liabilities include more nondeposit sources of funds, such as subordinate notes and debentures, than other depository institutions. Thrifts - depository institutions in the form of savings and loans, savings banks, and credit unions. Thrifts generally perform services similar to commercial banks, but they tend to concentrate their loans in one segment, such as real estate loans or consumer loans. Insurance companies - financial institutions that protect individuals and corporations (policyholders) from adverse events. Life insurance companies provide protection in the event of untimely death, illness, and retirement. Property casualty insurance protects against personal injury and liability due to accidents, theft, fire, etc. Securities firms and investment banks - financial institutions that underwrite securities and engage in related activities such as securities brokerage, securities trading, and making a market in which securities can trade. Finance companies - financial intermediaries that make loans to both individual and businesses. Unlike depository institutions, finance companies do not accept deposits but instead rely on short- and long-term debt for funding. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Mutual funds and hedge funds - financial institutions that pool financial resources of individuals and companies and invest those resources in diversified portfolios of asset. Pension funds - financial institutions that offer savings plans through which fund participants accumulated savings during their working years before withdrawing them during their retirement years. Funds originally invested in and accumulated in pension funds are exempt from current taxation. 9. If there were no FIs then the users of funds, such as corporations in the economy, would have to approach the savers of funds, such as households, directly in order to fund their investment projects and fill their borrowing needs. This would be extremely costly because of the up-front information costs faced by potential lenders. These include costs associated with identifying potential borrowers, pooling small savings into loans of sufficient size to finance corporate activities, and assessing risk and investment opportunities. Moreover, lenders would have to monitor the activities of borrowers over each loan's life span, which is compounded by the free rider problem. The net result is an imperfect allocation of resources in an economy. 10. There are at least three reasons for this. First, once they have lent money in exchange for financial claims, suppliers of funds need to monitor or check the use of their funds. They must be sure that the user of funds neither absconds with nor wastes the funds on projects that have low or negative returns. Such monitoring actions are often extremely costly for any given fund supplier because they require considerable time, expense, and effort to collect this information relative to the size of the average fund supplier’s investment. Second, the relatively long-term nature of some financial claims (e.g., mortgages, corporate stock, and bonds) creates a second disincentive for suppliers of funds to hold the direct financial claims issued by users of funds. Specifically, given the choice between holding cash and long-term securities, fund suppliers may well choose to hold cash for liquidity reasons, especially if they plan to use savings to finance consumption expenditures in the near future and financial markets are not very deep in terms of active buyers and sellers. Third, even though real-world financial markets provide some liquidity services, by allowing fund suppliers to trade financial securities among themselves, fund suppliers face a price risk upon the sale of securities. That is, the price at which investors can sell a security on secondary markets such as the New York Stock Exchange (NYSE) may well differ from the price they initially paid for the security either because investors change their valuation of the security between the time it was bought and when it was sold and/or because dealers, acting as intermediaries between buyers and sellers, charge transaction costs for completing a trade. 11. A suppler of funds who directly invests in a fund user’s financial claims faces a high cost of monitoring the fund user’s actions in a timely and complete fashion after purchasing securities. One solution to this problem is for a large number of small investors to place their funds with a single FI serving as a broker between the two parties. The FI groups the fund suppliers’ funds together and invests them in the direct or primary financial claims issued by fund users. This aggregation of funds resolves a number of problems. First, the “large” FI now has a much greater incentive to hire employees with superior skills and training in monitoring. This expertise can be used to collect information and monitor the ultimate fund user’s actions because the FI has far more at stake than any small individual fund supplier. Second, the monitoring function performed by the FI alleviates the “free-rider” problem that exists when small fund suppliers leave it to each other to collect information and monitor a fund user. In an economic sense, fund suppliers have appointed the financial institution as a delegated monitor to act on their behalf. For example, full-service securities firms such as Morgan Stanley carry out investment research on new issues and make investment recommendations for their retail clients (or investors), while commercial banks collect deposits from fund suppliers and lend these funds to ultimate users such as corporations. 12. In addition to information costs, FIs help small savers alleviate liquidity and price risk. Often claims issued by financial institutions have liquidity attributes that are superior to those of primary securities. For example, banks and thrift institutions (e.g., savings associations) issue transaction account deposit contracts with a fixed principal value and often a guaranteed interest rate that can be withdrawn immediately, on demand, by investors. Money market mutual funds issue shares to household savers that allow them to enjoy almost fixed principal (depositlike) contracts while earning higher interest rates than on bank deposits, and that can be withdrawn immediately. Even life Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e insurance companies allow policyholders to borrow against their policies held with the company at very short notice. Notice that in reducing the liquidity risk of investing funds for fund suppliers, the FI transfers this risk to its own balance sheet. That is, FIs such as depository institutions offer highly liquid, low price-risk securities to fund suppliers on the liability side of their balance sheets, while investing in relatively less liquid and higher price-risk securities—such as the debt and equity—issued by fund users on the asset side. 13. As long as the returns on different investments are not perfectly positively correlated, by spreading their investments across a number of assets, FIs can diversify away significant amounts of their portfolio risk. Thus, FIs can exploit the law of large numbers in making their investment decisions, whereas due to their smaller wealth size, individual fund suppliers are constrained to holding relatively undiversified portfolios. As a result, diversification allows an FI to predict more accurately its expected return and risk on its investment portfolio so that it can credibly fulfill its promises to the suppliers of funds to provide highly liquid claims with little price risk. As long as an FI is sufficiently large, to gain from diversification and monitoring on the asset side of its balance sheet, its financial claims (it issues as liabilities) are likely to be viewed as liquid and attractive to small savers, especially when compared to direct investments in the capital market. A mutual fund invested in a diverse group of stocks and fixed income securities will best provide diversification for an investor. 14. If net borrowers and net lenders have different optimal time horizons, FIs can service both sectors by mismatching their asset and liability maturities. That is, by maturity mismatching, FIs can produce long-term contracts such as long-term, fixed-rate mortgage loans to households, while still raising funds with short-term liability contracts such as deposits. In addition, although such mismatches can subject an FI to interest rate, a large FI is better able than a small investor to manage this risk through its superior access to markets and instruments for hedging the risks of such loans. 15. Because they are sold in very large denominations, many assets are either out of reach of individual savers or would result in savers holding highly undiversified asset portfolios. For example, the minimum size of a negotiable CD is $100,000; commercial paper (short-term corporate debt) is often sold in minimum packages of $250,000 or more. Individual savers may be unable to purchase such instruments directly. However, by buying shares in a mutual fund with other small investors, household savers overcome the constraints to buying assets imposed by large minimum denomination sizes. Such indirect access to these markets may allow small savers to generate higher returns on their portfolios as well. 16. Other services provided by FIs that benefit the overall economy include: Money Supply Transmission - Depository institutions are the conduit through which monetary policy actions impact the rest of the financial system and the economy in general. Credit Allocation - FIs are often viewed as the major, and sometimes only, source of financing for a particular sector of the economy, such as farming and residential real estate. Intergenerational Wealth Transfers - FIs, especially life insurance companies and pension funds, provide savers the ability to transfer wealth from one generation to the next. Payment Services - The efficiency with which depository institutions provide payment services directly benefits the economy. 17. As financial institutions perform the various services described above, they face many types of risk. Specifically, all FIs hold some assets that are potentially subject to default or credit risk (such as loans, stocks, and bonds). As FIs expand their services to non-U.S. customers or even domestic customers with business outside the United States, they are exposed to both foreign exchange risk and country or sovereign risk as well. Further, FIs tend to mismatch the maturities of their balance sheet assets and liabilities to a greater or lesser extent and are thus exposed to interest rate risk. If FIs actively trade these assets and liabilities rather than hold them for longer-term investments, they are further exposed to market risk or asset price risk. Increasingly, FIs hold contingent assets and liabilities off the balance sheet, which presents an additional risk called off-balance-sheet risk. Moreover, all FIs are exposed to some degree of liability withdrawal or liquidity risk, depending on the type of claims they have sold to Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e liability holders. All FIs are exposed to technology risk and operational risk because the production of financial services requires the use of real resources and back-office support systems (labor and technology combined to provide services). Finally, the risk that an FI may not have enough capital reserves to offset a sudden loss incurred as a result of one or more of the risks it faces creates insolvency risk for the FI. 18. FIs provide various services to sectors of the economy. Failure to provide these services, or a breakdown in their efficient provision, can be costly to both the ultimate suppliers (households) and users (firms) of funds as well as the overall economy. For example, bank failures may destroy household savings and at the same time restrict a firm’s access to credit. Insurance company failures may leave households totally exposed in old age to catastrophic illnesses and sudden drops in income on retirement. In addition, individual FI failures may create doubts in savers’ minds regarding the stability and solvency of FIs in general and cause panics and even runs on sound institutions. FIs are regulated in an attempt to prevent these types of market failures. 19. A major event that changed and reshaped the financial services industry was the financial crisis of the late 2000s. As FIs adjusted to regulatory changes brought about by the likes of the FSM Act, one result was a dramatic increase in systemic risk of the financial system, caused in large part by a shift in the banking model from that of “originate and hold” to “originate to distribute.” In the traditional model, banks take short term deposits and other sources of funds and use them to fund longer term loans to businesses and consumers. Banks typically hold these loans to maturity, and thus have an incentive to screen and monitor borrower activities even after a loan is made. However, the traditional banking model exposes the institution to potential liquidity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate improved return-risk tradeoffs, banks have shifted to an underwriting model in which they originated or warehouse loans, and then quickly sell them. When loans trade, the secondary market produces information that can substitute for the information and monitoring of banks. Further, banks may have lower incentives to collect information and monitor borrowers if they sell loans rather than keep them as part of the bank’s portfolio of assets. Indeed, most large banks are organized as financial service holding companies to facilitate these new activities. More recently activities of shadow banks, non-bank financial service firms that perform banking services, have facilitated the change from the originate and hold model of commercial banking to the originate and distribute banking model. In the shadow banking system savers place their funds with money market mutual7 and similar funds, which invest these funds in the liabilities of shadow banks. Borrowers get loans and leases from shadow banks rather than from banks. Like the traditional banking system, the shadow banking system intermediates the flow of funds between net savers and net borrowers. However, instead of the bank serving as the middleman, it is the nonbank financial service firm, or shadow bank, that intermediates. Further, unlike the traditional banking system, where the complete credit intermediation is performed by a single bank, in the shadow banking system it is performed through a series of steps involving many nonbank financial service firms. These innovations remove risk from the balance sheet of financial institutions and shift risk off the balance sheet and to other parts of the financial system. Since the FIs, acting as underwriters, are not exposed to the credit, liquidity, and interest rate risks of traditional banking, they have little incentive to screen and monitor activities of borrowers to whom they originate loans. Thus, FIs role as specialists in risk measurement and management has been reduced. 20. The boom (“bubble”) in the housing markets began building in 2001, particularly after the terrorist attacks of 9/11. The immediate response by regulators to the terrorist attacks was to create stability in the financial markets by providing liquidity to FIs. For example, the Federal Reserve lowered the short-term interest rate that banks and other financial institutions pay in the Federal funds market and even made lender of last resort funds available to non-bank FIs such as investment banks. Perhaps not surprisingly, low interest rates and the increased liquidity provided by Central banks resulted in a rapid expansion in consumer, mortgage, and corporate debt financing. Demand for residential mortgages and credit card debt rose dramatically. As the demand for mortgage debt grew, especially among those who had previously been excluded from participating in the market because of their poor credit ratings, FIs began lowering their credit quality cut-off points. Moreover, to boost their earnings, in the market now popularly known as the “subprime market,” banks and other mortgage-supplying institutions often offered relatively low “teaser” rates on adjustable rate mortgages (ARMs) at exceptionally low initial interest rates, but with substantial step-up in rates after the initial rate period expired two or three year later and if market rates rose in the future. Under the traditional banking structure, banks might have been reluctant to so aggressively pursue low credit quality Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e borrowers for fear that the loans would default. However, under the originate-to-distribute model of banking, asset securitization and loan syndication allowed banks to retain little or no part of the loans, and hence the default risk on loans that they originated. Thus, as long as the borrower did not default within the first months after a loan’s issuance and the loans were sold or securitized without recourse back to the bank, the issuing bank could ignore longer term credit risk concerns. The result was deterioration in credit quality, at the same time as there was a dramatic increase in consumer and corporate leverage. 21. Measured as more than $1 trillion in international debt outstanding as of 2019 the biggest issuers are France, Germany, the Netherlands, the United Kingdom, and the United States. 22. China, France, Japan, the United Kingdom, and the United States have the biggest banks (in terms of total assets held in 2019).

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 2 Questions: 1. The household sector (consumers) is one of the largest supplier of loanable funds. Households supply funds when they have excess income or want to reinvest a part of their wealth. For example, during times of high growth households may replace part of their cash holdings with earning assets. As the total wealth of the consumer increases, the total supply of funds from that household will also generally increase. Households determine their supply of funds not only on the basis of the general level of interest rates and their total wealth, but also on the risk on financial securities change. The greater a security’s risk, the less households are willing to invest at each interest rate. Further, the supply of funds provided from households will depend on the future spending needs. For example, near term educational or medical expenditures will reduce the supply of funds from a given household. Higher interest rates will also result in higher supplies of funds from the business sector. When businesses mismatch inflows and outflows of cash to the firm they have excess cash that they can invest for a short period of time in financial markets. In addition to interest rates on these investments, the expected risk on financial securities and the business’ future investment needs will affect the supply of funds from businesses. Loanable funds are also supplied by some government units that temporarily generate more cash inflows (e.g., taxes) than they have budgeted to spend. These funds are invested until they are needed by the governmental agency. Additionally, the federal government (i.e., the Federal Reserve) implements monetary policy by influencing the availability of credit and the growth in the money supply. Monetary policy implementation in the form of increases the money supply will increase the amount of loanable funds available. Finally, foreign investors increasingly view U.S. financial markets as alternatives to their domestic financial markets. When interest rates are higher on U.S. financial securities than on comparable securities in their home countries, foreign investors increase the supply of funds to U.S. markets. Indeed, the high savings rates of foreign households combined with relatively high U.S. interest rates compared to foreign rates, has resulted in foreign market participants as major suppliers of funds in U.S. financial markets. Similar to domestic suppliers of loanable funds, foreign suppliers assess not only the interest rate offered on financial securities, but also their total wealth, the risk on the security, and their future spending needs. Additionally, foreign investors alter their investment decisions as financial conditions in their home countries change relative to the U.S. economy. 2. Households (although they are net suppliers of funds) borrow funds in financial markets. The demand for loanable funds by households comes from their purchases of homes, durable goods (e.g., cars, appliances), and nondurable goods (e.g., education expenses, medical expenses). In addition to the interest rate on borrowed funds, the greater the utility the household receives from the purchased good, the higher the demand for funds. Additionally, nonprice conditions and requirements (discussed below) affect a households demand for funds at every level of interest rates. Businesses often finance investments in long-term (fixed) assets (e.g., plant and equipment) and in shortterm assets (e.g., inventory and accounts receivable) with debt and other financial instruments. When interest rates are high (i.e., the cost of loanable funds is high), businesses prefer to finance investments with internally generated funds (e.g., retained earnings) rather than through borrowed funds. Further, the greater the number of profitable projects available to businesses, or the better the overall economic conditions, the greater the demand for loanable funds. Governments also borrow heavily in financial markets. State and local governments often issue debt to finance temporary imbalances between operating revenues (e.g., taxes) and budgeted expenditures (e.g., road improvements, school construction). Higher interest rates cause state and local governments to postpone such capital expenditures. Similar to households and businesses, state and local governments’ demand for funds vary with general economic conditions. The federal government is also a large borrower partly to finance current budget deficits (expenditures greater than taxes) and partly to finance past deficits. In contrast to other demanders of funds, the federal government’s borrowing is not influenced by the level of interest rates. Expenditures in the federal government’s budget are spent regardless of the interest cost. Finally, foreign participants might also borrow in U.S. financial markets. Foreign borrowers look for the cheapest source of funds globally. Most foreign borrowing in U.S. financial markets comes from the business sector. In addition to interest costs, foreign borrowers consider nonprice terms on loanable funds as well as economic conditions in the home country. 3. Factors that affect the supply of funds include total wealth, risk of the financial security, future spending needs, monetary policy objectives, and economic conditions.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Wealth. As the total wealth of financial market participants (households, business, etc.) increases the absolute dollar value available for investment purposes increases. Accordingly, at every interest rate the supply of loanable funds increases, or the supply curve shifts down and to the right. The shift in the supply curve creates a disequilibrium in this financial market. As competitive forces adjust, and holding all other factors constant, the increase in the supply of funds due to an increase in the total wealth of market participants results in a decrease in the equilibrium interest rate, and an increase in the equilibrium quantity of funds traded. Conversely, as the total wealth of financial market participants decreases the absolute dollar value available for investment purposes decreases. Accordingly, at every interest rate the supply of loanable funds decreases, or the supply curve shifts up and to the left. The shift in the supply curve again creates a disequilibrium in this financial market. As competitive forces adjust, and holding all other factors constant, the decrease in the supply of funds due to a decrease in the total wealth of market participants results in an increase in the equilibrium interest rate, and a decrease in the equilibrium quantity of funds traded. Risk. As the risk of a financial security decreases, it becomes more attractive to supplier of funds. Accordingly, at every interest rate the supply of loanable funds increases, or the supply curve shifts down and to the right. The shift in the supply curve creates a disequilibrium in this financial market. As competitive forces adjust, and holding all other factors constant, the increase in the supply of funds due to a decrease in the risk of the financial security results in a decrease in the equilibrium interest rate, and an increase in the equilibrium quantity of funds traded. Conversely, as the risk of a financial security increases, it becomes less attractive to supplier of funds. Accordingly, at every interest rate the supply of loanable funds decreases, or the supply curve shifts up and to the left. The shift in the supply curve creates a disequilibrium in this financial market. As competitive forces adjust, and holding all other factors constant, the decrease in the supply of funds due to an increase in the financial security’s risk results in an increase in the equilibrium interest rate, and a decrease in the equilibrium quantity of funds traded. Near-term Spending Needs. When financial market participants have few near-term spending needs, the absolute dollar value of funds available to invest increases. Accordingly, at every interest rate the supply of loanable funds increases, or the supply curve shifts down and to the right. The financial market, holding all other factors constant, reacts to this increased supply of funds by decreasing the equilibrium interest rate, and increasing the equilibrium quantity of funds traded. Conversely, when financial market participants have near-term spending needs, the absolute dollar value of funds available to invest decreases. At every interest rate the supply of loanable funds decreases, or the supply curve shifts up and to the left. The shift in the supply curve creates a disequilibrium in this financial market that, when corrected results in an increase in the equilibrium interest rate, and a decrease in the equilibrium quantity of funds traded. Monetary Expansion. One method used by the Federal Reserve to implement monetary policy is to alter the availability of credit and thus, the growth in the money supply. When monetary policy objectives are to enhance growth in the economy, the Federal Reserve increases the supply of funds available in the financial markets. At every interest rate the supply of loanable funds increases, the supply curve shifts down and to the right, and the equilibrium interest rate falls, while the equilibrium quantity of funds traded increases. Conversely, when monetary policy objectives are to contract economic growth, the Federal Reserve decreases the supply of funds available in the financial markets. At every interest rate the supply of loanable funds decreases, the supply curve shifts up and to the left, and the equilibrium interest rate rises, while the equilibrium quantity of funds traded decreases. Economic Conditions. Finally, as economic conditions improve in a country relative to other countries, the flow of funds to that country increases. The inflow of foreign funds to U.S. financial markets increases the supply of loanable funds at every interest rate and the supply curve shifts down and to the right. Accordingly, the equilibrium interest rate falls, and the equilibrium quantity of funds traded increases. Conversely, when economic conditions in foreign countries improve, domestic and foreign investors take their funds out of domestic financial markets (e.g., the United States) and invest abroad. Thus, the supply of funds available in the financial markets decreases and the equilibrium interest rate rises, while the equilibrium quantity of funds traded decreases. 4. Factors that affect the demand for funds utility derived from the asset purchased with borrowed funds, restrictiveness of nonprice conditions of borrowing, domestic economic conditions, and foreign economic conditions. Utility Derived from Asset Purchased With Borrowed Funds. As the utility derived from an asset purchased with

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e borrowed funds increases the willingness of market participants (households, business, etc.) to borrow increases and the absolute dollar value borrowed increases. Accordingly, at every interest rate the demand for loanable funds increases, or the demand curve shifts up and to the right. The shift in the demand curve creates a disequilibrium in this financial market. As competitive forces adjust, and holding all other factors constant, the increase in the demand for funds due to an increase in the utility from the purchased asset results in an increase in the equilibrium interest rate, and an increase in the equilibrium quantity of funds traded. Conversely, as the utility derived from an asset purchased with borrowed funds decreases the willingness of market participants (households, business, etc.) to borrow decreases and the absolute dollar value borrowed decreases. Accordingly, at every interest rate the demand of loanable funds decreases, or the demand curve shifts down and to the left. The shift in the demand curve again creates a disequilibrium in this financial market. As competitive forces adjust, and holding all other factors constant, the decrease in the demand for funds due to a decrease in the utility from the purchased asset results in a decrease in the equilibrium interest rate, and a decrease in the equilibrium quantity of funds traded. Restrictiveness on Nonprice Conditions on Borrowed Funds. As the nonprice restrictions put on borrowers as a condition of borrowing decrease the willingness of market participants to borrow increases and the absolute dollar value borrowed increases. Accordingly, at every interest rate the demand of loanable funds increases, or the demand curve shifts up and to the right. The shift in the demand curve again creates a disequilibrium in this financial market. As competitive forces adjust, and holding all other factors constant, the increase in the demand for funds due to a decrease in the restrictive conditions on the borrowed funds results in an increase in the equilibrium interest rate, and an increase in the equilibrium quantity of funds traded. Conversely, as the nonprice restrictions put on borrowers as a condition of borrowing increase market participants willingness to borrow decreases and the absolute dollar value borrowed decreases. Accordingly, at every interest rate the demand for loanable funds decreases, or the demand curve shifts down and to the left. The shift in the demand curve results in a decrease in the equilibrium interest rate, and a decrease in the equilibrium quantity of funds traded.

Economic Conditions. When the domestic economy is experiencing a period of growth, market participants are willing to borrow more heavily. Accordingly, at every interest rate the demand of loanable funds increases, or the demand curve shifts up and to the right. As competitive forces adjust, and holding all other factors constant, the increase in the demand for funds due to economic growth results in an increase in the equilibrium interest rate, and an increase in the equilibrium quantity of funds traded. Conversely, when economic growth is stagnant market participants reduce their borrowings increases. Accordingly, at every interest rate the demand for loanable funds decreases, or the demand curve shifts down and to the left. The shift in the demand curve results in a decrease in the equilibrium interest rate, and a decrease in the equilibrium quantity of funds traded. 5. Specific factors that affect the nominal interest rate on any particular security include: inflation, the real risk-free rate, default risk, liquidity risk, special features regarding the use of funds raised by a particular security issuer, and the security’s term to maturity. 6. The nominal interest rate on a security reflects its relative liquidity, with highly liquid assets carrying the lowest interest rates (all other characteristics remaining the same). Likewise, if a security is illiquid, investors add a liquidity risk premium (LRP) to the interest rate on the security. 7. Explanations for the yield curve’s shape fall predominantly into three categories: the unbiased expectations theory, the liquidity premium theory, and the market segmentation theory. According to the unbiased expectations theory of the term structure of interest rates, at any given point in time, the yield curve reflects the market's current expectations of future short-term rates. The second popular explanation―the liquidity premium theory of the term structure of interest rates—builds on the unbiased expectations theory. The liquidity premium idea is as follows: investors will hold long-term maturities only if these securities with longer term maturities are offered at a premium to compensate for future uncertainty in the security’s value. The liquidity premium theory states that long-term rates are equal to geometric averages of current and expected short-term rates (like the unbiased expectations theory), plus liquidity risk premiums that increase with the security’s maturity (this is the extension of the liquidity premium added to the unbiased expectations theory). The market segmentation theory does not build on the unbiased expectations theory or the liquidity premium theory, but rather argues that individual investors and FIs have specific maturity preferences, and convincing them to hold securities with maturities other than their most preferred requires a higher interest rate (maturity premium). The main thrust of the market segmentation theory is that investors do not consider securities with different maturities as perfect substitutes. Rather, individual investors and FIs have distinctly preferred investment horizons dictated by the dates when their liabilities will come due. 8. According to the unbiased expectations theory, the one-year interest rate one year from now is expected to be less than the one-year interest rate today. 9. The liquidity premium theory is an extension of the unbiased expectations theory. It based on the idea that investors will hold long-term maturities only if they are offered at a premium to compensate for future uncertainty in a security’s value, which increases with an asset’s maturity. Specifically, in a world of uncertainty, short-term securities provide greater marketability (due to their more active secondary market) and have less price risk (due to smaller price fluctuations for a given change in interest rates) than long-term securities. As a result, investors prefer to hold shorter term securities because they can be converted into cash with little risk of a loss of capital, i.e., short-term securities are more liquid. Thus, investors must be offered a liquidity premium to get them to but longer term securities. The liquidity premium theory states that long-term rates are equal to geometric averages of current and expected short-term rates (as under the unbiased expectations theory), plus liquidity risk premiums that increase with the maturity of the security. For example, according to the liquidity premium theory, an upward-sloping yield curve may reflect investor’ expectations that future short-term rates will be flat, but because liquidity premiums increase with maturity, the yield curve will nevertheless be upward sloping. 10. A forward rate is an expected or implied rate on a short-term security that will originate at some point in the future. 11. The present value of an investment decreases as interest rates increase. Also as interest rates increase, present

values decrease at a decreasing rate. This is because as interest rates increase, fewer funds need to be invested at the beginning of an investment horizon to receive a stated amount at the end of the investment horizon. This inverse relationship between the value of a financial instrument—for example, a bond—and interest rates is one of the most fundamental relationships in finance and is evident in the swings that occur in financial asset prices whenever major changes in interest rates arise. Further, because of the compounding of interest rates, the inverse relationship between interest rates and the present value of security investments is neither linear nor proportional.

Problems: 1. The fair interest rate on a financial security is calculated as i* = IP + RFR + DRP + LRP + SCP + MP 8% = 1.75% + 3.5% + DRP + 0.25% + 0% + 0.85% Thus, DRP = 8% - 1.75% - 3.5% - 0.25% - 0% - 0.85% = 1.65% 2. a. IP = i* – RFR = 3.25% - 2.25% = 1.00% b. ij* = 1.00% + 2.25% + 1.15% + 0.50% + 1.75% = 6.65% 3. 8.00% = 1.75% + 3.50% + DRP + 0.25% + 0.85% => DRP = 8.00% - (1.75% + 3.50% + 0.25% + 0.85%) = 1.65% 4. 1.94% = 0.50% + 1.00% + 0.00% + 0.00% + MP => MP = 1.94% - (0.50% + 1.00% + 0.00% + 0.00%) = 0.44% 5. 8.25% = 2.25% + 3.50% + 0.80 + LRP + (0.75% + (0.04% × 10)) => LRP = 8.25% - (2.25% + 3.50% + 0.80% + (0.75% + (0.04% × 10))) = 0.55% 6.

6.05% = 1.00% + 2.10% + DRP + 0.25% + (0.10% + (0.05% × 8)) => DRP = 6.05% - (1.00% + 2.10% + 0.25% + (0.10% + (0.05% × 8))) = 2.20%

7. 1R2 = [(1 + 0.052)(1 + 0.058)]1/2 - 1 = 5.50% 8.

R1 = 6% R2 = [(1 + 0.06)(1 + 0.07)]1/2 - 1 = 6.499% 1/3 - 1 = 6.832% 1R3 = [(1 + 0.06)(1 + 0.07)(1 + 0.075)] 1/4 - 1 = 7.085% 1R4 = [(1 + 0.06)(1 + 0.07)(1 + 0.075)(1 + 0.0785)] 1 1

yield to maturity 7.085% 6.832% 6.499%

6.00%

_____________________________ term to maturity 0 1 2 3 4 (in years) 9. 10.

R2 = [(1 + 0.0345)(1 + 0.0365)]1/2 - 1 = 3.55%

1 + 1R2 = {(1 + 1R1)(1 + E(2r1))}1/2 1.10 = {1.08(1 + E(2r1))}1/2 1.21= 1.08 (1 + E(2r1)) 1.21/1.08 = 1 + E(2r1) 1 + E(2r1) = 1.1204

E(2r1) = 0.1204 = 12.04% 11.

1.12 = {(1 + 1R1)(1 + E(2r1))(1 + E(3r1))}1/3 1.12 = {(1 + 1R1)(1.08)(1.10)}1/3 1.4049 = (1 + 1R1 )(1.08)(1.10) 1 + 1R1 = 1.4049/{(1.08)(1.10)} 1R1 = 0.1826 = 18.26%

12.

1 + 1R5 = {(1 + 1R4)4(1 + E(5r1))}1/5 1.0615 = {(1.056)4(1 + E(5r1))}1/5 (1.0615)5 = (1.056)4 (1 + E(5r1)) (1.0615)5/(1.056)4 = 1 + E(5r1) 1 + E(5r1) = 1.08379 E(5r1) = 8.379%

13.

1 + 1R4 = {(1 + 1R3)3(1 + E(4r1))}1/4 1.026 = {(1.0225)3(1 + E(4r1))}1/4 (1.026)4 = (1.0225)3(1 + E(4r1)) (1.026)4/(1.0225)3 = 1 + E(4r1) 1 + E(4r1) = 1.03657 E(4r1) = 3.657% 1 + 1R5 = {(1 + 1R4)4(1 + E(5r1))}1/5 1.0298 = {(1.026)4(1 + E(5r1))}1/5 (1.0298)5 = (1.026)4 (1 + E(5r1)) (1.0298)5/(1.026)4 = 1 + E(5r1) 1 + E(5r1) = 1.04514 E(5r1) = 4.514% 1 + 1R6 = {(1 + 1R5)5(1 + E(6r1))}1/6 1.0325 = {(1.0298)5(1 + E(6r1))}1/6 (1.0325)6 = (1.0298)5(1 + E(6r1)) (1.0325)6/(1.0298)5 = 1 + E(6r1) 1 + E(6r1) = 1.04611 E(6r1) = 4.611%

14.

R1 = 5.65% R2 = [(1 + 0.0565)(1 + 0.0675 + 0.0005)]1/2 - 1 = 6.223% 1/3 - 1 = 6.465% 1R3 = [(1 + 0.0565)(1 + 0.0675 + 0.0005)(1 + 0.0685 + 0.0010)] R = [(1 + 0.0565)(1 + 0.0675 + 0.0005)(1 + 0.0685 + 0.0010)(1 + 0.0715 + 0.0012)]1/4 - 1 = 6.666% 1 4 1 1

yield to maturity 6.666% 6.465% 6.223%

5.65%

_____________________________ term to maturity

(in years)

15.

(1 + 1R2) = {(1 + 1R1)(1 + E(2r1) + L2)}1/2 1.14 = {1.10 × (1 + 0.18 + L2)}1/2 1.2996 = 1.10 × (1 + 0.18 + L2) 1.2996/1.10 = 1 + 0.18 + L2 1.18145 = 1 + 0.18 + L2 L2 = 0.00145 = 0.145%

16.

1 + 1R4 = {(1 + 1R3)(1 + E(4r1) + L4)}1/4 1.0550 = {(1.0525)3(1 + 0.0610 + L4)}1/4 (1.0550) 4 = (1.0525)3(1 + 0.0610 + L4) (1.0550) 4/(1.0525)3 = 1 + 0.0610 + L4 (1.0550) 4/(1.0525)3 – 1.0610 = L4 = .001536 = 0.1536% R2 = 0.065 = [(1 + 0.055)(1 + 2f1)]1/2 - 1 => [(1.065)2/(1.055)] - 1 = 2f1 = 7.51%

17.

18.

19.

R3 = 0.09 = [(1 + 0.065)2(1 + 3f1)]1/3 - 1 => [(1.09)3/(1.065)2)] - 1 = 3f1 = 14.18% f = [(1 + 1R2)2/(1 + 1R1)] - 1 = [(1 + 0.0495)2/(1 + 0.0475)] - 1 = 5.15% 3 2 3 2 3f1 = [(1 + 1R3) /(1 + 1R2) ] - 1 = [(1 + 0.0525) /(1 + 0.0495) ] - 1 = 5.85% 4 3 4 3 4f1 = [(1 + 1R4) /(1 + 1R3) ] - 1 = [(1 + 0.0565) /(1 + 0.0525) ] - 1 = 6.86% 2 1

f = [(1 + 1R4)4/(1 + 1R3)3] - 1 = [(1 + 0.0635)4/(1 + 0.06)3] - 1 = 7.41% 5 4 5 4 5f1 = [(1 + 1R5) /(1 + 1R4) ] - 1 = [(1 + 0.0665) /(1 + 0.0635) ] - 1 = 7.86% 6 5 6 5 6f1 = [(1 + 1R6) /(1 + 1R5) ] - 1 = [(1 + 0.0675) /(1 + 0.0665) ] - 1 = 7.25%

20.

4 1

21.

R1 = 4.5% R2 = 5.25% = [(1 + 0.045)(1 + 2f1)]1/2 - 1 => 2f1 = 6.01% 1/3 - 1 => 3f1 = 9.04% 1R3 = 6.50% = [(1 + 0.045)(1 + 0.0601)(1 + 3f1)] 1

22. a. PV = $5,000/(1+0.06)5 = $5,000 (0.747258) = $3,736.29 b. PV = $5,000/(1+0.08)5 = $5,000 (0.680583) = $3,402.92 c. PV = $5,000/(1+0.10)5 = $5,000 (0.620921) = $3,104.61 d. PV = $5,000/(1+0.05)10 = $5,000 (0.613913) = $3,069.57 e. PV = $5,000/(1+0.025)20 = $5,000 (0.610271) = $3,051.35 From these answers we see that the present values of a security investment decrease as interest rates increase. As rates rose from 6 percent to 8 percent, the (present) value of the security investment fell $333.37 (from $3,736.29 to $3,402.92). As interest rates rose from 8 percent to 10 percent, the value of the investment fell $298.31 (from $3,402.92 to $3,104.61). This is because as interest rates increase, fewer funds need to be invested at the beginning of an investment horizon to receive a stated amount at the end of the investment horizon. Also, as interest rates increase, the present values of the investment decrease at a decreasing rate. The fall in present value is greater when interest rates rise from 6 percent to 8 percent compared to when they rise from 8 percent to 10 percent. The inverse relationship between interest rates and the present value of security investments is neither linear nor proportional. From the above answers, we also see that the greater the number of compounding periods per year, the smaller the present value of a future amount. This is because, the greater the number of compounding periods the more frequently interest is paid and thus, a greater amount of interest that is paid. Thus, to get to a stated amount at the end of an investment horizon, the greater the amount that will come from interest and the less the amount the investor must pay up front.

23. a. FV = $5,000 (1+0.06)5 = $5,000 (1.338226) = $6,691.13 b. FV = $5,000 (1+0.08)5 = $5,000 (1.469328) = $7,346.64 c. FV = $5,000 (1+0.10)5 = $5,000 (1.610510) = $8,052.55 d. FV = $5,000 (1+0.05)10 = $5,000 (1.628895) = $8,144.47 e. FV = $5,000 (1+0.025)20 = $5,000 (1.638616) = $8,193.08 From these answers we see that the future values of a security investment increase as interest rates increase. As rates rose from 6 percent to 8 percent, the (future) value of the security investment rose to $655.51 (from $6,691.13 to $7,346.). As interest rates rose from 8 percent to 10 percent, the value of the investment rose to $705.91 (from $7,346.64 to $8,052.55). This is because as interest rates increase, a stated amount of funds invested at the beginning of an investment horizon accumulates to a larger amount at the end of the investment horizon. Also as interest rates increase, the future values of the investment increase at an increasing rate. The rise in present value is greater when interest rates rise from 8 percent to 10 percent compared to when they rise from 6 percent to 8 percent. The positive relationship between interest rates and the future value of security investments is neither linear nor proportional. From the above answers, we also see that the greater the number of compounding periods per year, the greater the future value of a future amount. This is because, the greater the number of compounding periods the more frequently interest is paid and thus, a greater amount of interest that is paid. The greater the amount of interest paid and the greater the future value of a present amount. 24. a. PV = $5,000{[1 - (1/(1 + 0.06)5)]/0.06} = $5,000 (4.212364) = $21,061.82 b. PV = $5,000{[1 - (1/(1 + 0.015)20)]/0.015} = $5,000 (17.168639) = $85,843.19 c. PV = $5,000{[1 - (1/(1 + 0.06)5)]/0.06}(1 + .06) = $5,000 (4.212364)(1 + .06) = $22,325.53 d. PV = $5,000{[1 - (1/(1 + 0.015)20)]/0.015}(1 + .015) = $5,000 (17.168639)(1.015) = $87,130.84 25. a. FV = $5,000{[(1 + 0.06)5 -1]/0.06} = $5,000 (5.637092) = $28,185.46 b. FV = $5,000{[(1 + 0.015)20 -1]/0.015} = $5,000 (23.123667) = $115,618.34 c. FV = $5,000{[(1 + 0.06)5 -1]/0.06}(1 + 0.06) = $5,000 (5.637092)(1 + .06) = $29,876.59 d. FV = $5,000{[(1 + 0.015)20 -1]/0.015}(1 + 0.015) = $5,000 (23.123667)(1.015) = $117,352.61 26. FV = $123{[(1 + 0.13)13 -1]/0.13} = $3,688.12 FV = $123{[(1 + 0.13)13 -1]/0.13} (1 + 0.13/1) = $4,167.57 FV = $4,555{[(1 + 0.08)8 - 1]/0.08} = $48,449.84 FV = $4,555{[(1 + 0.08)8 - 1]/0.08}(1 + 0.08/1) = $52,325.83 FV = $74,484{[(1+0.10)5-1]/0.10} = $454,732.27 FV = $74,484{[(1+0.10)5-1]/0.10(1 + 0.10/1) = $500,205.50 FV = $167,332{[(1 + 0.01)9 - 1]/0.01} = $1,567,654.40 FV = $167,332{[(1 + 0.01)9 - 1]/0.01}(1 + 0.01/1) = $1,583,330.95 27. PV = $678.09{[1 - (1/(1 + 0.13)7)]/0.13} = $2,998.93 PV = $678.09{[1 - (1/(1 + 0.13)7)]/0.13}(1 + 0.13/1) = $3,388.79 PV = $7,968.26{[1 - (1/(1 + 0.06)13)]/0.06} = $70,540.48 PV = $7,968.26{[1 - (1/(1 + 0.06)13)]/0.06}(1 + 0.06/1) = $74,772.91 PV = $20,322.93{[1 - (1/(1 + 0.04)23)]/0.04} = $301,934.55 PV = $20,322.93{[1 - (1/(1 + 0.04)23)]/0.04}(1 + 0.04/1) = $314,011.94 PV = $69,712.54{[1 - (1/(1 + 0.31)4)]/0.31} = $148,519.49 PV = $69,712.54{[1 - (1/(1 + 0.31)4)]/0.31}(1 + 0.31/1) = $194,560.54 28. FV = $500 (1.06)3 = $595.51. So, the interest portion is $95.51 = $595.51 − $500.

29. PV = $2,000/(1.08)4 = $1,470.06 30. PV = -$1,200 = $2,000/(1.075)t => Using a financial calculator, I = 7.5, PV= -1,200, PMT = 0, FV = 2,000, then compute N = 7.06 years 31. FV = $1,000{[(1 + 0.10)6 - 1]/0.10}(1 + 0.10) = $8,487.17 or using a financial calculator, N = 6, I = 10, PV = 0, PMT = -1,000, then compute FV = $7,715.61, then multiply $7,715.61 × (1+0.10) = $8,487.17. 32. PV = $180,000 = PMT{[1 - (1/(1 + 0.08/12)15x12)]/(0.08/12)} = $1,720.17 or using a financial calculator, N = 15x12 = 180, I = 8÷12 = .66667, PV = -180,000, FV = 0, then compute PMT = $1,720.17

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 3 Questions: 1. The required rate of return is the interest rate an investor should receive on a security given its risk. Required rate of return is used to calculate the fair present value on a security. The expected rate of return is the interest rate an investor expects to receive on a security if he or she buys the security at its current market price, receives all expected payments, and sells the security at the end of his or her investment horizon. 2. Once an expected rate of return, E(r), on a financial security is calculated, the market participant compares this expected rate of return to its required rate of return (r). If the expected rate of return is greater than the required rate of return, the projected cash flows on the security are greater than is required to compensate for the risk incurred from investing in the security and the current market price is less than the fair market price of the security. Thus, the market participant would want to buy more of this security. If the expected rate of return is less than the required rate of return, the projected cash flows from the security are less than those required to compensate for the risk involved and the current market price is greater than the fair market price of the security. Thus, the market participant would not want to invest in the security. 3. Most bonds pay a stated coupon rate of interest to the holders of the bonds. These bonds are called coupon bonds. The interest, or coupon, payments per year are generally constant (are fixed) over the life of the bond. Thus, the fixed interest payment is essentially an annuity paid to the bond holder periodically (normally semiannually) over the life of the bond. Bonds that do not pay coupon interest are called zero-coupon bonds. For these bonds interest payments are zero. 4.

a. Premium bond b. Par bond c. Discount bond d. Discount bond e. Premium bond f. Discount bond

5. Most bonds pay a stated coupon rate of interest to the holders of the bonds. The interest, or coupon, payments per year are generally constant (fixed) over the life of the bond. Thus, the fixed interest payment is essentially an annuity paid to the bond holder periodically (normally semiannually) over the life of the bond. In addition to coupon payments, the face or par value of the bond is a lump sum payment received by the bond holder when the bond matures. Face value is generally set at $1,000 in the U.S. bond market. In contrast, the valuation process for an equity instrument (such as common stock or a share) involves finding the present value of an infinite series of unequal cash flows on the equity discounted at an appropriate interest rate. Cash flows from holding equity come from dividends paid out by the firm over the life of the stock, which in expectation can be viewed as infinite since a firm (and thus the dividends it pays) has no defined maturity or life. Even if an equity holder decides not to hold the stock forever, he or she can sell it to someone else who in a fair and efficient market is willing to pay the present value of the remaining (expected) dividends to the seller at the time of sale. 6. The present values of the cash flows on bonds decreases as the required rate of return increases. This is the inverse relationship between present values and interest rates we discussed in Chapter 2. While the examples in the chapter refer to the relation between fair present values and required rates of returns, the inverse relation also exists between current market prices and expected rates of return—as yields on bonds increase, the current market prices of bonds decrease. The relationship between bond prices and the required rate of return is not linear. Rather, the percentage change in the present value of a bond to a given change in the required rate of return is smaller when interest rates are higher. The same nonlinear relation exists for current market prices and yield to maturities. Thus, as interest rates increase, present values of bonds (and bond prices) decrease at a decreasing rate. 7. All else equal, a long-term bond experiences larger price changes when interest rates change than a short-term bond. A bond’s price is the present value of all its cash flows. Changes in the discount rate (the interest rate) impact present values more for cash flows that are further out in time. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 8. The price of the bond with the small coupon will be impacted more by a change in interest rates than the price of the large coupon bond. For a small coupon bond, the cash flows are weighted much more toward the maturity date because of the small interest payments. The large coupon bond has high interest payments, many of which occur soon. These higher cash flows made earlier dampen the impact of interest rate changes because those changes in the discount rate impact the earlier cash flows to a lesser degree than the later cash flows. 9. Duration is the elasticity, or sensitivity, of the bond’s price to small interest rate (either required rate of return or yield to maturity) changes, and is represented as follows: -D = [P/P]/[rb/(1+ rb)] The negative sign in front of the D indicates the inverse relationship between interest rate changes and price changes. That is, -D describes the percentage value decrease —capital loss—on the security (P/P) for any given (discounted) small increase in interest rates (rb /(1 + rb)), where rb is the change in interest rates and 1 + rb is 1 plus the current (or beginning) level of interest rates. In other words, if duration is known, then the change in the price of a bond due to a small change in interest rates, rb, can be estimated using the above formula. 10. The higher the coupon or promised interest payment on the bond, the shorter its duration. This is due to the fact that the larger the coupon or promised interest payment, the more quickly investors receive cash flows on a bond and the higher are the present value weights of those cash flows in the duration calculation. On a time value of money basis, the investor recoups his or her initial investment faster when coupon payments are higher. 11. The 8 percent yield to maturity bond has the longer duration. This is because duration decreases as rate of return increases. This makes intuitive sense since the higher the rate of return on the bond, the lower the present value cost of waiting to receive the later cash flows on the bond. Higher rates of return discount later cash flows more heavily, and the relative importance, or weights, of those later cash flows decline when compared to cash flows received earlier. 12. Duration, which measures the weighted-average time to maturity of the asset or liability, also has economic meaning as the sensitivity (or elasticity) of that asset’s or liability’s value to small interest rate changes (either required rate of return or yield to maturity). That is, duration describes the percentage price, or present value, change of a financial security for a given (small) change in interest rates. Problems: 1. 935 = 75{[1 - (1/(1 +

´ 5 ´ r ) )]/ r } + 980/(1 +

´ 5 ´ r ) => r

= 8.83%

Or, on a financial calculator: N = 5, PV = -935, PMT = 75, FV = 980, => I =

´ r

= 8.83%

2. 980 = 75{[1 - (1/(1 + E(rb))3)]/E(rb)} + 990/(1 + E(rb))3 => E(rb) = 7.97% Or, on a financial calculator: N = 3, PV = -980, PMT = 75, FV = 990, => I = E(r) = 7.97% 3. Vb = 1,000(0.08) {[1 - (1/(1 + 0.09)10)]/0.09} + 1,000(1 + 0.09)10 = $935.82 Or, on a financial calculator: N = 10, I = 9, PMT = 80, FV = 1,000, => PV = $935.82 4. EXCEL Problem:

Bond Value (required return = 5%) = $1,268.27 Bond Value (required return = 6%) = $1,169.36 Bond Value (required return = 8%) = $1,000.00 Bond Value (required return = 10%) = $862.01

5. $1,100 = 1,000(0.12) {[1 - (1/(1 + ytm/2)2(10))]/ytm/2} + 1,000/(1 + ytm/2)2(10) => ytm = 10.37% Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 2 Or, on a financial calculator: N = 20, PV= -1,100, PMT = 60, FV = 1,000, => I = ytm = 5.185% for 6 months or 10.37% per year 6. EXCEL Problem:

Yield to Maturity (current market value = $945.50) = 9.87% Yield to Maturity (current market value = $987.50) = 9.19% Yield to Maturity (current market value = $1,090.00) = 7.69% Yield to Maturity (current market value = $1,225.875) = 5.97%

7. Vb = 1,000(0.07) {[1 - (1/(1 + 0.14/4)4(4))]/0.14/4} + 1,000/(1 + 0.14/4)4(4) = $788.35 4 Or, on a financial calculator: N = 16, I = 3.5, PMT = 17.5, FV = 1,000, => PV = $788.35 8.

$863.73 = 1,000(0.08) {[1 - (1/(1 + 0.10)n)]/0.10} + 1,000/(1 + 0.10)n => n = 12 years Or, on a financial calculator: I = 10, PV = -863.73, PMT = 80, FV = 1,000, => n = 12 years

9. a. Vb = 1,000(0.10) {[1 - (1/(1 + 0.06/2)2(10))]/(0.06/2)} + 1,000/(1 + 0.06/2)2(10) = $1,297.55 2 On a financial calculator: N = 20, I = 3, PMT = 50, FV = 1,000, => PV = $1,297.55 b. Vb = 1,000(0.10) {[1 - (1/(1 + 0.08/2)2(10))]/(0.08/2)} + 1,000/(1 + 0.08/2)2(10) = $1,135.90 2 On a financial calculator: N = 20, I = 4, PMT = 50, FV = 1,000, => PV = $1,135.90 c. From parts a. and b. of this problem, there is a negative relation between required rates of return and fair values of bonds. 10. a. 985 = 1,000(0.09) {[1 - (1/(1 + ytm/2)2(15))]/ytm/2} + 1,000/(1 + ytm/2)2(15) => ytm = 9.186% 2 On a financial calculator: N = 30, PV= -985, PMT = 45, FV = 1,000, => I = ytm = 4.593% for 6 months or 9.186% per year b. 915 = 1,000(0.08) {[1 - (1/(1 + ytm/4)4(10))]/ytm/4} + 1,000/(1 + ytm/4)4(10) => ytm = 9.316% 4 On a financial calculator: N = 40, PV= -915, PMT = 20, FV = 1,000, => I = ytm = 2.329% for 3 months or 9.316% per year c. 1,065 = 1,000(0.11) {[1-(1/(1 + ytm)6)]/ytm} + 1,000/(1 + ytm)6 => ytm = 9.528% On a financial calculator: N = 6, PV= -1,065, PMT = 110, FV = 1,000, => I = ytm = 9.528% 11. a. Vb = 1,000(0.06) {[1 - (1/(1 + 0.10/2)2(12))]/(0.10/2)} + 1,000/(1 + 0.10/2)2(12) = $724.03 2 On a financial calculator: N = 24, I = 5, PMT = 30, FV = 1,000, => PV = $724.03 b. Vb = 1,000(0.08) {[1 - (1/(1 + 0.10/2)2(12))]/(0.10/2)} + 1,000/(1 + 0.10/2)2(12) = $862.01 2 On a financial calculator: N = 24, I = 5, PMT = 40, FV = 1,000, => PV = $862.01 c. Vb = 1,000(0.10) {[1 - (1/(1 + 0.10/2)2(12))]/(0.10/2)} + 1,000/(1 + 0.10/2)2(12) = $1,000.00 2 On a financial calculator: N = 24, I = 5, PMT = 50, FV = 1,000, => PV = $1,000.00 d. From parts a. through c. in this problem, there is a positive relation between coupon rates and present values of bonds.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 12. a. Vb = 1,000(0.06) {[1 - (1/(1 + 0.08/2)2(12))]/(0.08/2)} + 1,000/(1 + 0.08/2)2(12)= $847.53 2 On a financial calculator: N = 24, I = 4, PMT = 30, FV = 1,000, => PV = $847.53 b. Vb = 1,000(0.08) {[1 - (1/(1 + 0.08/2)2(12))]/(0.08/2)} + 1,000/(1 + 0.08/2)2(12) = $1,000.00 2 On a financial calculator: N = 24, I = 4, PMT = 40, FV = 1,000, => PV = $1,000.00 % change in bond value versus part (a) = ($1,000 - $847.53)/$847.53 = 17.99% c. Vb = 1,000(0.10) {[1 - (1/(1 + 0.08/2)2(12))]/(0.08/2)} + 1,000/(1 + 0.08/2)2(12) = $1,152.47 2 On a financial calculator: N = 24, I = 4, PMT = 50, FV = 1,000, => PV = $1,152.47 % change in bond value versus part (b) = ($1,152.47 - $1,000)/$1,000 = 15.25% From these results we see that as coupon rates increase, price volatility decreases. 13. a. Vb = 1,000(0.10) {[1 - (1/(1 + 0.08/2)2(10))]/(0.08/2)} + 1,000/(1 + 0.08/2)2(10) = $1,135.90 2 On a financial calculator: N = 20, I = 4, PMT = 50, FV = 1,000, => PV = $1,135.90 b. Vb = 1,000(0.10) {[1-(1/(1 + 0.08/2)2(15))]/(0.08/2)} + 1,000/(1 + 0.08/2)2(15) = $1,172.92 2 On a financial calculator: N = 30, I = 4, PMT = 50, FV = 1,000, => PV = $1,172.92 c. Vb = 1,000(0.10) {[1 - (1/(1 + 0.08/2)2(20))]/(0.08/2)} + 1,000/(1 + 0.08/2)2(20) = $1,197.93 2 On a financial calculator: N = 40, I = 4, PMT = 50, FV = 1,000, => PV = $1,197.93 d. From these results we see that there is a positive relation between time to maturity and the difference between present values and face values on bonds. 14. a. Vb = 1,000(0.10) {[1 - (1/(1 + 0.11/2)2(10))]/(0.11/2)} + 1,000/(1 + 0.11/2)2(10) = $940.25 2 On a financial calculator: N = 20, I = 5.5, PMT = 50, FV = 1,000, => PV = $940.25 % change in bond value = ($940.25 - $1,135.90)/$1,135.90 = -17.22% b. Vb = 1,000(0.10) {[1 - (1/(1 + 0.11/2)2(15))]/(0.11/2)} + 1,000/(1 + 0.11/2)2(15) = $927.33 2 On a financial calculator: N = 30, I = 5.5, PMT = 50, FV = 1,000, => PV = $927.33

% change 3.72%

% change in bond value = ($927.33 - $1,172.92)/$1,172.92 = -20.94% c. Vb = 1,000(0.10) {[1 - (1/(1 + 0.11/2)2(20))]/(0.11/2)} + 1,000/(1 + 0.11/2)2(20) = $919.77 2 On a financial calculator: N = 40, I = 5.5, PMT = 50, FV = 1,000, => PV = $919.77

% change 2.28%

% change in bond value = ($919.77 - $1,197.93)/$1,197.93 = -23.22% As interest rates increase the variability in bond prices increases as time to maturity increases but at a decreasing rate. 15. Price before the change in interest rates: Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Vb = 1,000(0.06) {[1 - (1/(1 + 0.05/2)2(5))]/(0.05/2)} + 1,000/(1 + 0.05/2)2(5) = $1,043.76 2 On a financial calculator: N = 10, I = 2.5, PMT = 30, FV = 1,000 => PV = $1,043.76 Price after the change in interest rates: Vb = 1,000(0.06) {[1 - (1/(1 + 0.055/2)2(5))]/(0.055/2)} + 1,000/(1 + 0.055/2)2(5) = $1,021.60 2 On a financial calculator: N = 10, I = 2.75, PMT = 30, FV = 1,000 => PV = $1,021.60. Or, the bond decreases in price by $22.16. 16. Vb = 945.80 = 1,000(0.09) {[1 - (1/(1 + ytm/2)2(7))]/ytm/2} + 1,000/(1 + ytm/2)2(7) => ytm = 10.099% 2 On a financial calculator: N = 14, PV= -945.80, PMT = 45, FV = 1,000, => I = ytm = 5.049% for 6 months or 10.10% per year 17.

P0 = 5/0.10 = $50

18.

P0 = 2.10/0.054 = $38.89

19.

P0 = 3.50/0.068 = $51.47

20.

Po = 1.20(1 + 0.10) = $66.00 0.12 - 0.10

21.

Po = 0.60(1 + 0.125) = $33.75 0.145 - 0.125

22. a.

Po = 2.50(1 + 0.015) = $24.167 0.12 - 0.015

P4 = 2.50(1 + 0.015)5 = $19.95 0.15 - 0.015

23. a.

E(rs) = 4.50 + 0.03 = 10.03% 64

b. E(rs) = 4.50 + 0.05 = 12.03% 64 c. From parts a. and b. of this problem, there is a positive relation between the dividend growth rate and the expected rate of return on stocks. 24. Step 1: Find the present value of dividends during the period of supernormal growth. Year 1 2 3 4 5 6

Dividends (D0(1 + gs)t) 5.5(1 + 0.08)1 = 5.940 5.5(1 + 0.08)2 = 6.415 5.5(1 + 0.08)3 = 6.928 5.5(1 + 0.08)4 = 7.483 5.5(1 + 0.08)5 = 8.081 5.5(1 + 0.08)6 = 8.728

1/(1 + 0.10)t 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645

Present Value 5.400 5.302 5.205 5.111 5.018 4.927

Present value of dividends during supernormal growth period $30.963 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Step 2: Find present value of dividends after period of supernormal growth a. Find stock value at beginning of constant growth period P6 = D7 = D0(1 + gs)6(1 + g)1 = 5.5 (1 + 0.08 )6(1 + 0.03)1 = $128.423 rs - g rs - g 0.10 - 0.03 b. Find present value of constant growth dividends P0 = P6/(1 + 0.10)6 = 128.423(0.5645) = $72.492 Step 3: Find present value of stock = value during supernormal growth period + value during normal growth period $30.963 + $72.492 = $103.455 25.

E(rs) = 0.46(1 + 0.145) + 0.145 = 15.69% 44.12

26.

E(rs) = 0.84(1 + 0.15) + 0.15 = 17.41% 40.11

27.

P0 = $41.30 = ($1.32 × (1 + 0.095))/(0.13 − 0.095)

28.

E(rs) = 12.09% = [$0.35 × (1 + 0.105)/ $24.25] + 0.105

29. a.

Year 1 2

Cash Flows (CF) 100 1,100

1/(1 + 0.12)t 0.8929 0.7972

PV of CF 89.29 876.91 966.20

PV of CF  t 89.29 1,753.83 1,843.12

Duration = $1,843.12/$966.20 = 1.9076 years b. The duration of a two-year zero coupon bond is 2 years. c. Duration always will be lower than the maturity for a coupon bond. That is because duration takes into account the timing of cash flows. The only time duration equals maturity is when there is only one single payment, as is the case with zero-coupon bonds. 30. a. The value of the Bank 1’s loan is $945,737.57 = 120,000 {[1 - (1/(1 + 0.12)10)]/0 .12} + 1,000,000/(1 + 0.12)10 On a financial calculator: N = 10, I = 12, PMT = 120,000, FV = 1,000,000 => PV = 1,000,000 If interest rates rise by 1%, the value of the Bank 1’s loan will be $945,737.57 = 120,000 {[1 - (1/(1 + 0.13)10)]/0.13} + 1,000,000/(1 + 0.13)10 On a financial calculator: N = 10, I = 13, PMT = 120,000, FV = 1,000,000 => PV = $945,737.57. The value of the CD is $1,000,000 = 100,000{[1 - (1/(1 + 0.10)10)]/0.10} + 1,000,000/(1 + 0.10)10 On a financial calculator: N = 10, I = 11, PMT = 100,000, FV = 1,000,000 => PV = $941,107.68 If interest rates rise by 1%, the value of the CD will be $941,107.68 = 100,000{[1 - (1/(1 + 0.11)10)]/0.11} + 1,000,000/(1 + 0.11)10 On a financial calculator: N = 10, I = 11, PMT = 100,000, FV = 1,000,000 => PV = $941,107.68 The difference in the changes in the assets ($54,262.43) and liabilities ($58,892.32) is $4,629.89. The asset decreased in value by less than the liability. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e The value of Bank 2’s the zero-coupon bond is $894,006.20 = 1,976,362.88/(1 + 0.12)7 On a financial calculator: N = 7, I = 12, PMT = 0, FV = 1,000,000 => PV = $894,006.20 The value of Bank 2’s the zero-coupon bond when rates rise by 1% is $840,074.08 = 1,976,362.88/(1 + 0.13)7 On a financial calculator: N = 7, I = 13, PMT = 0, FV = 1,000,000 => PV = $840,074.08 The value of the CD before the interest change is $894,006.22 = 82,750{[1 - (1/(1 + 0.10)10)]/0.11} + 1,000,000/(1 + 0.10)10 On a financial calculator: N = 10, I = 10, PMT = 82,750, FV = 1,000,000 => PV = $894,006.22 The value of the CD after the interest change is $839,518.43 = 82,750{[1 - (1/(1 + 0.11)10)]/0.11} + 1,000,000/(1 + 0.11)10 On a financial calculator: N = 10, I = 11, PMT = 82,750, FV = 1,000,000 => PV = $839,518.43 The value of the Bank 2’s zero-coupon bond was $1,976,362.88 and is now $840,074.08. The value of the Bank 2’s CD was $894,006.22 and is now $839,518.43. The difference in the changes in the assets ($53,932.12) and liabilities ($54,487.79) is $555.67. b. Although the numbers are a bit contrived, the point of the problem is to show that in part a, even though Bank 1’s assets and liabilities had the same face values and maturities, they have different durations and so the changes in prices because of a change in interest rates was different for the assets compared to the liability. Bank 2’s assets and liabilities have the same current values, but different maturities. But students can verify that the duration of the asset is about the same as the duration of the liability. Consequently, a one percent change in interest rates produces approximately the same change in the prices of the asset and liability. 31. Coupon Bond: Par value = $1,000,

Coupon rate = 10%, annual payments, rb = 8%, Maturity = 2 years

CF/(1 + 0.08)t

PV of CF × t

1 2

$100 1,100

$92.59 943.07 $1,035.67

$92.59 1,886.15 $1,978.74

Duration = $1,978.74/$1,035.67 = 1.9106

If rb = 10% t

CF/(1 + 0.10)t

PV of CF × t

1 2

$100 1,100

$90.91 909.09 $1,000.00

$90.91 1,818.18 $1,909.09

Duration = $1,909.09/$1,000.00 = 1.9091

If rb = 12% t

CF/(1 + 0.12)t

PV of CF × t

1 2

$100 1,100

$89.29 876.91 $966.20

$89.23 1,753.83 $1,843.11

Duration = $1,843.11/$966.20 = 1.9076

b. Increasing the yield to maturity decreases the duration of the bond. c. Zero Coupon Bond: Par value = $1,000, Coupon rate = 0%, rb = 8%, Maturity = 2 years t

CF/(1 + 0.08)t

PV of CF × t

$1,000

$857.34

$1,714.68

$857.34

$1,714.68

Duration = $1,714.68/$857.34 = 2.0000

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e t

CF/(1 + 0.10)t

PV of CF × t

$1,000

$826.45

$1,652.89

$826.45

$1,652.89

Duration = $1,652.89/$826.45 = 2.0000

If rb = 12% t

CF/(1 + 0.12)t

PV of CF × t

$1,000

$797.19

$1,594.39

$797.19

$1,594.39

Duration = $1,594.39/$797.19 = 2.0000

d. Changing the yield to maturity does not affect the duration of the zero coupon bond. e. Increasing the yield to maturity on the coupon bond allows for a higher reinvestment income that more quickly recovers the initial investment. The zero-coupon bond has no cash flow until maturity. 32. Five-year Treasury Bond: Par value = $1,000, Coupon rate = 10%, semiannual payments, rb = 10%, Maturity = 5 years t 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5

CF $50 $50 $50 $50 $50 $50 $50 $50 $50 $1,050

CF/(1 + 0.10/2)t(2)

PV of CF × t

$47.62 $45.35 $43.19 $41.14 $39.18 $37.31 $35.53 $33.84 $32.23 $644.61 $1,000.00

$23.81 $45.35 $64.79 $82.27 $97.94 $111.93 $124.37 $135.37 $145.04 $3,223.04 $4,053.91

Duration = $4,053.91/$1,000.00 = 4.0539

CF/(1 + 0.12/2)t(2) $47.17 $44.50 $41.98 $39.60 $37.36 $35.25 $33.25 $31.37 $29.59 $586.31 $926.40

PV of CF × t $23.58 $44.50 $62.97 $79.21 $93.41 $105.74 $116.38 $125.48 $133.18 $2,931.57 $3,716.03

Duration = $3,716.03/$926.40 = 4.0113

CF/(1 + 0.14/2)t(2) $46.73 $43.67 $40.81 $38.14 $35.65 $33.32 $31.14 $29.10

PV of CF × t $23.36 $43.67 $61.22 $76.29 $89.12 $99.95 $108.98 $116.40

If rb = 12% t 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5

CF $50 $50 $50 $50 $50 $50 $50 $50 $50 $1,050

If rb = 14% t 0.5 1 1.5 2 2.5 3 3.5 4

CF $50 $50 $50 $50 $50 $50 $50 $50

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 4.5 $50 5 $1,050

$27.20 $533.77 $859.53

$122.39 $2,668.83 $3,410.22

Duration = $3, 410.22/$859.53 = 3.9676

Duration and YTM 4.08 4.04 Years

4.0539 4.0113

4.00 3.9676 3.96 3.92 0.12000000000000002 0.1 0.14000000000000001 Yield to Maturity

Increasing the yield to maturity on the coupon bond allows for a higher reinvestment income that more quickly recovers the initial investment and, thus, lowers the duration of the bond. 33. a. Vb = 1,000(0.12) {[1 - (1/(1 + 0.10)12)]} + 1,000/(1 + 0.10)12 = $1,136.27 On a financial calculator: N = 12, I = 10, PMT = 120, FV = 1,000, => PV = $1,136.27 b. Vb = 1,000(0.12) {[1 - (1/(1 + 0.11)12)]} + 1,000/(1 + 0.11)12 = $1,064.92 On a financial calculator: N = 12, I = 11, PMT = 120, FV = 1,000, => PV = $1,064.92 c. Vb = ($1,064.92 - $1,136.27)/$1,136.27 = -0.0628 or -6.28 percent. d. Vb = 1,000(0.12) {[1 - (1/(1 + 0.10)16)]} + 1,000/(1 + 0.10)16 = $1,156.47 On a financial calculator: N = 16, I = 10, PMT = 120, FV = 1,000, => PV = $1,156.47 Vb = 1,000(0.12) {[1 - (1/(1 + 0.11)16)]} + 1,000/(1 + .11)16 = $1,073.79 On a financial calculator: N = 16, I = 11, PMT = 120, FV = 1,000, => PV = $1,073.79 Vb = ($1,073.79 - $1,156.47)/$1,156.47 = -0.0715 or -7.15 percent. e. For the same change in interest rates, longer-term fixed-rate assets experience a greater change in price. 34. a. Vb = 1,000(0.15) {[1 - (1/(1 + 0.12)5)]} + 1,000/(1 + 0.12)12 = $1,108.14 On a financial calculator: N = 5, I = 12, PMT = 150, FV = 1,000, => PV = $1,108.14 b. Vb = 1,000(0.15) {[1 - (1/(1 + 0.13)5)]} + 1,000/(1 + 0.13)12 = $1,070.34 On a financial calculator: N = 5, I = 13, PMT = 150, FV = 1,000, => PV = $1,070.34 c. Vb = ($1,070.34 - $1,108.14)/$1,108.14 = -0.0341 or -3.41 percent. d. Vb = 1,000(0.15) {[1 - (1/(1 + 0.11)5)]} + 1,000/(1 + 0.11)12 = $1,147.84 On a financial calculator: N = 5, I = 11, PMT = 150, FV = 1,000, => PV = $1,147.84 Vb = ($1,147.84 - $1,108.14)/$1,108.14 = 0.0358 or 3.58 percent e. For a given percentage change in interest rates, the absolute value of the increase in price caused by a decrease in Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e rates is greater than the absolute value of the decrease in price caused by an increase in rates. 35. a.

D = 4.05 years

time 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0

cash flow 50 50 50 50 50 50 50 50 50 1,050

(1 + 0.10/2)t(2) 0.9524 0.9070 0.8638 0.8227 0.7835 0.7462 0.7107 0.6768 0.6446 0.6139

CF/(1 + 0.10/2)t(2) 47.620 45.350 43.190 41.135 39.175 37.310 35.535 33.842 32.230 644.595 1,000.00

PV of CF × t 23.810 45.350 64.785 82.270 97.937 111.930 124.373 135.368 145.035 3,222.975 4,053.833

b. Duration for a 14% yield to maturity = 3409.95/859.53 = 3.97 years Duration for a 16% yield to maturity = 3133.14/798.7 = 3.92 years c. From this we see that as yield to maturity increases, duration decreases. 36. a.

D = 3,393.18/1,000 = 3.39 years

Time 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

Cash Flow 50 50 50 50 50 50 50 1,050

1/(1 + 0.10/2)t(2) 0.9524 0.9070 0.8638 0.8227 0.7835 0.7462 0.7107 0.6768

CF/(1 + 0.10/2)t(2) 47.62 45.35 43.19 41.14 39.18 37.31 35.53 710.68 $1,000.00

PV of CF × t 23.81 45.35 64.79 82.27 97.94 111.93 124.37 2,842.72 $3,393.18

b. Duration on a 3-year bond = 2,664.74/1,000 = 2.66 years, a decrease of 0.73 years. c. Duration on a 2-year bond = 1,861.62/1,000 = 1.86 years, a decrease of 0.80 years. d. As maturity increases, duration increases but at a decreasing rate. 37.

38. a. time 1.0 2.0 3.0 4.0 5.0

D = 8 years D = 10 years D = 12 years cash flow 137.6 137.6 137.6 137.6 1,137.6

(1 + 0.10)t 0.9091 0.8264 0.7513 0.6830 0.6209

CF/(1 + 0.10)t 125.091 113.719 103.381 93.983 706.360 $1,142.534

PV of CF × t 125.091 227.438 310.143 375.931 3,531.800 $4,570.403

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Duration = 4,570.403/1,142.534 = 4 years b. The cash flows from this investment during the four-year investment horizon will be -$1,142.534 at time zero + 137.6 × {[(1 + 0.11)4 - 1]/0.11} for the future value of the interest payment reinvested at 11% + 1,024.87 the present value of $1,000 + $137.6 at the 11% discount rate. The three cash flows are $1,142.53 at time 0, and $648.06 + $1,024.87 at time 4. These cash flows produce a return of 10%. 39. a. time 1.0 2.0 3.0 4.0 5.0

cash flow 800 800 800 800 10,800

(1 + 0.10)t 0.9091 0.8264 0.7513 0.6830 0.6209

CF/(1 + 0.10)t 727.27 661.16 601.05 546.41 6705.95 $9,241.84

PV of CF × t 727.27 1322.31 1803.16 2185.64 33,529.75 $39,568.13

Duration = 39,568.13/9,24184 = 4.28 years b. Duration on 10% coupon bond = 4.17 years c. Duration on 12% coupon bond = 4.07 years 40.

At +0.10%: Pb = 1,000(0.08) {[1 - (1/(1 + 0.081)30)]} + 1,000/(1 + 0.081)30 = $988.85 On a financial calculator: N = 30, I = 8.1, PMT = 80, FV = 1,000, => PV = $988.85 At –0.10%: Pb = 1,000(0.08) {[1 - (1/(1 + 0.079)30)]} + 1,000/(1 + 0.079)30 = $1,011.36 On a financial calculator: N = 30, I = 7.9, PMT = 80, FV = 1,000, => PV = $1,011.36 At +2.0%: Pb = 1,000(0.08) {[1 - (1/(1 + 0.10)30)]} + 1,000/(1 + 0.10)30 = $811.46 On a financial calculator: N = 30, I = 10, PMT = 80, FV = 1,000, => PV = $811.46 At –2.0%: Pb = 1,000(0.08) {[1 - (1/(1 + 0.06)30)]} + 1,000/(1 + 0.06)30 = $1,275.30 On a financial calculator: N = 30, I = 10, PMT = 80, FV = 1,000, => PV = $1,275.30 Pb = -D × [rb/(1+ rb)] × Pb

b. At +0.10%: At -0.10%:

Pb = -12.1608 × 0.001/1.08 × $1,000 = -$11.26 => Pb = $988.74 Pb = -12.1608 × (-0.001/1.08) × $1,000 = $11.26 => Pb = $1,011.26

At +2.0%: At -2.0%:

Pb = -12.1608 × 0.02/1.08) × $1,000 = -$225.20 => Pb = $774.80 Pb = -12.1608 × (-0.02/1.08) × $1,000 = $225.20 => Pb = $1,225.20

At +0.10%: At -0.10%: At +2.0%: At -2.0%:

Price - market determined $988.85 $1,011.36 $811.46 $1,275.30

Price - duration estimation $988.74 $1,011.26 $774.80 $1,225.20

Amount of error $0.11 $0.10 $36.66 $50.10

41. We know -D = [Pb/Pb]/[rb/(1+ rb)], so -D = (20/975)/(-0.005/1.0975) =- 4.5 years; D = 4.5 years.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 4 Questions: 1. As part of the Federal Reserve System, Federal Reserve Banks perform multiple functions. These include assistance in the conduct of monetary policy, supervision and regulation of member banks and other large financial institutions, consumer protection, and the provision of services, such as new currency issue, check clearing, wire transfer services, and research services to either the federal government or member banks. We summarize each function as follows. Assistance in the Conduct of Monetary Policy: Federal Reserve Bank (FRB) presidents serve on the Federal Open Market Committee (FOMC). FRBs set and change discount rates. Supervision and Regulation: FRBs have supervisory and regulatory authority over the activities of banks and other large financial institutions located in their district. Consumer Protection and Community Affairs: FRBs write regulations to implement many of the major consumer protection laws and establish programs to promote community development and fair and impartial access to credit. Government Services: FRBs serve as the commercial bank for the U.S. Treasury. New Currency Issue: FRBs are responsible for the collection and replacement of damaged currency from circulation. Check Clearing: FRBs process, route, and transfer funds from one bank to another as checks clear through the Federal Reserve System. Wire Transfer Services: FRBs and their member banks are linked electronically through the Federal Reserve Communications System. Research Services: Each FRB has a staff of professional economists who gather, analyze, and interpret economic data and developments in the banking sector in their district and economy wide. 2. The discount rate is the interest rate on loans made by Federal Reserve Banks to financial institutions. These loans are transacted through each Federal Reserve Bank’s discount window and involve the discounting of eligible short-term securities in return for cash loans. 3. The Federal Reserve System is divided into 12 Federal Reserve districts as shown in Figure 4-1. Each district has one main Federal Reserve Bank, some of which also have branches in other cities within the district. In terms of total assets, the three largest Federal Reserve Banks are the New York, San Francisco, and Richmond banks. Together these three banks hold over 65 percent of the total assets of the Federal Reserve System. The Federal Reserve Bank of New York is generally considered the most important of the Federal Reserve Banks because so many of the largest U.S. and international banks are located in the New York district (the so-called money center banks). Further, the Federal Reserve’s Trading Desk is located at the FRBNY which carries out all the open market purchases for the Federal Reserve. Federal Reserve Banks operate under the general supervision of the Board of Governors of the Federal Reserve based in Washington D.C. Each Federal Reserve Bank has its own nine-member Board of Directors that oversee its operations: six are elected by member banks in the district (three are professional bankers and three are business people) and three are appointed by the Federal Reserve Board of Governors (directors in this group are prohibited from being employees, officers, or stockholders of a member bank). These nine directors are responsible for appointing the president of their Federal Reserve Bank. 4. The primary responsibilities of the Federal Reserve Board are the formulation and conduct of monetary policy and the supervision and regulation of banks. All seven Board members sit on the Federal Open Market Committee which makes key decisions affecting the availability of money and credit in the economy. The Federal Reserve Board also has primary responsibility for the supervision and regulation of i) all bank holding companies (their nonbank subsidiaries and their foreign subsidiaries), ii) state chartered banks that are members of the Federal Reserve System (state chartered member banks) (their foreign branches and subsidiaries), and iii) Edge Act and agreement corporations (through which U.S. banks conduct foreign operations). The Fed also shares supervisory and regulatory responsibilities with state supervisors and other federal supervisors (e.g., the OCC, the FDIC), including overseeing both the operations of foreign banking organizations in the U.S. and the establishment, examination, and termination of branches, commercial lending subsidiaries, and representative offices of foreign banks in the U.S. The Board approves member bank mergers and acquisitions, and specifies permissible nonbank activities of bank Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e holding companies. The Board is also responsible for the development and administration of regulations governing the fair provision of consumer credit (e.g., the Truth in Lending Act, the Equal Credit Opportunity Act, etc.). Finally, the Wall Street Reform and Consumer Protection Act of 2010 provided unprecedented powers to the Federal Reserve, putting it in charge of monitoring any of the country’s biggest financial firms—those considered critical to the health of the financial system as a whole. 5. The main responsibilities of the FOMC are to formulate policies to promote full employment, economic growth, price stability, and a sustainable pattern of international trade. The FOMC seeks to accomplish this by setting guidelines regarding open market operations. Open market operations−the purchase and sale of U.S. government and federal agency securities−is the main policy tool that the Fed uses to achieve its monetary targets (although the operations themselves are normally carried out by traders at the Federal Reserve Bank of New York). The FOMC also sets ranges for the growth of the monetary aggregates and directs operations of the Federal Reserve in foreign exchange markets. In addition, although reserve requirements and the discount rate are not specifically set by the FOMC, their levels are monitored and guided by the FOMC. 6. The major liabilities on the Fed’s balance sheet are currency in circulation and reserves (depository institution reserve balances in accounts at Federal Reserve Banks plus vault cash on hand of commercial banks). Their sum is often referred to as the Fed’s monetary base or money base. Changes in these accounts are the major determinants of the size of the nation’s money supply. That is, increases (decreases) in either or both of these balances will lead to an increase (decrease) in the money supply. Reserve Deposits. The largest liability on the Federal Reserve’s balance sheet is depository institution reserves. All depository institutions hold reserve accounts at their local Federal Reserve Bank. These reserve holdings are used to settle accounts between depository institutions when checks and wire transfers are cleared. Reserve accounts also influence the size of the money supply. Currency Outside Banks. The second largest liability, in terms of percent of total liabilities and equity, of the Federal Reserve System is notes (bills) in circulation. At the top of each Federal Reserve note ($1 bill, $5 bill, $10 bill, etc.) is the seal of the Federal Reserve Bank that issued it. Federal Reserve notes are basically IOUs from the issuing Federal Reserve Bank to the bearer. In the U.S., Federal Reserve notes are recognized as the principal medium of exchange, and therefore, function as money. 7. In the fall of 2008, the Federal Reserve implemented several measures to provide liquidity to financial markets that had frozen up as a result of the financial crisis. The liquidity facilities introduced by the Federal Reserve in response to the crisis created a large quantity of excess reserves at DIs. For example, in October 2008 the Federal Reserve began paying interest on excess reserves, for the first time. Further, during the financial crisis, the Fed set the interest rate it paid on excess reserves equal to its target for the fed funds rate. This policy essentially removed the opportunity cost of holding reserves. That is, the interest banks earned by holding excess reserves was approximately equal to what was previously earned by lending to other FIs. As a result, banks dramatically increased their holdings of excess reserves at Federal Reserve Banks. Because the U.S. economy was slow to recover from the financial crisis, the Fed kept the fed funds rate at historic lows through 2015. Thus, banks continued to hold large amounts of excess reserves. Depository institution reserves were 43.5 percent of total liabilities and equity of the Fed in 2016 and 37.9 percent in 2008. This is up from 2.2 percent in 2007, prior to the start of the financial crisis. Some observers claim that the large increase in excess reserves implied that many of the policies introduced by the Federal Reserve in response to the financial crisis were ineffective. Rather than promoting the flow of credit to firms and households, it was argued that the increase in excess reserves indicated that the money lent to banks and other FIs by the Federal Reserve in late 2008 and 2009 was simply sitting idle in banks’ reserve accounts. Many asked why banks were choosing to hold so many reserves instead of lending them out, and some claimed that banks’ lending of their excess reserves was crucial for resolving the credit crisis. In this case, the Fed’s lending policy generated a large quantity of excess reserves without changing banks’ incentives to lend to firms and households. Thus, the total level of reserves in the banking system is determined almost entirely by the actions of the central bank and is not necessarily affected by private banks’ lending decisions. 8. The major assets on the Federal Reserve’s balance sheet are Treasury securities, Treasury currency, and gold and foreign exchange. While interbank loans (loans to domestic banks) are quite a small portion of the Federal Reserve’s assets, they play an important role in implementing monetary policy. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Treasury Securities. Treasury securities are the largest asset on the Fed’s balance sheet in 2016 (54.2 percent of total assets). The represent the Fed’s holdings of securities issued by the U.S. Treasury (U.S. government). The Fed’s open market operations involve the buying and selling of these securities. An increase (decrease) in Treasury securities held by the Fed leads to an increase (decrease) in the money supply. U.S. Government Agency Securities. U.S. government agency securities are the second largest asset account on the Fed’s balance sheet in 2016 (39.2 percent of total assets). However, in 2007, this account was 0.0 percent of total assets. This account grew as the Fed took steps to improve credit market liquidity and support the mortgage and housing markets during the financial crisis by buying mortgage-backed securities backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Under the MBS purchase program, the FOMC called for the purchase of up to $1.25 trillion of agency MBS. The purchase activity began on January 5, 2009 and continued through 2016. Thus, the Fed expanded its role as purchaser/guarantor of assets in the financial markets. Gold and Foreign Exchange and Treasury Currency. The Federal Reserve holds Treasury gold certificates that are redeemable at the U.S. Treasury for gold. The Fed also holds small amounts of Treasury issued coinage and foreigndenominated assets to assist in foreign currency transactions or currency swap agreements with central banks of other nations. Interbank Loans. As mentioned earlier, in a liquidity emergency depository institutions in need of additional funds can borrow at the Federal Reserve’s discount window. The interest rate or discount rate charged on these loans is often lower than other interest rates in the short term money markets. To prevent excessive borrowing from the discount window, the Fed discourages borrowing unless a bank is in serious liquidity need. As a result, (discount) interbank loans are normally a relatively small portion of the Fed’s total assets. Miscellaneous assets. Generally, miscellaneous assets are a small portion of the Fed’s total assets (e.g., 4.8 percent in 2016). However, during the financial crisis, the Fed undertook a number of measures to support various sectors of the financial markets. For example, as mentioned above (and below), during the financial crisis the Fed provided AIG with a loan to prevent its failure, for the first time ever it lent funds through its discount window to brokers and dealers, and it committed over $1 trillion of loans to support the commercial paper market. These temporary programs were recorded as miscellaneous assets and as a result this item rose to 46.7 percent of total assets in 2008. 9. This account grew as the Fed took steps to improve credit market liquidity and support the mortgage and housing markets during the financial crisis by buying mortgage-backed securities backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Under the MBS purchase program, the FOMC called for the purchase of up to $1.25 trillion of agency MBS. The purchase activity began on January 5, 2009 and continued through 2016. Thus, the Fed expanded its role as purchaser/guarantor of assets in the financial markets. 10. The tools used by the Federal Reserve to implement its monetary policy include open market operations, the discount rate, and reserve requirements. Open market operations are the Federal Reserves’ purchases or sales of securities in the U.S. Treasury securities market. The discount rate is the rate of interest Federal Reserve Banks charge on loans to financial institutions in their district. Reserve requirements determine the minimum amount of reserve assets (vault cash plus bank deposits at Federal Reserve Banks) that depository institutions must maintain by law to back transaction deposits held as liabilities on their balance sheets. This requirement is usually set as a ratio of transaction accounts, e.g., 10 percent. 11. Changing the discount rate signals to the market and the economy that the Federal Reserve would like to see higher or lower rates in the economy. Thus, the discount rate is like a signal of the FOMC’s intention regarding the tenor of monetary policy. For example, raising the discount rate signals that the Fed would like to see a tightening of monetary conditions and higher interest rates in general (and a relatively lower amount of borrowing). Lowering the discount rate signals a desire to see more expansionary monetary conditions and lower interest rates in general. 12. For two reasons, the Federal Reserve rarely uses the discount rate as a monetary policy tool. First, it is difficult for the Fed to predict changes in bank discount window borrowing when the discount rate changes. There is no guarantee that FIs will borrow more (less at the discount window in response to a decrease (increase) in the discount rate. Thus, the exact effect of a discount rate change on the money supply is often uncertain, which increases the Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e probability of missing the target change in the money supply. Second, in addition to their effect on the money supply, discount rate changes often have great effects on the financial markets. For example, the decrease in the discount rate in December 16, 2008 resulted in a 359.61 point increase in the Dow Jones Industrial Average, one of the largest point gains in the history of the Dow, and one of a handful of up days during the height of the financial crisis. 13. Historically, discount window lending was limited only to depository institutions (DIs) with severe liquidity needs. The discount window rate, which was set below the fed funds rate, was charged on loans to depository institutions only under emergency or special liquidity situations. However, in January 2003, the Fed implemented changes to its discount window lending that increased the cost of borrowing but eased the terms. Specifically, three lending programs are now offered through the Feds discount window. Primary credit is available to generally sound depository institutions on a very short-term basis, typically overnight, at a rate above the Federal Open Market Committee's (FOMC) target rate for federal funds. Primary credit may be used for any purpose, including financing the sale of fed funds. Primary credit may be extended for periods of up to a few weeks to depository institutions in generally sound financial condition that cannot obtain temporary funds in the financial markets at reasonable terms. Secondary credit is available to depository institutions that are not eligible for primary credit. It is extended on a very short-term basis, typically overnight, at a rate that is above the primary credit rate. Secondary credit is available to meet backup liquidity needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution. Secondary credit may not be used to fund an expansion of the borrower’s assets. The Federal Reserve's seasonal credit program is designed to assist small depository institutions in managing significant seasonal swings in their loans and deposits. Seasonal credit is available to depository institutions that can demonstrate a clear pattern of recurring intra-yearly swings in funding needs. Eligible institutions are usually located in agricultural or tourist areas. Under the seasonal program, borrowers may obtain longer term funds from the discount window during periods of seasonal need so that they can carry fewer liquid assets during the rest of the year and make more funds available for local lending. With the change, discount window loans to healthy banks would be priced at 1 percent above the fed funds rate rather than below as it generally was in the period preceding January 2003. Loans to troubled banks would cost 1.5 percent above the fed funds rate. The changes were not intended to change the Fed’s use of the discount window to implement monetary policy, but significantly increase the discount rate while making it easier to get a discount window loan. By increasing banks’ use of the discount window as a source of funding, the Fed hopes to reduce volatility in the fed funds market as well. The change also allows healthy banks to borrow from the Fed regardless of the availability of private funds. Previously, the Fed required borrowers to prove they could not get funds from the private sector, which put a stigma on discount window borrowing. With the changes, the Fed lends to all banks, but the subsidy of below fed fund rate borrowing is gone. The Fed took additional unprecedented steps, expanding the usual function of the discount window, to address the financial crisis. While the discount window had traditionally been available only to DIs, in the spring of 2008 (as Bears Stearns nearly failed) investment banks gained access to the discount window through the Primary Dealer Credit Facility (PDCF). In the first three days, securities firms borrowed an average of $31.3 billion per day from the Fed. The largest expansion of the discount window’s availability to all FIs occurred in the wake of the Lehman Brothers failure, as a series of actions were taken in response to the increasingly fragile state of financial markets. During the financial crisis, the Fed also significantly reduced the spread (premium) between the discount rate and the federal funds target to just a quarter of a point, bringing the discount rate down to a half percent. With lower rates at the Fed's discount window and inter-bank liquidity scarce as many lenders cut back their lending, more financial institutions chose to borrow at the window. The magnitude and diversity of nontraditional lending programs and initiatives developed during the crisis were unprecedented in Federal Reserve history. The lending programs were all designed to "unfreeze" and stabilize various parts of the credit markets, with the overall goal that parties receiving credit via these new Fed programs would, in turn, provide funding to creditworthy individuals and firms. 14. The Federal Reserve uses mainly open market operations to implement its monetary policy. As mentioned in question 12, adjustments to the discount rate are rarely used because it is difficult for the Fed to predict changes in bank discount window borrowing when the discount rate changes and because in addition to their effect on the money supply, discount rate changes often have great effects on the financial markets. Further, because changes in the reserve requirements can result in unpredictable changes in the money base (depending on the amount of excess reserves held by banks and the willingness of the public to redeposit funds at banks instead of holding cash (i.e., Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e they have a preferred cash-deposit ratio)), the reserve requirement is rarely used by the Federal Reserve as a monetary policy tool. The unpredictability comes from at least two sources. First, there is uncertainty about whether banks will actually convert excess reserves (created from a decrease in the reserve requirement) into new loans. Second, there is uncertainty about what portion of the new loans will be returned to depository institutions in the form of transaction deposits. Thus, like the discount window rate, the use of the reserve requirement as a monetary policy tool increases the probability that a money base or interest rate target set by the FOMC will not be achieved. 15. Expansionary Activities: The chapter discusses three monetary policy tools that the Fed can use to increase the money supply. These include open market purchases of securities, discount rate decreases, and reserve requirement decreases. All else constant, when the Federal Reserve purchases securities in the open market, reserve accounts of banks (and thus, the money base) increase. When the Fed lowers the discount rate, this generally results in a lowering of interest rates in the economy. Finally, a decrease in the reserve requirements, all else constant, results in an increase in reserves for all banks. In two of the three cases (open market operations and reserve requirement changes), an increase in reserves results in an increase in bank deposits and assets. One immediate effect of this is that interest rates fall and security prices to rise. In the third case (a discount rate change), the impact of a lowering of interest rates is more direct. Lower interest rates encourage borrowing. Economic agents spend more when they can get cheaper funds. Households, business, and governments are more likely to invest in fixed assets (e.g., housing, plant, and equipment). Households increase their purchases of durable goods (e.g., automobiles, appliances). State and local government spending increases (e.g., new road construction, school improvements). Finally, lower domestic interest rates relative to foreign rates can result in a drop in the (foreign) exchange value of the dollar relative to other currencies. As the dollar’s (foreign) exchange value drops, U.S. goods become relatively cheaper compared to foreign goods. Eventually, U.S. exports increase. The increase in spending from all of these market participants results in economic expansion, stimulates additional real production, and may cause inflation to rise. Ideally, the expansionary policies of the Fed are meant to be conducive to real economic expansion (economic growth, full employment, sustainable international trade) without price inflation. However, when the Fed undertakes expansionary activities, the resulting increase in demand for goods and services tends to push wages and other costs higher, and can lead to inflation. Indeed, price stabilization can be viewed as the primary objective of the Fed. Contractionary Activities: To decrease the money supply the Fed can undertake open market sales, discount rate increases, and reserve requirement increases. All else constant, when the Federal Reserve sells securities in the open market, reserve accounts of banks (and the money base) decrease. When the Fed raises the discount rate, interest rates generally increase in the open market. Finally, an increase in the reserve requirement, all else constant, results in a decrease in excess reserves for all banks. In all three cases, interest rates will tend to rise. Higher interest rates discourage credit availability and borrowing. Economic participants spend less when funds are expensive. Households, business, and governments are less likely to invest in fixed assets. Households decrease their purchases of durable goods. State and local government spending decreases. Finally, a decrease in domestic interest rates relative to foreign rates may result in an increase in the (foreign) exchange value (rate) of the dollar. As the dollar’s exchange rate increases, U.S. goods become relatively expensive compared to foreign goods. Eventually, U.S. exports decrease. The decrease in spending from all of these market participants results in economic contraction, (depressing additional real production) and causes prices to fall (causing the rate of inflation to fall). 16. The programs can be categorized into four general areas: expansion of retail deposit insurance, capital injections, debt guarantees, and asset purchases/guarantees. Expansion of retail deposit insurance. Increased retail bank deposit insurance coverage was widely used during the crisis to ensure continued access to deposit funding. As shown in Figure 4-8, the amounts covered by deposit insurance varied substantially across countries, with some countries extending unlimited guarantees of retail deposits. Capital Injections. Direct injections of capital by central governments were the main mechanism used to directly support balance sheets. Governments increased banks’ capital by injecting combinations of common shares, preferred shares, warrants, subordinated debt, mandatory convertible notes, or silent participations. These capital injections improved banks’ abilities to absorb additional losses and strengthened protection for banks’ uninsured creditors. Further, because they relieved balance sheet constraints, the capital injections allowed banks to increase their lending. Countries varied in the capital instruments used and the conditions of capital injections. Some countries (e.g., the U.S.) also imposed restrictions on executive compensation and/or dividend payments to common Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e stockholders. As seen in Table 4-9, countries also varied in the amounts of capital injected into the banking system. The Netherlands made commitments totaling 6.2 percent of the country’s GDP, the U.K. made commitments worth 3.4 percent of its GDP, and Switzerland made commitments worth 1.1 percent of its GDP. Debt guarantees. As financial markets froze, so did the wholesale funding market used by banks to support lending activities. In response to these events, governments announced state guarantees on bank wholesale debt. Specifically, governments provided explicit guarantees against default on uninsured bank liabilities. These programs allowed banks to maintain access to reasonably priced, medium-term funding. They also reduced liquidity risk and lowered overall borrowing costs for banks. Countries varied in the range of liabilities covered and fee structures associated with these programs, e.g., some charged a flat fee, others linked fees to bank CDS spreads. Further, as seen in Table 4-9, countries committed significantly larger amounts to the debt guarantee programs than to the capital injection programs. Many countries (e.g., Australia, Canada, Italy, and Switzerland) committed unspecified amounts for debt guarantees, the Netherlands committed an amount totaling 33.6 percent of the country’s GDP, the U.K. made commitments worth 17.2 percent of its GDP, and Spain made commitments worth 9.1 percent of its GDP. Asset purchases or guarantees. Asset purchase programs removed distressed assets from bank balance sheets. Thus, bank liquidity was improved and capital relief was provided (particularly if purchase prices were higher than book values). Asset guarantee programs left the distressed assets with the banks. However, the central banks assumed part or all of the risk of the portfolio of distressed or illiquid assets from the banks. Asset purchase and guarantee programs were not used extensively. A main reason for this is that it was difficult to determine the price at which the central bank would purchase the distressed assets. A purchase price set too close to par effectively amounted to a covert recapitalization of the bank. Further, there was a debate regarding the range of eligible assets. To have a significant and immediate impact on market confidence, the programs would have to cover all distressed assets, which would require large programs. As seen in Table 4-9, the U.K. used asset guarantees extensively (commitments amounted to 33.4 percent of the country’s GDP). Beyond this, Germany committed an unspecified amount for asset purchases and an amount totaling 8.0 percent of the country’s GDP for asset guarantees, while the U.S. committed 1.0 percent of its GDP for asset purchases and an amount totaling 2.5 percent of the country’s GDP for asset guarantees. Problems: 1. For the purchase of $1 billion in securities, the balance sheet of the Federal Reserve System and commercial banks is shown below. Change in Federal Reserve’s Balance Sheet Assets Liabilities Treasury securities + $1 b Reserve account of + $1 b securities dealers’ banks ---------------------------------------------------------------------------------------------------Change in Commercial Bank Balance Sheets Assets Liabilities Reserve accounts + $1 b Securities dealers’ demand + $1 b at Federal Reserve deposit accounts 2. For the sale of $850 million in securities, the balance sheet of the Federal Reserve System and commercial banks is shown below. Change in Federal Reserve’s Balance Sheet Assets Liabilities Treasury securities - $850 m Reserve account of - $850 m securities dealers’ banks --------------------------------------------------------------------------------------------------Change in Commercial Bank Balance Sheets Assets Liabilities Reserve accounts - $850 m Securities dealers’ demand - $850 at Federal Reserve deposit accounts Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 3. a. Panel A: Initial Balance Sheets Federal Reserve Bank Assets Liabilities Securities $60m Reserve accounts $60m --------------------------------------------------------------------------------------------Bank Three Assets Liabilities Loans $540m Transaction deposits $600m Reserve deposits 60m at Fed Panel B: Balance Sheet after All Changes Resulting from Decrease in Reserve Requirement New initial required reserves = 0.08 × $600m = $48m Change in bank deposits = (1/0.08) × ($60m - $48m) = $150m Federal Reserve Bank Assets Liabilities Securities $60m Reserve accounts $60m --------------------------------------------------------------------------------------------------Bank Three Assets Liabilities Loans $690m Transaction deposits $750m ($750 - $60) ($60/0.08) Reserve deposits 60m at Fed b. Panel A: Initial Balance Sheets Federal Reserve Bank Assets Liabilities Securities $60m Reserve accounts $60m --------------------------------------------------------------------------------------------Bank Three Assets Liabilities Loans $540m Transaction deposits $600m Reserve deposits 60m at Fed Panel B: Balance Sheet after All Changes Resulting from Increase in Reserve Requirement New initial required reserves = 0.12 × $600m = $72m Change in bank deposits = (1/0.12) × ($60m - $72m) = -$100m Federal Reserve Bank Assets Liabilities Securities $60m Reserve accounts $60m --------------------------------------------------------------------------------------------------Bank Three Assets Liabilities Loans $440m Transaction deposits $500m ($500 - $60) ($60 / 0.12) Reserve deposits 60m at Fed 4. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e a. Panel A: Initial Balance Sheets Federal Reserve Bank Assets Liabilities Securities $15m Reserve accounts $15m --------------------------------------------------------------------------------------------BSW Bank Assets Liabilities Loans $135m Transaction deposits $150m Reserve deposits 15m at Fed Panel B: Balance Sheet after All Changes Resulting from Decrease in Reserve Requirement New initial required reserves = 0.06 × $150m = $9m Change in bank deposits = (1/0.06) × ($15m - $9m) = $100m Federal Reserve Bank Assets Liabilities Securities $15m Reserve accounts $15m --------------------------------------------------------------------------------------------------BSW Bank Assets Liabilities Loans $235m Transaction deposits $250m ($250 - $15) ($15 / 0.06) Reserve deposits 15m at Fed b. Panel A: Initial Balance Sheets Federal Reserve Bank Assets Liabilities Securities $15m Reserve accounts $15m --------------------------------------------------------------------------------------------BSW Bank Assets Liabilities Loans $135m Transaction deposits $150m Reserve deposits 15m at Fed Panel B: Balance Sheet after All Changes Resulting from Increase in Reserve Requirement New initial required reserves = 0.14 × $150m = $21m Change in bank deposits = (1/0.14 × ($15m - $21m) = -$42.857m Federal Reserve Bank Assets Liabilities Securities $15m Reserve accounts $15m --------------------------------------------------------------------------------------------------BSW Bank Assets Liabilities Loans $92.143m Transaction deposits $107.143m ($107.143 - $15) ($15 / 0.14) Reserve deposits 15m at Fed 5. a. Panel A: Initial Balance Sheets Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Federal Reserve Bank Assets Liabilities Securities $50m Reserve accounts --------------------------------------------------------------------------------------------National Bank Assets Liabilities Loans $450m Transaction deposits Reserve deposits 50m at Fed

$50m

$500m

Panel B: Balance Sheet after All Changes Resulting from Decrease in Reserve Requirement New initial required reserves = 0.08 × $500m = $40m Change in bank deposits = (1/(0.08 + (1 - 0.5))) × ($50m - $40m) = $17.241m Federal Reserve Bank Assets

Liabilities Securities $41.379m Reserve accounts $41.379m --------------------------------------------------------------------------------------------------National Bank Assets Liabilities Loans $475.862m Transaction deposits $517.241m ($517.241 - $41.379) ($500 + ($10 × (1/(0.08 + 0.5))) Reserve deposits 41.379m at Fed ($517.241 × 0.08) b. Panel A: Initial Balance Sheets Federal Reserve Bank Assets

Liabilities Securities $50m Reserve accounts $50m -----------------------------------------------------------------------------------------------------------------National Bank Assets Loans Reserve deposits at Fed

Liabilities Transaction deposits

$450m 50m

$500m

Panel B: Balance Sheet after All Changes Resulting from Decrease in Reserve Requirement New initial required reserves = 0.08 × $500m = $40m Change in bank deposits = (1/(0.08 + (1 - 0.6))) × ($50m - $40m) × 0.75 = $15.625m Federal Reserve Bank Assets

Liabilities Securities $41.25m Reserve accounts $41.25m --------------------------------------------------------------------------------------------------National Bank Assets Liabilities Loans $474.375m Transaction deposits $515.625m ($515.625 - $41.25) ($500 + ($10 × 0.75 × (1/(0.08 + 0.4))) Reserve deposits 41.25m at Fed ($515.625 × 0.08) 6. a. Panel A: Initial Balance Sheets Federal Reserve Bank Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Assets Liabilities Securities $25m Reserve accounts --------------------------------------------------------------------------------------------MHM Bank Assets Liabilities Loans $225m Transaction deposits Reserve deposits 25m at Fed

$25m

$250m

Panel B: Balance Sheet after All Changes Resulting from Increase in Reserve Requirement New initial required reserves = 0.12 × $250m = $30m Change in bank deposits = (1/(0.12 + (1 - 0.8))) × ($30m - $25m) = $15.625m Federal Reserve Bank Assets

Liabilities Securities $31.875m Reserve accounts $31.875m --------------------------------------------------------------------------------------------------MHM Bank Assets Liabilities Loans $233.75m Transaction deposits $265.625m ($265.625 - $31.875) ($250 + ($5 × (1/(0.12 + 0.2))) Reserve deposits 31.875m at Fed ($265.625 × 0.12) b. Panel A: Initial Balance Sheets Federal Reserve Bank Assets

Liabilities Securities $25m Reserve accounts $25m -----------------------------------------------------------------------------------------------------------MHM Bank Assets Loans Reserve deposits at Fed

Liabilities Transaction deposits

$225m 25m

$250m

Panel B: Balance Sheet after All Changes Resulting from Increase in Reserve Requirement New initial required reserves = 0.12 × $250m = $30m Change in bank deposits = (1/(0.12 + (1 - 0.9))) × ($30m - $25m) × 0.85 = $19.318m Federal Reserve Bank Assets

Liabilities Securities $32.318m Reserve accounts $32.318m --------------------------------------------------------------------------------------------------MHM Bank Assets Liabilities Loans $237.000m Transaction deposits $269.318m ($269.318 - $32.318) ($250 + ($5 × 0.85 × (1/(0.12 + 0.1))) Reserve deposits 32.318m at Fed ($269.318 × 0.12) 7. a. Increase in bank deposits and money supply = (1/0.05) × $500m = $10 billion b. Increase in bank deposits and money supply = (1/(0.05 + (1 - 0.95))) × $500m = $5.00 billion 8. a. Increase in bank deposits and money supply = (1/0.10) × $750m = $7.5 billion Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e b. Increase in bank deposits and money supply = (1/(0.10 + (1 - 0.90))) × $750m = $3.75 billion 9. a. Panel A: Initial Balance Sheets Federal Reserve Bank Assets Liabilities Securities $65m Reserve accounts --------------------------------------------------------------------------------------------National Bank Assets Liabilities Loans $585m Transaction deposits Reserve deposits 65m at Fed

$65m

$650m

Panel B: Balance Sheet after All Changes Resulting from Decrease in Reserve Requirement New initial required reserves = 0.09 × $650m = $58.5m Change in bank deposits = (1/(0.09 + (1 - 0.6))) × ($65m - $58.5m) = $13.265m Federal Reserve Bank Assets

Liabilities Securities $59.694m Reserve accounts $59.694m --------------------------------------------------------------------------------------------------National Bank Assets Liabilities Loans $603.571m Transaction deposits $663.265m ($663.265- $59.694) ($650 + ($6.5 × (1/(0.09 + 0.4))) Reserve deposits 59.694m at Fed ($663.265 × 0.09) b. Panel A: Initial Balance Sheets Federal Reserve Bank Assets

Liabilities Securities $65m Reserve accounts $65m -----------------------------------------------------------------------------------------------------------------National Bank Assets Loans Reserve deposits at Fed

Liabilities Transaction deposits

$585m 65m

$650m

Panel B: Balance Sheet after All Changes Resulting from Decrease in Reserve Requirement New initial required reserves = 0.09 × $650m = $58.5m Change in bank deposits = (1/(0.09 + (1 - 0.75))) × ($65m - $58.5m) × 0.90 = $17.206m Federal Reserve Bank Assets

Liabilities Securities $60.05m Reserve accounts $60.05m --------------------------------------------------------------------------------------------------National Bank Assets Liabilities Loans $607.157m Transaction deposits $667.206m ($667.206- $60.05) ($650 + ($6.5 × 0.9 × (1/(0.09 + 0.25))) Reserve deposits 60.05m Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e at Fed ($667.206 × 0.09) 10. a. Panel A: Initial Balance Sheets Federal Reserve Bank Assets Liabilities Securities $35m Reserve accounts --------------------------------------------------------------------------------------------National Bank Assets Liabilities Loans $315m Transaction deposits Reserve deposits 35m at Fed

$35m

$350m

Panel B: Balance Sheet after All Changes Resulting from Decrease in Reserve Requirement New initial required reserves = 0.11 × $350m = $38.5m Change in bank deposits = (1/(0.11 + (1 - 0.5))) × ($38.5m - $35m) = $5.738m Federal Reserve Bank Assets

Liabilities Securities $39.092m Reserve accounts $39.092m --------------------------------------------------------------------------------------------------National Bank Assets Liabilities Loans $316.293m Transaction deposits $355.385m ($355.385 - $39.092) ($350 + ($3.5 × (1/(0.11 + 0.5))) Reserve deposits 39.092m at Fed ($355.385 × 0.11) b. Panel A: Initial Balance Sheets Federal Reserve Bank Assets

Liabilities Securities $35m Reserve accounts $35m -----------------------------------------------------------------------------------------------------------------National Bank Assets Loans Reserve deposits at Fed

Liabilities Transaction deposits

$315m 35m

$350m

Panel B: Balance Sheet after All Changes Resulting from Decrease in Reserve Requirement New initial required reserves = 0.11 × $350m = $38.5m Change in bank deposits = (1/(0.11 + (1 - 0.6))) × ($38.5m - $35m) × 0.75 = $5.147m Federal Reserve Bank Assets

Liabilities Securities $39.066m Reserve accounts $39.066m --------------------------------------------------------------------------------------------------National Bank Assets Liabilities Loans $316.081m Transaction deposits $355.147m ($355.147 - $39.066) ($350 + ($3.5 × 0.75 × (1/(0.11 + 0.4))) Reserve deposits 39.066m at Fed ($355.147 × 0.11) Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 5 Questions: 1. First, money market instruments are generally sold in large denominations (often in units of $1 million to $10 million). Most money market participants want or need to borrow large amounts of cash so that transactions costs are low relative to the interest paid. The size of these initial transactions prohibits most individual investors from investing directly in money market securities. Rather, individuals generally only invest in money market securities indirectly with the help of financial institutions such as money market mutual funds. Second, money market securities have low default risk; the risk of late or nonpayment of principal and/or interest is generally small. Since cash lent in the money markets must be available for a quick return to the lender, money market instruments can generally be issued only by high quality borrowers with little risk of default. Finally, money market securities must have an original maturity of one year or less. Recall from Chapter 3 that the longer the maturity of a debt security, the greater is its interest rate risk and the higher its required rate of return (the higher its liquidity risk premium). Given that adverse price movements resulting from interest rate changes are smaller for short term securities, the short term maturity of money market instruments helps lower the risk that interest rate changes will significantly affect the security’s market value and price. 2. The discount yield differs from a bond equivalent yield for two reasons: i) the base price used is the face value of the security and not the purchase price of the security and ii) a 360-day year is used. The bond equivalent yield uses a 365-day year and the purchase price, rather than the face value of the security, is used as the base price. Treasury bills are quoted on a discount yield basis. 3. There are several features of a discount yield that prohibit it from being compared to yields on other (nondiscount) securities. Specifically, the discount yield uses the terminal price (or face value) as the base price in calculating a nominal interest rate. Typically, nominal rates are based on the purchase price of a security. Further, discount yields use a 360-day rather than a 365-day year. An appropriate comparison of nominal interest rates on discount securities versus nondiscount securities would require that the discount yield be converted to a bond equivalent yield in the following manner: ibe = id (Pf/Po)(365/360) Finally, neither of these yields considers the compounding of interest rates during the (less than one year) investment horizon. The EAR on a discount security would be calculated by applying the bond equivalent yield for the discount security to the EAR equation. 4. Single-payment securities pay interest only once, at maturity. Quoted interest rates on single-payment securities assume a 360-day year. Therefore, to compare single-payment yields with bond equivalent yields, the quoted singlepayment yield must be converted into a bond equivalent rate or yield. The conversion of a single-payment yield to a bond equivalent rate is calculated as follows: ibe = isp (365/360). 5. The U.S. Treasury has a formal process by which it sells new issues of Treasury bills through its regular Treasury bill auctions. Every week (usually on a Thursday) the amount of new 13-week and 26-week T-bills the Treasury will offer for sale is announced. Bids may be submitted by government securities dealers, financial and nonfinancial corporations, and individuals and must be received by a Federal Reserve Bank by the 1 pm Monday following the auction announcement. Allocations and prices are announced the following morning (Tuesday). 6. Submitted bids can be either competitive bids or noncompetitive bids. Competitive bids specify the amount of par value of bills desired (the minimum is $100) and the discount yield (in increments of 0.005%), rather than the price. The amount of noncompetitive bids is subtracted from the total face value of the auctioned bills, with the remainder to be allocated to competitive bidders. Competitive bids are then ranked from the lowest discount yield (highest price) to the highest yield (lowest price). The cut-off yield (the yield of the last accepted bid) is the highest accepted discount yield; it is known as the stop-out yield or stop-out rate of the auction. It determines the price per $100 that every successful bidder pays. All bids with yields above the stop-out yields are rejected. If the amount of Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e competitive bids at the stop-out yield exceeds the amount of bills remaining to be allocated after the superior bids have been allocated, the bids at the stop-out rate are distributed on a pro-rata basis. For example, if the bids at the stop-out yield total $5 billion of par value, but there is only $3 billion of par value remaining after satisfying noncompetitive bids and competitive bids with lower yields (higher prices), then the bidders whose yield turned out to be the stop-out yield will receive 60 percent of their desired allocations ($3 billion/$5 billion). This proportion is reported as ‘allotted at high’ in the U.S. Treasury auction result announcements. Bidders cannot submit negative yields in T-bill auctions, but may submit a yield of zero, which means that they are willing to pay face value and earn no income from the bills. Competitive bids are generally used by large investors and government securities dealers and make up the majority of the auction market. Noncompetitive bids are limited to $5 million; they specify only the desired amount of the face value of the bills. Noncompetitive bids usually represent a small portion of total Treasury bills auctioned. If the amount of noncompetitive bids exceeds the amount of bills auctioned, all noncompetitive bids would be satisfied on a pro-rata basis, all competitive bids would be rejected, and the price of the bills would be set at par, reflecting a yield of zero. Noncompetitive bids allow small investors to participate in the T-bill auction market without incurring large risks. That is, small investors who are unfamiliar with money market interest rate movements can use a noncompetitive bid to avoid bidding a price too low to receive any of the T-bills or bidding too high and paying more than the “fair” market price. 7. The secondary market for T-bills is the largest of any U.S. money market security. At the heart of this market are those securities dealers designated as primary government securities dealers by the Federal Reserve Bank of New York (consisting of 23 financial institutions) who purchase the majority of the T-bills sold competitively at auction and who create an active secondary market. In addition, there are many (approximately 500) smaller dealers who directly trade in the secondary market. Primary dealers make a market for T-bills by buying and selling securities for their own account and by trading for their customers, including depository institutions, insurance companies, pension funds, and so on. T-bill transactions by primary dealers averaged $820 billion per day in June 2016. The Tbill market is decentralized, with most trading transacted over the telephone. Brokers keep track of the market via closed circuit television screens located in the trading rooms of the primary dealers. These television screens display bid and asked prices available at any point in time. Treasury markets are generally open from 9:00 A.M. to 3:30 P.M. EST. Secondary market T-bill transactions between primary government securities dealers are conducted over the Federal Reserve’s wire transfer service and are recorded via the Federal Reserve’s book-entry system. A bank or broker that is not a primary government securities dealer or a secondary market dealer must contact (via phone, fax, or wire) one of these dealers to complete the transaction. T-bill dealers maintain records identifying owners of all Treasury securities held in its account in the book-entry system. 8. Federal funds are not formal securities. Rather, fed funds are short term loans between financial institutions, usually for a period of one day. The institution that borrows fed funds incurs a liability on its balance sheet, “federal funds purchased,” while the institutions that lends the fed funds records an asset, “federal funds sold.” 9. Two forms of federal funds transactions are commonly used: i) negotiations between two commercial banks often takes place directly over the telephone between the “money dealers” of the banks involved or ii) the transaction may occur through a fed funds broker. Figure 5-3 illustrates the two methods through which a fed funds transaction can occur. For example, a bank that finds itself with $75 million in excess reserves can call its correspondent banks to see if they need overnight reserves. The bank will then sell its excess reserves to those correspondent banks that offer the highest rates for these fed funds. When a transaction is agreed upon, the lending bank instructs its district Federal Reserve Bank to transfer the $75 million in excess reserves to the borrowing bank’s reserve account at its Federal Reserve Bank. The Federal Reserve System’s wire transfer network, Fedwire, is used to complete the transfer of funds. The next day the funds are transferred back, via Fedwire, from the borrowing bank to the lending bank’s reserve account at the Federal Reserve Bank plus one day’s interest. Overnight fed fund loans will likely be based on an oral agreement between the two parties and are generally unsecured. Increasingly, participants in the fed funds markets do not hold balances at the Federal Reserve. In this case the fed funds transaction is settled in immediately available funds: fed funds on deposit at the lending bank that may be transferred or withdrawn with no delay. In this case a federal funds broker, typically a commercial bank, matches up institutions using a Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e telecommunications network that links federal funds brokers with participating institutions. Upon maturity of the fed funds loan, the borrowing bank’s fed fund demand deposit account at the lending bank is debited for the total value of the loan and the lending bank pays the borrowing bank an interest payment for the use of the fed funds. 10. One of the primary risks of the interbank lending system is that the borrowing bank does not have to pledge collateral for the funds it receives, which are usually in millions of dollars. While the Fed has the ability to use open market operations to influence the interest rates banks charge each other and can introduce new capital to encourage banks to lend, the interbank loans are conducted with little scrutiny between parties. The financial crisis of 2008‐ 2009 produced unprecedented and persistent strains in interbank lending and exposed problems produced by banks that were heavily leveraged with fed funds. The financial crisis created a huge demand for liquid assets across the entire financial system. Rather than lend excess funds in the interbank market, banks preferred to hold onto liquid assets just in case their own needs might increase. Banks also grew concerned about the risks of borrowing banks and became increasingly unwilling to lend, even very high interest rates, as the level of confidence in the banking system plunged. Interbank loans fell to $153 billion in June 2010 from a peak of $494 billion in September 2008, the month that Lehman Brothers declared bankruptcy. Unable to borrow in the interbank market, U.S. banks turned to the Fed for short-term borrowing, and the Fed obliged. At height of the financial crisis, the Fed unexpectedly announced that it would drop its target fed funds rate to a range between zero and one-quarter of 1 percent. (The rate remained at these historically low levels until December 2015.) Eventually, unprecedented actions by the Fed to add liquidity and guarantee bank debt were able to counter the record strains in the interbank market. However, the financial crisis made it painfully clear that financial institutions cannot always count on being able to borrow at a low cost when needed. 11. A repurchase agreement (repos or RPs) is an agreement involving the sale of securities by one party to another with a promise to repurchase the securities at a specified price and on a specified date in the future. Thus, a repurchase agreement is essentially a collateralized fed funds loan backed by the securities. The securities used most often in repos are U.S. Treasury securities (e.g., T-bills) and government agency securities (e.g., Fannie Mae). A reverse repurchase agreement (reverse repo) is an agreement involving the purchase of securities by one party from another with the promise to sell them back at a given date in the future. 12. Repurchase agreements are arranged either directly between two parties or with the help of brokers and dealers. Figure 5–4 illustrates a $75 million repurchase agreement of Treasury bonds arranged directly between two parties (e.g., J.P. Morgan Chase and Bank of America). The repo buyer, J.P. Morgan Chase, arranges to purchase fed funds from the repo seller, Bank of America, with an agreement that the seller will repurchase the fed funds within a stated period of time—one day. The repo is collateralized with T-bonds. In most repurchase agreements, the repo buyer acquires title to the securities for the term of the agreement. Once the transaction is agreed upon, the repo buyer, J.P. Morgan Chase, instructs its district Federal Reserve Bank (the FRBNY) to transfer $75 million in excess reserves, via Fedwire, to the repo seller’s reserve account. The repo seller, Bank of America, instructs its district Federal Reserve Bank (the FRB of San Francisco) to transfer $75 million from its T-bond account via securities Fedwire to the repo buyer’s T-bond account. Upon maturity of the repo (one day in this example), these transactions are reversed. In addition, the repo seller transfers additional funds (representing one day’s interest) from its reserve account to the reserve account of the repo buyer. 13. This 270 day maximum is due to a Securities and Exchange Commission (SEC) rule that securities with a maturity of more than 270 days must go through the time consuming and costly registration process to become a public debt offering (i.e., a corporate bond). 14. Because commercial paper is not actively traded and because it is also unsecured debt, the credit rating of the issuing company is of particular importance in determining the marketability of a commercial paper issue. Credit ratings provide potential investors with information regarding the ability of the issuing firm to repay the borrowed funds, as promised, and to compare the commercial paper issues of different companies. Several credit rating firms Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e rate commercial paper issues (e.g., Standard & Poor’s, Moody’s, and Fitch Investor Service). Virtually all companies that issue commercial paper obtain ratings from at least one rating services company and most obtain two rating evaluations. The better the credit rating on a commercial paper issue the lower the interest rate on the issue. 15. One reason for the growth of the commercial paper markets is that companies with strong credit ratings can generally borrow money at a lower interest rate by issuing commercial paper than by directly borrowing (via loans) from banks. Indeed, although business loans were the major asset on bank balance sheets between 1965 and 1990, they have dropped in importance since 1990. Companies have replaced this bank debt with commercial paper. This trend reflects the growth of the commercial paper market. In the early 2000s, the slowdown in the U.S. economy resulted in ratings downgrades for some of the largest commercial paper issuers. For example, the downgrade of General Motors and Ford from a tier-one to tier-two commercial paper issuer had a huge impact on the commercial paper markets. The result is that these commercial paper issuers were forced to give up the cost advantage of commercial paper and to move to the long-term debt markets to ensure they would have access to cash. The decrease in the number of eligible commercial paper issuers in the early 2000s resulted in a decrease in the size of the commercial paper market for the first time in 40 years. The mid-2000s saw a huge rise in the use of asset-backed commercial paper (ABCP). In July 2007, $1.19 trillion of the total $2.16 trillion commercial paper outstanding was ABCP. ABCP is collateralized by other financial assets of the issuer. The financial assets that serve as collateral for ABCP are ordinarily a mix of many different assets, which are jointly judged to have a low risk of bankruptcy by a ratings agency. In the mid-2000s, the collateralized assets were mainly mortgage-backed securities. However, in 2007–2008 many of these mortgage-backed securities performed more poorly than expected. Billions of dollars of asset-backed commercial paper were tainted because some of the proceeds were used to buy investments tied to U.S. subprime mortgages. Issuers found buyers much less willing to purchase ABCP. The result was another big drop in the dollar value of the commercial paper markets. [In 2016, just $256 billion of ABCP was outstanding (of the total $1.116 trillion commercial paper market)]. In addition, on September 16, 2008 (one day after Lehman Brothers filed for bankruptcy), Reserve Primary Fund, the oldest money market fund in the United States saw its shares fall to 97 cents (below the $1.00 book value) after writing off debt issued by Lehman Brothers. Resulting investor anxiety about Reserve Primary Fund spread to other funds, and money market mutual funds withdrawals skyrocketed. Fund investors pulled out a record $144.5 billion during the week ending Wednesday, September 17 (redemptions during the week of September 10 totaled just $7.1 billion) as investors worried about the safety of even these safest investments. Money market mutual funds participate heavily in the commercial paper market. As investors pulled their money from these funds, the commercial paper market shrank by $52.1 billion for the week (through Wednesday). These outflows severely undermined the stability of short-term funding markets, upon which many financial institutions and large corporations rely heavily to meet their short-term borrowing needs. In response, the Federal Reserve Board announced the creation of the Commercial Paper Funding Facility (CPFF), a facility that complemented the Federal Reserve’s existing credit facilities, to help provide liquidity to short-term funding markets. Under the plan, the Federal Reserve stepped in to purchase commercial paper and other short-term debt. Even as markets stabilized after the financial crisis, outstanding values of financial and non-financial commercial paper continued to fall: from over $2.16 trillion at its peak in July 2007, the commercial paper market has fallen to $1.76 trillion in July 2008, $1.21 trillion in July 2009, and just $0.99 trillion in July 2013. Reasons for this include a combination of related factors. First, negative and low positive economic growth experienced for years after the financial crisis produced lower demand for funds and thus less of a need to issue commercial paper. Second, financial and non-financial firms held record amounts of cash reserves after the financial crisis and thus did not need to borrow as much in the short-term commercial paper markets. Finally, long-term debt rates were at historical lows after the financial crisis. As a result, many corporations increased their issuance of longer term debt so as to lock in their financing costs at these low rates for many years: the financial crisis showed how risky rolling over short-term borrowings can be. 16. The bank and the CD investor directly negotiate a rate, the maturity and, the size of the CD. Once this is done, the issuing bank delivers the CD to a “custodian” bank specified by the investor. The custodian bank verifies the CD, debits the amount to the investor’s account, and credits the amount to the issuing bank. This is done though the Fedwire system, i.e., by transferring fed funds from the custodian bank’s reserve account at the Fed to the issuing Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e bank’s reserve account. 17. Most banker’s acceptances arise from international trade transactions and are used to finance trade in goods that have yet to be shipped from a foreign exporter (seller) to a domestic importer (buyer). Foreign exporters often prefer that banks act as guarantors for payment before sending goods to domestic importers, particularly when the foreign supplier has not previously done business with the domestic importer on a regular basis. The U.S. bank ensures the international transaction by stamping “Accepted” on a trade draft between the exporter and the importer, signifying its obligation to pay the foreign exporter (or its bank) on a specified date should the importer fail to pay for the goods. Foreign exporters can then hold the banker’s acceptance until the date specified on the trade draft or, if they have an immediate need for cash, can sell the acceptance before that date at a discount from the face value to a buyer in the money market (e.g., a bank). In this case, the ultimate bearer will receive the face value of the banker’s acceptance on maturity. 18. The major money market participants are the U.S. Treasury, the Federal Reserve, commercial banks, money market mutual funds, brokers and dealers, corporations, other financial institutions such as insurance companies, and individuals. The U.S. Treasury raises significant amounts of funds in the money market when it issues T-bills. T-bills are the most actively traded of the money market securities. T-bills allow the U.S. government to raise money to meet unavoidable expenditure needs prior to the receipt of tax revenues. Tax receipts are generally concentrated around quarterly dates, but government expenditures are more evenly distributed over the year. The Federal Reserve is a key participant in the money markets. The Federal Reserve holds T-bills (as well as T-notes and T-bonds) to conduct open market transactions: purchasing T-bills when it wants to increase the money supply and selling T-bills when it wants to decrease the money supply. The Federal Reserve often uses repurchase agreements and reverse repos to temporarily smooth interest rates and the money supply. Moreover, the Fed targets the federal funds rate on interbank loans as part of its overall monetary policy strategy, which can in turn affect other money market rates. Finally, the Fed operates the discount window which it can use to influence the supply of bank reserves to commercial banks and ultimately the demand for and supply of fed funds and the fed funds rate. Commercial banks are the most diverse group of participants in the money markets. Banks participate as issuers and/or investors of almost all money market instruments. For example, banks are the major issuers of negotiable CDs, banker’s acceptances, federal funds, and repurchase agreements. The importance of banks in the money markets is driven in part by their need to meet regulatory imposed reserve requirements. For example, during periods of economic expansion, heavy loan demand can produce reserve deficiencies for banks (i.e., their actual reserve holdings are pushed below the minimums required by regulation). Additional reserves can be obtained by borrowing fed funds from other banks, engaging in a reverse repurchase agreement, selling negotiable CDs, or selling commercial paper. Conversely, during contractionary periods, many banks have excess reserves which they can use to purchase Treasury securities, trade fed funds, engage in a repo, etc. Money market mutual funds purchase large amounts of money market securities and sell shares in these pools based on the value of their underlying (money market) securities. In doing so, money market mutual funds allow small investors to invest in money market instruments. Money market mutual funds provide an alternative investment opportunity to interest-bearing deposits at commercial banks. Brokers and dealers services are important to the smooth functioning of money markets. We have alluded to various categories of brokers and dealers in the chapter. First, are the 23 primary government security dealers. This group of participants plays a key role in marketing new issues of Treasury bills (and other Treasury securities). Primary government securities dealers also make the market in Treasury bills; buying securities from the Federal Reserve when they are issued and selling them in the secondary market. Secondary market transactions in the T-bill markets are transacted in the trading rooms of these primary dealers. These dealers also assist the Federal Reserve when it uses the repo market to temporarily increase or decrease the supply of bank reserves available. The second group of brokers and dealers are money and security brokers. These brokers play a major role in linking buyers and sellers in the fed funds market and assist secondary trading in other money market securities as well. The third group of brokers and dealers are the thousands of brokers and dealers who act as intermediaries in the money markets by linking buyers and sellers of money market securities. This group of brokers and dealers often act as the intermediaries for smaller investors who do not have sufficient funds to invest in primary issues of money market Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e securities or who simply want to invest in the money markets. Nonfinancial and financial corporations raise large amounts of funds in the money markets, primarily in the form of commercial paper. The volume of commercial paper issued by corporations has been so large that there is now more commercial paper outstanding than any other type of money market security. Because corporate cash inflows rarely equal their cash outflows, they often invest their excess cash funds in money market securities, especially T-bills, repos, commercial paper, negotiable CDs, and banker’s acceptances. Because their liability payments are relatively unpredictable, property-casualty (PC) insurance companies, and to a lesser extent life insurance companies, must maintain large balances of liquid assets. To accomplish this insurance companies invest heavily in highly liquid money market securities, especially T-bills, repos, commercial paper and negotiable CDs. Since finance companies are not banks and cannot issue deposits, they raise large amounts of funds in the money markets, especially through the issuance of commercial paper. Finally, money market mutual funds purchase large amounts of money market securities and sell shares in these pools based on the value of their underlying (money market) securities. In doing so, money market mutual funds allow small investors to invest in money market instruments. Individual investors participate in the money markets through direct investments in these securities (e.g., negotiable CDs) or through investments in money market mutual funds, which contain a mix of all types of money market securities. 19. One of the more grievous actions by some global investment banks during the financial crisis was the manipulation of the LIBOR. LIBOR is the average of the interest rates submitted by major banks in the United States, Europe, and the United Kingdom in a variety of major currencies such as the dollar, euro, and yen. The scandal arose when it was discovered that banks had been manipulating the LIBOR rate so as to make either profits on its derivative positions (such as interest rate swaps) or to make the bank look stronger for reputational reasons. It is estimated that the banks involved made at least $75 billion on the manipulations. The scandal became widely public in June 2012 when British investment bank Barclays agreed to pay $450 million to settle allegations by U.S. and British authorities that some of its traders attempted to manipulate LIBOR rates to increase the bank’s profits and reduce concerns about its stability during the financial crisis. Concerns were also raised about the failure of British and U.S. regulators to stop the manipulation of LIBOR when there was evidence that both were aware of it. In July 2012, a former trader stated that LIBOR manipulation had been occurring since at least 1991. In July 2012, the Federal Reserve Bank of New York released documents dated as far back as 2007 showing that they knew that banks were misreporting their borrowing costs when setting LIBOR. Yet, no action was taken. Similarly, documents from the Bank of England indicated that the bank knew as early as November 2007 that the LIBOR rate was being manipulated. It was not until June 2012 that Barclays became the first bank to agree to settle LIBOR manipulation allegations. In December 2012, UBS agreed to pay about $1.5 billion to settle charges that it manipulated LIBOR. Also, in December, the U.S. Justice Department charged Tom Hayes, a former UBS and Citigroup trader, with conspiracy to commit fraud by manipulating the LIBOR (in June 2013, he was charged with eight counts of fraud as part of the U.K. investigation). In February 2013, the Royal Bank of Scotland also decided to settle at a cost of $610 million. In early 2013, Deutsche Bank stated that it had set aside money to cover potential fines associated with its role in the manipulation of the LIBOR. While several big banks pleaded guilty to and accepted penalties for manipulating LIBOR, the first criminal conviction of an individual occurred in August 2015. Former bank trader Tom Hayes was sentenced to 14 years in prison after a London jury convicted him of trying to fraudulently rig the LIBOR. The unanimous jury verdict delivered one of the harshest penalties against a banker since the financial crisis. Finally, in 2016 U.S. and British regulators fined six major global banks (Barclays, J.P. Morgan Chase, Citigroup, the Royal Bank of Scotland, UBS, and Bank of America) a total of nearly $6 billion for rigging the foreign exchange market and Libor interest rates. Forex traders from the banks had met in online chatroom groups, one brazenly named "the Cartel" and another "Mafia," to set rates that cheated customers while adding to their own profits. Since its inception in the 1980s, LIBOR was managed by the British Bankers' Association (a London-based trade group whose members are some of the world's biggest banks). As a result of the LIBOR scandal, British authorities started looking for a new owner for LIBOR in 2012. In July 2013, the British government announced that LIBOR Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e would be sold to NYSE Euronext which was, in turn, acquired by the Intercontinental Exchange in 2014. Further, while ownership of LIBOR would be based in the U.S., responsibility for regulating it would remain in the U.K. 20. Eurodollar certificates of deposits (CDs) are U.S. dollar denominated CDs in foreign banks. Maturities on Eurodollar CDs are less than one year and most have a maturity of one week to six months. Because these securities are deposited in non-U.S. banks, Eurodollar CDs are not subject to reserve requirements in the same manner as U.S. deposits. This allows the rate offered on Eurodollar CDs to be somewhat higher than on comparable U.S. bank issued CDs. However, U.S. deposits are insured up to certain amounts while Eurodollar CDs are not, which lowers the Eurodollar CD rate compared to U.S. bank issued CDs. Eurocommercial paper (Euro-CP) is issued in Europe by dealers of commercial paper without involving a bank. The Eurocommercial paper rate is generally about one-half to one percent above the LIBOR rate.

Problems: 1.

Discount yield: Bond equivalent yield: EAR:

iT-bill, d = (($1m. - $993,750)/$1m.)(360/65) = 3.462% iT-bill, be = (($1m. - $993,750)/$993,750)(365/65) = 3.532% EAR = (1 + 0.03532/(365/65))365/65 - 1 = 3.583%

Discount yield: Bond equivalent yield: EAR:

icp, d = (($5m. – 0.98625($5m.))/$5m.)(360/136) = 3.640% icp, be = (($5m. - 0.98625($5m.))/0.98625($5m.)))(365/136) = 3.742% EAR = (1 + 0.03742/(365/136))365/136 - 1 = 3.786%

3. The nominal bond equivalent yield is calculated as: iCD, be = 6.56%(365/360) = 6.651% The EAR on the CD is calculated as: EAR = (1 + (0.06651)/(365/115))365/115 - 1 = 6.804% 4. The nominal bond equivalent yield is calculated as: iff, be = 0.25%(365/360) = 0.2535% The EAR on the CD is calculated as: EAR = (1 + (0.002535)/(365/3))365/3 - 1 = 0.2538% 5. iT-bill, d = ((10,000 - 9,875)/10,000) (360/68) = 6.62% 6. a. The T-bill’s quoted yield is calculated as iT-bill, d = $10,000 - $9,765 × 360 = 6.768% $10,000 125 b. The T-bill’s bond equivalent yield is calculated as iT-bill, be = $10,000 - $9,765 × 365 = 7.027% $9,765 125 7. a. The T-bill’s quoted yield is calculated as iT-bill, d = $10,000 - $9,965 × 360 = 1.326% Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e $10,000

b. The T-bill’s bond equivalent yield is calculated as iT-bill, be = $10,000 - $9,965 × 365 = 1.349% $9,965 95 c. The T-bill’s bond EAR is calculated as EAR = [1 + 0.01349/(365/95)]365/95 - 1 = 1.356% 8. a. The T-bill ask price is calculated as Po = $10,000 - [0.01515 × 55 × $10,000] = $9,976.85 360 b. The T-bill bid price is calculated as Po = $10,000 - [0.01518 × 125 × $10,000] = $9,947.29 360 9. EXCEL Problem:

10. a.

Bid Price = $9,993.81 Bid Price = $9,984.51 Bid Price = $9,969.03 Bid Price = $9,938.06 Bid Price = $9,845.14

iT-bill, d = ($100,000-$98,850)/$100,000) × (360/225) = 1.840% iT-bill, be = ($100,000-$98,850)/$98,850) × (365/225) = 1.887% EAR = [1 + 0.01887/(365/225)]365/225 - 1 = 1.894%

b. iT-bill, d = ($100,000-$98,850)/$100,000) × (360/300) = 1.380% iT-bill, be = ($100,000-$98,850)/$98,850) × (365/300) = 1.415% EAR = [1 + 0.01415/(365/300)]365/300 - 1 = 1.417% 11. EXCEL Problem:

Yield = 4.014% Yield = 1.606% Yield = 0.803% Yield = 0.401% Yield = 0.161%

12.

iff, be = 0.75%(365/360) = 0.7604% iff, be = 1.00%(365/360) = 1.0139%

13.

iff, be = 1.55%(365/360) = 1.5715%

Remembering that fed funds are generally lent for one day, The EAR on the fed funds can then be calculated as: EAR = [1 + 0.015715/(365/1)]365/1 - 1 = 1.5839% 14. a. The yield on this repo to the bank is calculated as follows irepo, sp = $25,000,000 - $24,995,000 × 360 = 1.02878% $24,995,000 7

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e b. The yield on this repo to the bank is calculated as follows irepo, sp = $25,000,000 - $24,995,000 × 360 = 0.34293% $24,995,000 21 15. a. irepo, be = 1.02878%(365/360) = 1.04307% EAR = [1 + 0.00104307/(365/7)]365/7 - 1 = 1.04842% b. irepo, be = 0.34293%(365/360) = 0.34769% EAR = [1 + 0.0034769/(365/21)]365/21 - 1 = 0.34826% 16. The discount yield on the commercial paper is calculated as icp, d = $500,000 - $498,000 × 360 = 3.20% $500,000 45 And the bond equivalent yield is: icp, be = $500,000 - $498,000 × 365 = 3.2575% $498,000 45 17. The discount yield on the commercial paper is calculated as: icp, d = $1,000,000 - $995,235 × 360 = 1.3723% $1,000,000 125 And the bond equivalent yield is: icp, be = $1,000,000 - $995,235 × 365 = 1.3980% $995,235 125 Finally, the EAR on the commercial paper is: EAR = [1 + 0.013980/(365/125)]365/125 - 1 = 1.4045% 18. a.

iCD, be = 0.52%(365/360) = 0.527% EAR = [1 + 0.00527/2]2 - 1 = 0.528%

FV = $2m. (1 + 0.00528/2) = $2,005,279

$2,005,279/(1 + iCD, be/2)) = $1,998,750 => iCD, be = 0.6533%

The single payment yield increases to: iCD, sp = 0.6533%(360/365) = 0.6444% and the EAR becomes: EAR = [1 + 0.006533/2]2 - 1 = 0.6544% 19. a.

iCD, be = 0.35%(365/360) = 0.3549% EAR = [1 + 0.003549/2]2 - 1 = 0.3552%

FV = $5m. (1 + 0.003552/2) = $5,008,879

$5,008,879/(1 + iCD, be/2)) = $4,994,500 => iCD, be = 0.5758%

The single payment yield increases to: iCD, sp = 0.5758%(360/365) = 0.5679% and the EAR becomes: EAR = [1 + 0.005758/2]2 - 1 = 0.5766% 20. a. Before the rate change, the CD holder will receive FV = $500,000 (1 + 0.055/4) = $506,875

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e in four months in exchange for $500,000 deposited in the bank today. Immediately after the market rate on the CD rises to 6 percent, the CD value decreases to PV = 506,875/(1 + 0.06/4) = $499,384.24 b. Immediately after the market rate on the CD falls to 5.25 percent, the CD value decreases to PV = 506,875/(1 + 0.0525/4) = $500,308.45

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 6 Questions: 1. Capital markets are markets that trade equity (stocks) and debt (notes, bonds, and mortgages) instruments with maturities of more than one year. Bonds are long term debt obligations issued by corporations and government units. Proceeds from a bond issue are used to raise funds to support long term operations of the issuer (e.g., for capital expenditure projects). In return for the investor’s funds, bond issuers promise to pay a specified amount in the future on the maturity of the bond (the face value) plus coupon interest on the borrowed funds (the coupon rate times the face value of the bond). If the terms of the repayment are not met by the bond issuer, the bondholder (investor) has a claim on the assets of the bond issuer. Bond markets are markets in which bonds are issued and trade. They are used to assist in the transfer of funds from individuals, corporations, and government units with excess funds to corporations and government units in need of long term debt funding. Bond markets are traditionally classified into three types: Treasury notes and bonds, municipal bonds, and corporate bonds. 2. T-bills have an original maturity of less than one year. Treasury notes have original maturities from 1 to 10 years, while T-bonds have original maturities from 10 to 30 years. Further, in contrast to T-bills which are sold on a discount basis from face value, T-notes and T-bonds pay coupon interest (semiannually). 3. A STRIPS is a Treasury security in which periodic coupon interest payments can be separated from each other and from the final principal payment. A STRIPS effectively creates two securities--one for each interest payment and one for the final principal payment. STRIPS are attractive investments to investors who want to receive a certain amount at a specified time in the future and are not concerned about receiving current income. For example, STRIPS are used as investment securities for individual retirement accounts, Keogh Plans, and pension funds. 4. Like the fixed-coupon bonds issued by the Treasury, the coupon rate on TIPS is determined by the auction process described below. However, unlike the fixed-principal bonds, the principal value of a TIPS bond can increase (or decrease) every six months by the amount of U.S. inflation (or deflation) as measured by the percentage change in the consumer price index (CPI). This principal is called the inflation-adjusted principal. TIPS bonds are used by investors who wish to earn a rate of return on their investments that keeps up with the inflation rate over time. The TIPS yield may be viewed as a real yield and the spread between the yields of TIPS and non-TIPS of the same maturity is the market’s consensus estimate of average annual inflation over the period. While TIPS may appear attractive to investors fearing inflation, the yields are lower. Further, the periodic principal adjustments are taxable as interest. Thus, while TIPS may provide a large pay-off at maturity (due to an increase in the principal value) they may end up being negative cash-flow securities for taxable investors in some periods. Consequently, TIPS may not be an appropriate investment for someone looking for significant current income. 5. Similar to primary market T-bill sales, the U.S. Treasury sells T-notes and T-bonds through competitive and noncompetitive Treasury auctions. The Treasury issues a press release about a week before each auction announcing the details of the auction, including the auction date, the amount to be sold, and other details about the securities to be issued. Bids may be submitted by government securities dealers, businesses, and individuals through the Treasury Direct website until noon Eastern time for noncompetitive bids and 1 p.m. Eastern time for competitive bids on the day of the auction. Bidders submit the yield to maturities they are willing to accept (in increments of 0.001%). Awards are announced the following day. The auction is a single-price auction-all bidders pay the same price which is the price associated with the highest of the competitive yields bid. At each auction, first noncompetitive bids are filled. Next, competitive bids are ranked from the lowest to highest yield (a bidder willing to accept the lowest yield is willing to pay the highest price). The stop-out yield of the auction is the highest accepted yield. The bids at the stop-out yield are filled on a pro-rata basis, and all the bids above the stop-out yield are rejected. So far, the procedure described is the same as the one for T-bill auctions. The differences arise because notes and bonds are coupon-bearing instruments. The coupon rate of the auctioned notes or bonds is the stop-out yield rounded down to the nearest 1/8 percent (unless it already falls on 1/8 percent). Recall that coupon rates are set in increments of one-eighth of one percent. The security’s price is set for the yield to maturity to equal the auction’s stop-out yield. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Because the coupon rate is the stop-out yield rounded down, the coupon rate is usually below the stop-out yield, meaning that the price is usually slightly below par. This process helps ensure that successful bidders will not pay more than the par value of the requested bonds. In Treasury auction result announcements, the stop-out yield is called “high yield” and the coupon rate is called “interest rate.” Negative yields cannot be bid in the auctions for non-inflation-protected Treasuries, but are allowed (and have happened) in TIPS auctions. A negative yield on TIPS implies that investors are willing to accept a negative real return on their investment. 6. General obligation (GO) bonds are backed by the full faith and credit of the issuer, i.e., the state or local government promises to use all of its financial resources (e.g., its taxation powers) to repay the bond. GO bonds have neither specific assets pledged as collateral backing the bond nor a specific revenue source identified as a source of repayment of the bond’s principal and interest. Because the taxing authority of the government issuer is promised to ensure repayment, the issuance of new GO bonds generally requires local taxpayer approval. Possibly because of this requirement, and taxpayers reluctance to have their taxes increase, general obligation bonds represent a smaller portion of municipal bonds issued. Revenue bonds are sold to finance a specific revenue generating project and are backed by cash flows from that project. For example, a revenue bond may be issued to finance an extension of a state highway. To help pay off the interest and principal on that bond, tolls collected from the use of the highway may be pledged as collateral to pay off the bond. If the revenue from the project is insufficient to pay interest and retire the bonds on maturity as promised, general tax revenues may not be used to meet these payments. Instead, the revenue bond goes into default and bondholders are not paid. Thus, revenue bonds are generally riskier then GO bonds. 7. Bond insurance ensures payment to bondholders in the event that the issuer defaults on a payment. Generally, the insurance company assuring a bond has a higher credit rating than the issuer. As a result, the bond issued will have the credit rating of the insurance company. This helps improve the credit ratings of bond issuers and lowers interest rates on bonds backed by insurance substantially. Bond insurance also increases the liquidity of bonds because it is easier to sell an insured bond on the market. 8. Public offerings of municipal bonds are most often made through an investment banking firm serving as the underwriter. Normally, the investment bank facilitates this transfer using a firm commitment underwriting. The investment bank guarantees the municipality (or corporation for a corporate bond) a price for newly issued bonds by buying the whole issue at a fixed price from the municipal issuer (the bid price). The investment bank then seeks to resell these securities to suppliers of funds (investors) at a higher price (the offer price). As a result, the investment bank takes a risk that it may not be able to resell the securities to investors at a higher price. This may occur if prices of municipal bonds suddenly fall due to an unexpected change in interest rates or negative information being released about the creditworthiness of the issuing municipality. If this occurs, the investment bank takes a loss on its underwriting of the security. However, the municipal issuer is protected by being able to sell the whole issue. Some municipal (and corporate) securities are offered on a best efforts basis, in which the investment bank does not guarantee a firm price to the issuer (as with a firm commitment offering) and acts more as a placing or distribution agent for a fee. With best-efforts offerings, the investment bank incurs no risk of mispricing the security since it seeks to sell the bonds at the price it can get in the market. In return the investment bank receives a fee. Further, the investment bank offers the securities at a price originally set by the municipality. Thus, the investment bank does not incur the expense of establishing the market price for the customer. Often, knowing that the investment bank has not put any of its own funds into the issue, investors in best-efforts issues are not willing to pay as much for the bonds as with a firm commitment issue. 9. The bond indenture is the legal contract that specifies the rights and obligations of the bond issuer and the bond holders. The bond indenture contains a number of covenants associated with a bond issue. These bond covenants describe rules and restrictions placed on the bond issuer and bond holders. These covenants include such rights for the bond issuer as the ability to call the bond issue and restrictions as to limits on the ability of the issuer to increase dividends paid to equity holders. By legally documenting the rights and obligations of all parties involved in a bond issue, the bond indenture helps lower the risk (and therefore the interest cost) of the bond issue. All matters pertaining to the bond issuer’s performance regarding any debt covenants as well as bond repayments are overseen by a trustee (frequently a bank trust department) who is appointed as the bond holders’ representative or “monitor.” Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e The signature of a trustee on the bond is a guarantee of the bond’s authenticity. The trustee also acts as the transfer agent for the bonds when ownership changes as a result of secondary market sales and when interest payments are made from the bond issuer to the bond holder. The trustee also informs the bond holders if the firm is no longer meeting the terms of the indenture. In this case, the trustee initiates any legal action on behalf of the bond holders against the issuing firm. In the event of a subsequent reorganization or liquidation of the bond issuer, the trustee continues to act on behalf of the bond holders to protect their principal. 10. With bearer bonds, coupons are attached to the bond and the holder (bearer) at the time of the coupon payment gets the relevant coupon paid on presentation to the issuer. With a registered bond, the bondholder’s (or owner’s) identification is kept in an electronic record by the issuer and the coupon payments are mailed or wire transferred to the registered owner. Because of the lack of security with bearer bonds, they have largely been replaced by registered bonds in the United States. 11. Most corporate bonds are term bonds meaning that the entire issue matures on a single date. Some corporate bonds and most municipals bonds, on the other hand, are serial bonds, meaning that the issue contains many maturity dates, with a portion of the issue paid off on each. The economic reason for this is that many issuers like to avoid a “crisis at maturity.” Rather than having to pay off one very large principal sum at a given time in the future (as with a term issue), many issuers like to stretch out the period over which principal payments are made especially if their earnings are quite volatile. 12.

a. subordinated debenture b. mortgage bond c. subordinated debenture

13. Convertible bonds are bonds that may be exchanged for another security of the issuing firm (e.g., common stock) at the discretion of the bondholder. If the market value of the securities the bondholder receives with conversion exceeds the market value of the bond, the bondholder can return the bonds to the issuer in exchange for the new securities and make a profit. As a result, conversion is an attractive feature to bondholders. It gives the bondholder an investment opportunity that is not available with nonconvertible bonds. As a result, the yield on a convertible bond is lower than that on a nonconvertible bond. 14. A call provision allows the issuer to require the bondholder to sell the bond back to the issuer at a given (call) price--usually set above the par value of the bond. The difference between the call price and the face value on the bond is the call premium. Bonds are usually called in when interest rates drop (and bond prices rise) so that the issuer can gain by calling in the old bonds (with higher coupon rates) and issuing new bonds (with lower coupon rates). A call provision is an unattractive feature to bond holders, since the bond holder may be forced to return the bond to the issuer before he or she is ready to end the investment and the investor can only reinvest the funds at a lower interest rate. As a result, callable bonds have higher yields (generally between 0.05 and 0.25 percent) than comparable noncallable bonds 15. A sinking fund provision is a requirement that the issuer retire a certain amount of the bond issue early over a number of years, especially as the bond approaches maturity. The bond issuer provides the funds to the trustee by making frequent payments to a so-called sinking fund. This sinking fund accumulates in value and is eventually used to retire the specified dollar amount either by purchasing them in the open market or by calling them. Since it reduces the probability of default at the maturity date, a sinking fund provision is an attractive feature to bond holders. Thus, bonds with a sinking fund provision are less risky to the bond holder and generally have lower yields than comparable bonds without a sinking fund provision. Some sinking fund bonds, however, are redeemed at par or market value, whichever is less, which creates price risk for the holder (if a bond is redeemed at par when its straight value is above par). 16. Bonds rated Baa or better by Moody’s and BBB or better by S&P and Fitch are considered to be investment grade bonds. Financial institutions are generally prohibited by state and federal law from purchasing anything but investment grade bond securities. Bonds rated below Baa by Moody’s and BBB by S&P are considered to be speculative grade bonds and are often termed junk bonds, or high-yield bonds.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 17. The present values of the cash flows on bonds decreases as the required rate of return increases. This is the inverse relationship between present values and interest rates we discussed in Chapter 2. While the examples in the chapter refer to the relation between fair present values and required rates of returns, the inverse relation also exists between current market prices and expected rates of return—as yields on bonds increase, the current market prices of bonds decrease. The relationship between bond prices and the required rate of return is not linear. Rather, the percentage change in the present value of a bond to a given change in the required rate of return is smaller when interest rates are higher. The same nonlinear relation exists for current market prices and yield to maturities. Thus, as interest rates increase, present values of bonds (and bond prices) decrease at a decreasing rate. 18. All else equal, a long-term bond experiences larger price changes when interest rates change than a short-term bond. A bond’s price is the present value of all its cash flows. Changes in the discount rate (the interest rate) impact present values more for cash flows that are further out in time. 19. Rating agencies consider several factors in determining and assigning credit ratings on bond issues. For example, a financial analysis is conducted of the issuer’s operations and its needs, its position in the industry, and its overall financial strength and ability to pay the required interest and principal on the bonds. Rating agencies analyze the issuer’s liquidity, profitability, debt capacity, and more recently its corporate governance structure (following the passage of the Sarbanes-Oxley Act in 2002). Then for each particular issue, rating agencies evaluate the nature and provisions of the debt issue (e.g., the covenants and callability of the bond) and the protection afforded by, and relative position of, the debt issue in the event of bankruptcy, reorganization, or other arrangements under the laws of bankruptcy and other laws affecting creditors’ rights. In recent years rating agencies have been criticized as slow to react. One example of this was the failure of rating agencies to downgrade ratings on mortgage-backed securities. Throughout the financial crisis, major credit rating firms were criticized for putting top ratings on these securities, which ultimately collapsed in value and led to billions of dollars of losses for investors who had relied on the ratings to signal which securities were safe to buy. Further, because rating agencies, in particular Moody’s, Standard & Poor’s, and Fitch, are for-profit companies, their incentives were criticized for being misaligned. Specifically, conflicts of interest arose because the rating agencies are paid by the investment companies issuing the securities—an arrangement that came under fire as a disincentive for the agencies to be vigilant on behalf of investors. As a result of these criticisms, the Wall Street Reform and Consumer Protection Act, passed in July 2010, included a provision that allows investors to sue credit rating firms for “knowing or reckless” failure, establishes an oversight office within the SEC with the ability to fine credit raters, and empowers the SEC to deregister firms that give too many incorrect ratings over time. Almost three years later, in February 2013, the U.S. Justice Department sued S&P alleging the firm ignored its own standards to rate mortgage bonds that imploded in the financial crisis, cost investors billions, and nearly brought down the world’s financial systems. A week later thirteen state attorneys general also filed lawsuits against S&P alleging the firm presented its ratings as based on objective and independent analysis, when they were actually inflated to cater to banking clients. 20. In Chapter 2, we examined factors that affect interest rates on individual bonds. These factors included default risk, liquidity risk, special provisions written into the bond contract (e.g., callability, sinking fund provisions), and the term to maturity of the bond. In addition to these factors that are unique to each bond, interest rates on all bonds are affected by inflation and the real risk free rate (typically measured using Treasury rates). The interest rate spread on a bond contains information on how these other factors along with default risk affect the yield on a bond. The interest rate spread (or just spread) is the difference between the yield on a bond and the return on a similar maturity Treasury security. The spread measures the return premium a bond earns to compensate not just for default risk, but also for liquidity risk and any special provisions on the bond. Thus, a spread is considered by many investors to be a more comprehensive and more current source of information regarding the overall risk of a bond than Moody’s, S&P, and Fitch credit ratings. Given the added factors incorporated into bond spreads, it is possible for spreads and credit ratings to sometimes appear to conflict with each other. Consider a bond issued by a company that is financially sound, but trades very infrequently. The credit rating (which captures mainly default risk) may be high, which would imply that the interest rate and thus the spread on the bond would be low. However, the spread also incorporates liquidity risk, which is high in this case and results in a higher interest rate and a higher spread on the bond.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 21. Bond markets bring together suppliers and demanders of long-term funds. The major issuers of debt market securities are federal, state, and local governments and corporations. The major purchasers of capital market securities are households, businesses, government units, and foreign investors. Figure 6–10 shows the percentage of each type of bond security held by the major groups. Notice in Figure 6–10 that financial firms, called Business Financial, (e.g., banks, insurance companies, mutual funds) are the major suppliers of funds for two of the three types of bonds. Financial firms hold 29.83 percent of all Treasury securities, 56.04 percent of municipal bonds, and 69.35 percent of the corporate bonds outstanding. In addition to their direct investment reported in Figure 6–10, households often deposit excess funds in financial firms (such as mutual bond funds and pension funds) that use these funds to purchase bond market securities. Thus, much of the business and financial holdings of bond securities shown in Figure 6–10 reflects indirect investments of households in the bond market. 22. Eurobonds are long term bonds issued and sold outside the country of the currency in which they are denominated (e.g., dollar denominated bonds issued in Europe or Asia). Foreign bonds are long term bonds issued by firms and governments outside of the issuer’s home country and are usually denominated in the currency of the country in which they are issued, for example a Japanese company issuing a dollar-denominate public bond in the U.S. Foreign bonds were issued long before Eurodollars and, as a result, are frequently called traditional international bonds. 23. Sovereign bonds are government-issued debt. Sovereign bonds have historically been issued in foreign currencies, either U.S. dollars or euros. Lesser developed country (LDC) sovereign debt tends to have lower credit ratings than other sovereign debt because of the increased economic and political risks. Where most developed countries are either AAA or AA-rated, most LDC issuance is rated below investment grade, though a few countries that have seen significant improvements have been upgraded to BBB or A ratings, and a handful of lower income countries have reached ratings levels equivalent to more developed countries. Accordingly, sovereign bonds require higher interest spreads. For example, sovereign bonds are uncollateralized and their price or value reflects the credit risk rating of the country issuing the bonds. The $2.8 billion June 1997 issue by Brazil of 30-year dollar denominated bonds (rated BB grade by Standard & Poor’s) was sold at a yield spread of nearly 4 percent over U.S. Treasuries at the time of issue. 24. In July 2001, Argentinian sovereign bonds were trading at spreads of over 15 percent above U.S. Treasury rates, with the J.P. Morgan Emerging Market Bond Index showing a spread of nearly 10 percent over U.S. Treasuries. This reflected the serious economic problems in Argentina and the contagious effects these were having on other sovereign bond markets. More recently, in September 2008, fears of the global economic crisis and falling commodity prices hit emerging markets particularly hard: Mexico’s sovereign debt spread jumped from 165bps to over 587bps, Brazil’s from 200bps to over 586bps, Chile’s from 69bps to over 322bps, Colombia’s from over 29bps to more than 600bps, and Argentina’s and Venezuela’s spreads went from 942bps and 873bps to over 4,019bps and 2,325bps, respectively. By the week of October 24, spreads had tripled since early August 2008. However, it should also be noted that credit default spreads on 10-year U.S. Treasury debt rose to a record 29.2bps: developed countries were not immune to the crisis. Problems with sovereign bonds continued into 2009 and 2010. For example, in November 2009, Dubai World, the finance arm of Dubai, asked creditors for a six month delay on interest payments due on $60 billion of the country’s debt. In the mid- and late 2000s, Dubai became a center of investment and development, much of it funded by burgeoning oil wealth from neighboring countries. But during the financial crisis, the Middle East nation was hard hit by a falling real estate market. Further, throughout the spring of 2010 Greece struggled with a severe debt crisis. Early on, some of the healthier European countries tried to step in and assist the debt ridden country. Specifically, in March 2010 a plan led by Germany and France to bail out Greece with as much as $41 billion in aid began to take shape. However, in late April Greek bond prices dropped dramatically as traders began betting a debt default was inevitable, even if the country received a massive bailout. The selloff was the result of still more bad news for Greece, which showed that the 2009 budget deficit was worse than had been previously reported, and as a result politicians in Germany began to voice opposition to a Greek bailout. Further, Moody’s Investors Service downgraded Greece’s debt rating and warned that additional cuts could be on the way. The problems in the Greek bond market then spread to other European nations with fiscal problems, such as Portugal, Spain, and Italy. As a result, in May euro-zone countries and the International Monetary Fund, seeking to Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e halt a widening European debt crisis that had now threatened the stability of the euro, agreed to extend Greece an unprecedented $147 billion rescue in return for huge budget cuts. Additional rescue packages and promises of further austerity measures intended to cut the burgeoning Greek deficit occurred through 2012. Yet the European debt crisis continued. While Greece had not yet missed a bond payment, in March the International Swaps and Derivatives Association (ISDA) declared that Greece had undergone a “restructuring credit event” which triggered insurance policy payments. The restructuring event was a forced swap of old debt held by some of its private bondholders for new debt. The swap forced a 74 percent haircut on those creditors that held out, triggering the effective default. At one point, Greece seemed unable to form a government and the leader of one party rejected the country's bailout commitments. It seemed increasingly conceivable that Greece might have to leave the euro zone. Economists’ estimated that a Greek exit from the Eurozone would cost the European Union $1 trillion, or about 5 percent of the Union’s annual economic output. Yet, the leaders of EU countries, particularly Germany and France, continued to work to keep Greek reform on track and the EU together. Further, the ECB stated that it would do whatever it took to protect the euro; ECB prepared to move forcefully into bond markets in tandem with Europe’s rescue funds and would concentrate on buying shorter-term debt. Through June 2012, the cost of bailouts required to do so totaled over $480 billion and, while calmer, the crisis in the EU was not over as Spain and Italy required bailouts as well. Fear arose that keeping the European Union together and the euro intact might actually draw sound countries into a crisis as they bail out unhealthy countries to prevent them from leaving the currency union. Even into 2013 the eurozone crisis continued, becoming Europe's longest economic slump of the post-WWII era. Continued government austerity, minimal bank lending, and high levels of household debts hampered growth in most countries. However, in June a closely watched purchasing managers survey for the euro zone rose to a 15-month high of 48.9. This and other evidence that overall economic activity in the 17-country bloc could stabilize led the European Central Bank to project that growth would return by year-end 2013. Under the doctrine of sovereign-immunity, the repayment of sovereign debt cannot be forced by the creditors and it is thus subject to compulsory rescheduling, interest rate reduction, or even repudiation. The only protection available to the creditors is threat of the loss of credibility and lowering of the international standing (the sovereign debt rating of the country, which may make it much more difficult to borrow in the future). Problems: 1. a. The Ask price is $10,000 × 107.5391% = $10,753.91 b. The Bid price is $10,000 × 100.0391% = $10,003.91 2. a. May 24, 2016 to November 30, 2017 is 1 year 191 days, or 1.52328767years. Thus, Vb = (0.875%/2) {[1-(1/(1 + 0.00849/2)2(1.52328767))]/0.00849/2} + 100%/(1 + 0.00849/2)2(1.52328767) = 100.0391% On a financial calculator: N = 1.52328767 (2) = 3.04109589, I = 0.849 / 2 = 0.4245, PMT = 0.875/2 = 0.4375, FV = 100, => PV = 100.0318% b. May 24, 2016 to July 31, 2017 is 1 year, 69 days, or 1.1890411 years. Thus, 99.8047% = (0.625%/2) {[1-(1/(1 + ask yield/2)2(1.1890411))]/ask yield/2} + 100%/(1 + ask yield/2)2(1.1890411) Solving for Asked yield, we get 0.791% On a financial calculator: N = 1.1890411(2) = 2.37808219, PV = -99.8047%, PMT = 0.625/2 = 0.3125, FV = 100, => I = 0.39517365% × 2 = 0.790% 3. a. May 24, 2016 to August 15, 2019 is 3.23013699 years. Also, the Asked price is 96.553%. Thus, 96.553% = 100%/ (1 + Asked yield/2)2x3.23013699 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Solving for “Asked yield,” we get 1.09% b. May 24, 2016 to November 30, 2016 is 0.52328767 years. Thus, Vb = 100%/ (1 + 0.56%/2)2x0.52328767 = 99.708% 4. a. Accrued interest over the 144 days is calculated as: (4.375%/2) × 144/184 = 1.71195652% of the face value of the bond, or $171.196 per $10,000 face value bond. b. Clean price + Accrued interest = Dirty price 105.25% + 1.71196% = 106.96196% of the face value of the bond, or $10,696.196 per $10,000 face value bond. 5. a. Accrued interest over the 11 days is calculated as: (2.125%/2) × 11/184 = 0.06351902% of the face value of the bond, or $6.3519 per $10,000 face value bond. b. Clean price + Accrued interest = Dirty price 98.250% + 0.063519% = 98.31359% of the face value of the bond, or $9,831.359 per $10,000 face value bond. 6. a. The inflation-adjusted principal at the end of the first six months June 30, 2022, is found by multiplying the original par value ($100,000) by the semiannual inflation rate. Thus, the principal amount is adjusted upward by 0.3 percent (e.g., $100,000 × 1.003), or to $100,300. Therefore, the first coupon payment, paid on June 30, 2022, is $4,012 ($100,300 × 4.0%). b. The inflation adjusted principal at the beginning of the second six months is $100,300. c. The principal amount used to determine the second coupon payment is adjusted upward by 1 percent (e.g., $100,300 × 1.01), or to $101,303. The coupon payment to the investor for the second six month period is the inflation-adjusted principal on this coupon payment date ($101,303) times the semiannual coupon rate (4 percent). Or on December 31, 2022, the investor receives a coupon payment of $4,052.12 ($101,303 × 4.0%). 7. a. The inflation-adjusted principal at the end of the first six months June 30, 2020, is found by multiplying the original par value ($100,000) by the semiannual inflation rate. Thus, is adjusted upward by 1.25 percent (e.g., $100,000 × 1.025), or to $102,500. Therefore, the first coupon payment, paid on June 30, 2020, is $2,306.25 ($102,500 × 2.25%). b. The inflation adjusted principal at the beginning of the second six months is $102,500. c. The principal amount used to determine the second coupon payment is adjusted upward by 0.5 percent (e.g., $102,500 × 1.005), or to $103,012.5. The coupon payment to the investor for the second six month period is the inflation-adjusted principal on this coupon payment date ($103,012.5) times the semiannual coupon rate (2.25 percent). Or on December 31, 2020, the investor receives a coupon payment of $2,317.78 ($103,012.5 × 2.25%). 8. If your marginal tax rate is 21 percent, the after-tax or equivalent tax exempt yield on the taxable bond is 9.5% (1 - 0.21) = 7.50% The municipal that pays 7.75 percent is the better deal. 9. a. If your marginal tax rate is 28 percent, the after-tax or equivalent tax exempt yield on the taxable bond is 6.75%/(1 - .28) = 9.375%

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e b. If your marginal tax rate is 21 percent, the after-tax or equivalent tax exempt yield on the taxable bond is 6.75%/(1 - .21) = 8.554% 10. a. The Delaware River Port Authority bonds had a coupon rate of 5.000%, their price was 118.00%, and the yield was 3.77%. b. On May 23, 2016, the yield to maturity on State of California bonds (maturing on November 1, 2043) was 3.83%. 11. May 25, 2016 to July 1, 2038 is 22 years 38 days, or 22.10410959 years. Thus, 111.00% = (5.500%/2) {[1-(1/(1 + bid yield/2)2(22.10410959))]/bid yield/2} + 100%/(1 + bid yield/2)2(22.10410959) Solving for bid yield, we get 4.69% 12. 109.7142857% = (4.000%/2) {[1-(1/(1 + 0.0340083577/2)2(years))]/0.0340083577ytm/2} + 100%/(1 + 0.0340083577)2(years) Solving for the years, we get 23.76986321 years, or 23 years 281 days. On a financial calculator: PV = -109.7142857%, PMT = 2.000, FV = 100, I = 3.40083577/2 = 2.5450725 => N = 47.53972642 and years = 23.76986321 years 13. a. The closing price of CVS 5.050 percent bonds on January 10, 2020 was 118.15400% of the face value of the bond. b. The S&P bond rating on Las Vegas Sands Corp 3.200 percent coupon bonds maturing in 2024 on January 10, 2020 was BBB-. c. The closing price of Petroleos Mexicanos 6.500 percent bonds on January 8, 2020 was 105.340% + 1.553% = 106.893% of the face value of the bond. 14. January 10, 2020 to March 15, 2043 is 23 years 70 days, or 23.19178 years. Thus, 105.876% = (4.375%/2) {[1-(1/(1 + yield/2)2(23.19178))]/yield/2} + 100%/(1 + yield/2)2(23.19178) Solving for yield, we get 3.984%. 15. Before the rating change: Vb = ($1,000(6.5%)/2) {[1-(1/(1 + 0.072/2)2(15))]/0.072/2} + 1,000/(1 + 0.072/2)2(15) Solving for Vb, we get $936.4268335. On a financial calculator: PMT = 32.50, FV = 1,000, I = 7.20/2 = 3.60, N = 15(2) = 30=> PV = -936.4268335 After the rating change: Vb = ($1,000(6.5%)/2) {[1-(1/(1 + 0.085/2)2(15))]/0.085/2} + 1,000/(1 + 0.085/2)2(15) Solving for Vb, we get $832.2098283. On a financial calculator: PMT = 32.50, FV = 1,000, I = 8.5/2 = 4.25, N = 15(2) = 30=> PV = -832.2098283 $ change in Vb = $832.2098283 - $936.4268335 = -$104.2170052 % change in Vb = ($832.2098283 - $936.4268335)/$936.4268335 = -$104.2170052/$936.4268335 = -11.129% 16. Since the client’s marginal tax rate is 33 percent, the tax equivalent yield on the municipal bond is 4.5%/(1 0.33) = 6.716%. This is greater than the yield on the corporate bond, 6.45%, so the client would make more profit with the municipal bond. 17. Before the rating change: Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Vb = (1,000(6.75%)/2) {[1-(1/(1 + 0.082/2)2(10))]/0.082/2} + 1,000/(1 + 0.082/2)2(10) Solving for Vb, we get $902.336888. On a financial calculator: PMT = 33.75, FV = 1,000, I = 8.20/2 = 4.10, N = 10(2) = 20=> PV = -902.336888 After the rating change: Vb = (1,000(6.75%)/2) {[1-(1/(1 + 0.071/2)2(10))]/0.071/2} + 1,000/(1 + 0.071/2)2(10) Solving for Vb, we get $975.2404439. On a financial calculator: PMT = 33.75, FV = 1,000, I = 7.1/2 = 3.55, N = 10(2) = 20=> PV = -975.2404439 $ change in Vb = $975.2404439 - $902.336888 = $72.9035558 % change in Vb = ($975.2404439 - $902.336888)/$ 902.336888 = $72.9035558/$902.336888 = 8.079% 18. EXCEL Problem:

Bond value = 102.531% Bond value = 103.094% Bond value = 103.594% Bond value = 104.437%

19. a. If a bond holder were to convert Hilton Hotels bonds into stock, each bond (worth $975.00) could be exchanged for 61.2983 shares of stock worth $15.90. The conversion value of the bonds is: $15.90 × 61.2983 = $974.50 b. The bonds are currently worth $975.00 per bond, while their conversion value is $974.5. Thus, there is virtually no difference in dollar value of the investment to the investor if he or she holds Hilton’s debt or its common stock equivalent. 20. a. If a bond holder were to convert Gentherm bonds into stock, each bond (worth $1,025.00) could be exchanged for 42.25 shares of stock worth $19.85. The conversion value of the bonds is: $19.85 × 42.25 = $838.6625 b. The bonds are currently worth $1,025.00 per bond, while their conversion value is $838.6625. Thus, the conversion of the debt to stock would result in a loss of $186.3375 ($1,025.00 - $838.6625) in dollar value for the investor. He or she is better off by continuing to hold Gentherm’s debt.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 7 Questions: 1. Mortgage markets are examined separately from bond and stock markets for several reasons. First, mortgages are backed by a specific piece of real property. If the borrower defaults on a mortgage, the financial institution can take ownership of the property. Only mortgage bonds are backed by a specific piece of property that allows the lender to take claim in the event of a default. All other corporate bonds and stocks give the holder a general claim to a borrower’s assets. Second, there is no set denomination for primary mortgages. Rather, the size of each mortgage depends on the borrower’s needs. Bonds generally have a denomination of $1,000 or a multiple of $1,000 per bond and shares of stock are generally issued in denominations of $1 per share. Third, primary mortgages generally involve a single investor (e.g., a bank or mortgage company). Bond and stock issues, on the other hand, are generally held by many (sometimes thousands of) investors. Finally, the typical issuers in the mortgage market (individuals) are quite different from issuers (corporations and governments) in other financial markets. Because primary mortgage borrowers are often individuals, information on these borrowers is less extensive and unaudited. Bonds and stocks are issued by publicly traded corporations and governments which are subject to extensive rules and regulations regarding information availability and reliability. 2. Four basic categories of mortgages are issued by financial institutions: homes, multifamily dwellings, commercial, and farms. Home mortgages ($10.01 trillion outstanding in 2016) are used to purchase one- to fourfamily dwellings. Multifamily dwelling mortgages ($1.11 trillion outstanding) are used to finance the purchase of apartment complexes, townhouses, and condominiums. Commercial mortgages ($2.52 trillion outstanding) are used to finance the purchase of real estate for business purposes (e.g., office buildings, shopping malls). Farm mortgages ($0.21 trillion outstanding) are used to finance the purchase of farms. As seen in Figure 7-1, all four areas have experienced tremendous growth due to the historically low mortgage rates in the 1990s and 2000s: single family home mortgages, 189 percent growth from 1995 through 2016; commercial business mortgages, 241 percent growth; multifamily residential mortgages, 296 percent growth; and farm mortgages, 200 percent growth. 3. A lien is a public record attached to the title of the property that gives the financial institution the right to sell the property if the mortgage borrower defaults or falls into arrears on his or her payments. The mortgage is secured by the lien. That is, until the loan is paid off, no one can buy the property and obtain clear title to it. If someone tries to purchase the property, the financial institution can file notice of the lien at the public recorders office to stop the transaction. 4. Federally insured mortgages are originated by financial institutions, but repayment is guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA). In order to qualify, FHA and VA mortgage loan applicants must meet specific requirements set by these government agencies. Further, the maximum size of the mortgage is limited. FHA or VA mortgages require either a very low or zero down payment. Conventional mortgages are mortgages issued by financial institutions and are not federally insured (but they generally are required to be privately insured if the borrower=s down payment is less than 20 percent of the property’s value). 5. A fixed rate mortgage locks in the borrower=s interest rate and thus required monthly payments over the life of the mortgage, regardless of how market rates change. In contrast, the interest rate on an adjustable rate mortgage (ARM) is tied to some market interest rate or interest rate index. Thus, the required monthly payments can change over the life of the mortgage. ARMs generally limit the change in the interest rate allowed each year and during the life of the mortgage Mortgage borrowers generally prefer fixed rate loans to ARMs, particularly when interest rates in the economy are low. In fact, if interest rates rise, ARMs may cause borrowers to be unable to meet the promised payments on the mortgage. In contrast, most mortgage lenders prefer ARMs when interest rates are low. When interest rates eventually rise, ARM payments on their mortgage assets will rise. Since deposit rates and other liability rates too will be rising, it will be easier for financial institutions to pay the higher interest rates to their depositors when they issue ARMs. However, higher interest payments mean mortgage borrowers may have trouble making their payments. Thus, default risk increases. As a result, while ARMs reduce a financial institutions interest rate risk, they also increase their default risk. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 6. By refinancing the mortgage at a lower interest rate, the borrower pays less each month—even if the new mortgage is for the same amount as the current mortgage. Mortgage refinancing involves many of the same details and steps involved in applying for a new mortgage and can involve many of the same fees and expenses. Mortgages are most often refinanced when a current mortgage has an interest rate that is higher than the current interest rate. As coupon rates on new mortgages fall, the incentive for mortgage borrowers to pay off old, high coupon rate mortgages and refinance at lower rates increases. Traditionally, the decision to refinance involves balancing the savings of a lower monthly payment against the costs (fees) of refinancing. That is, refinancing adds transaction and recontracting costs. Origination costs or points for new mortgages, along with the cost of appraisals and credit checks, frequently arise as well. An often-cited rule of thumb is that the interest rate for a new mortgage should be 2 percentage points below the rate on the current mortgage for refinancing to make financial sense. 7. Points are fees or payments made when a mortgage loan is issued (at closing). One discount point paid up front is equal to 1 percent of the principal value of the mortgage. A borrower pays points on a mortgage up front in exchange for a reduced interest rate and, consequently, reduced monthly payments. The choice of points (and lower monthly payments) versus no points (and higher monthly payments) depends on how long the mortgage borrower takes to pay off the mortgage. Specifically, the longer the borrower takes to pay off the mortgage, the more likely he or she is to choose points and a lower mortgage rate. Thus, by offering points, the mortgage lender decreases the probability that the mortgage borrower will prepay the mortgage—paying the mortgage off early reduces the present value of the monthly savings to the mortgage borrower. 8. Jumbo mortgages are those mortgages that exceed the conventional mortgage conforming limits. Limits are set by the two government-sponsored enterprises, Fannie Mae and Freddie Mac (discussed below) and are based on the maximum value of any individual mortgage they will purchase from a mortgage lender. In 2016, the general limit was $417,000 for most of the U.S. (the limit is set higher in high cost areas of the country). Because the large size and the inability to sell jumbo mortgages to Fannie Mae or Freddie Mac creates more risk for mortgage lenders, interest rates on jumbo mortgages are generally higher than on conforming mortgages. Typically, the spread in interest rates on jumbo versus conventional mortgages is about 0.25 to 0.50 percent. However, during periods of high economy-wide risk (e.g., during the late 2000s), the spread can be greater than 1.50 percent. Further, to reduce the risk of these loans, lenders will often require a higher down payment on jumbo mortgages than conventional mortgages. 9. Subprime mortgages are mortgages to borrowers that do not qualify for prime mortgages because of weakened credit histories including payment delinquencies, and possibly more severe problems such as charge-offs, judgments, and bankruptcies. Subprime borrowers may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories. Subprime mortgages have a higher rate of default than prime mortgage loans and are thus, riskier loans for the mortgage lender and. As a result, these mortgages have higher interest rates than prime mortgages. The majority of home loans are not subprime mortgages; however their numbers rapidly grew in the mid-2000s. Subprime mortgages accounted for 9 percent of all mortgage originations from 1996 through 2004 and rose to about 21 percent from 2004 through 2006. It was subprime mortgages and the huge growth in them that was a major instigator of the financial crisis. The low interest rate environment in the early and mid-2000s led to a dramatic increase in the demand for residential mortgages, especially among those who had previously been excluded from participating in the market because of their poor credit ratings, i.e., subprime borrowers. To boost their earnings, FIs began lowering their credit quality cut-off points. In the subprime market, banks and other mortgage lenders often offered relatively low “teaser” rates on adjustable rate mortgages (ARMs). Eventually, housing prices started to fall and interest rates started to rise. Since many subprime mortgages had floating rates, meeting mortgage payments became impossible for many low income households. The results were a wave of mortgage defaults in the subprime market and foreclosures that only reinforced the downward trend in house prices. As this happened, the poor quality of the collateral and credit quality underlying subprime mortgage pools became apparent. Subprime mortgage-backed securities plummeted in value and the financial crisis began. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 10. Option ARMs, also called pick-a-payment or pay-option ARMs, are 15- or 30-year adjustable rate mortgages that offer the borrower several monthly payment options. The four major types of payment options include: minimum payment options, interest only payment, a 15-year fully amortizing payment, and a 30-year fully amortizing payment. Minimum payment option. The minimum payment is the lowest of the four payment options and carries the most risk. With these option ARMs, the monthly payment is set for 12 months at an initial interest rate. After that, the payment changes annually, and a payment cap limits how much it can increase or decrease each year (generally 7.5 percent). If the minimum payment is continued after the end of the initial interest rate period, which usually holds only for the first 1 to 3 months, it may not be enough to pay all of the interest charged on the loan for the previous month and the unpaid interest will be added to the principal balance. This is called negative amortization, and it means that the amount owed increases and the borrower will be charged additional interest at the rate on the loan on the new, larger principal balance. The minimum payment on most option arm programs is 1percent fully amortized. Every time the borrower makes the minimum payment, the difference between the minimum payment and the interest-only payment is tacked onto the balance of the loan. A borrower can pay the minimum payment until the loan balance reaches 110 to 115 percent of the original loan balance. This allows the typical borrower to pay the minimum payment for roughly the first five years of the life of the loan. After the loan balance reaches 110 to 115 percent, the borrower loses the minimum payment option, leaving them with the three remaining payment options. Interest-only payment: An interest-only option ARM requires the borrower to pay only the interest on the loan during the initial period of the loan. During this period, no principal must be repaid. After the interest-only period, the mortgage must amortize so that the mortgage will be paid off by the end of its original term. This means that monthly payments must increase substantially after the initial interest-only period lapses. The length of the interestonly period varies with each mortgage type. The interest-only payment may change every month based on changes in the ARM index used to determine the loan interest rate. After ten years from the start of the loan, the interest-only option typically goes away as well, and the borrower must pay using one of the two remaining payment options. Interest-only payment option ARMs carry a great deal of payment-shock risk. Not only do the payments have the potential to increase because of an increasing fully indexed interest rate, but the expiration of the interest-only payment means that payments will increase when the mortgage becomes a fully amortizing loan. 30-year fully amortizing payment: With fully amortizing option ARMs, the borrower pays both principal and interest on the loan. By making this payment each month, the borrower is ensured that all interest and principal are fully paid on schedule. The payment is calculated each month based on the prior month's fully indexed rate, loan balance, and remaining loan term. 15-year fully amortizing payment: This option ARM is similar to the 30-year fully amortizing payment option ARM, with a full principal and interest payment, but with a larger amount of principal paid each month. This amount includes all of the interest charged on the loan for the previous month plus principal to pay off the loan based on a 15-year term (instead of a 30 term). The payment amount may change from month to month based on changes in the index value used to determine the fully indexed rate. Choosing the 15- year fully amortizing payment puts the mortgage on an accelerated amortization schedule. 11. The secondary mortgage markets were created by the federal government to help boost U.S. economic activity during the Great Depression. As borrowers defaulted on mortgages, banks and thrifts found themselves strapped for cash. To create liquidity in the mortgage markets and to raise levels of home ownership and the availability of affordable housing, in 1938 the government established the Federal National Mortgage Association (FNMA or Fannie Mae) to buy mortgages from depository institutions so they could lend to other mortgage borrowers. FNMA’s mandate was to act as a secondary mortgage market facility that could purchase, hold, and sell mortgage loans. The government also established the Federal Housing Administration (FHA) and the Veterans Administration (VA) to insure certain mortgages against default risk (described earlier). This made it easier to sell/securitize mortgages. Financial institutions originated the mortgages and secondary market buyers did not have to be as concerned with a borrower’s credit history or the value of collateral backing the mortgage since they had a federal Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e government guarantee protecting them against default risk. Fannie Mae grew very large over the years. To remove Fannie Mae's growing debt portfolio from the government balance sheet, in 1968 Fannie Mae was converted into a publicly traded company owned by investors. Further, by the late 1960s, fewer veterans were obtaining guaranteed VA loans. As a result, the secondary market for mortgages declined. To encourage continued expansion in the housing Market and to promote competition for FNMA (which was functioning as a virtual monopoly), the U.S. government created the Government National Mortgage Association (GNMA or Ginnie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). Like FNMA, GNMA and FHLMC provide direct or indirect guarantees that allow for the creation of mortgage-backed securities (we provide a detailed description of each agency below). Also, like FNMA, FHLMC became quite large and was converted to a public company in 1989, removing the debt from the balance sheet of the federal government. 12. A mortgage sale occurs when a financial institution originates a mortgage and sells it with or without recourse to an outside buyer. Mortgage sales usually involve no creation of new types of securities. Securitization of mortgages involves the pooling of a group of mortgages with similar characteristics, the removal of these mortgages from the balance sheet, and the subsequent sale of interests in the pool to secondary market investors. Securitization of mortgages results in the creation of mortgage-backed securities (e.g., government agency securities, collateralized mortgage obligations), which can be traded in secondary mortgage markets. 13. Mortgage-backed securities allow mortgage issuers to separate the credit risk exposure from the lending process itself. That is, FIs can assess the creditworthiness of loan applicants, originate loans, fund loans, and even monitor and service loans without retaining exposure to loss from credit events, such as default or missed payments. This moves banks away from the traditional “originate and hold” banking model, in which the originating bank retains the loan and the risk exposure, until the loan is paid off. Rather, mortgage securitization and loan syndication allows banks to retain little or no part of the loans, and hence little or no part of the default risk on loans that they originate: bank have moved to the originate-to-distribute model of banking. Thus, as long as the borrower did not default within the first months after a loan’s issuance and the loans were sold or securitized without recourse back to the bank, the issuing bank could ignore longer term credit risk concerns. This decoupling of the risk from the lending activity allows the market to efficiently transfer risk across counterparties. However, it also loosens the incentives to carefully perform each of the steps of the lending process. This loosening of incentives has been an important factor leading to the global financial crisis of 2008-2009, which has witnessed the aftereffects of poor loan underwriting, shoddy documentation and due diligence, failure to monitor borrower activity, and fraudulent activity on the part of both lenders and borrowers. The result was a deterioration in credit quality at the same time as there was a dramatic increase in consumer and corporate leverage. Eventually, in 2006, housing prices started to fall. At the same time, the Federal Reserve started to raise interest rates as it began to fear inflation. Since many of the subprime mortgages that originated in the 2001–2005 period had adjustable rates, the cost of meeting mortgage commitments rose to unsustainable levels for many low-income households. The confluence of falling house prices, rising interest rates, and rising mortgage costs led to a wave of mortgage defaults in the subprime market and foreclosures that only reinforced the downward trend in housing prices. As this happened, the poor quality of the collateral and credit quality underlying subprime mortgage pools became apparent, with default rates far exceeding those apparently anticipated by the rating agencies who set their initial subprime mortgage securitizations ratings. The financial crisis began. Although bank regulators attempt to examine the off balance sheet activities of banks so as to ascertain their safety and soundness, there is far less scrutiny off the balance sheet than there is for their on-balance-sheet activities (i.e., traditional lending and deposit taking). To the extent that counterparty credit risk was not fully disclosed to, or monitored by regulators, the increased use of these innovations transferred risk in ways that were not necessarily scrutinized or understood. It is in this context of increased risk and inadequate regulation that the credit crisis developed. 14. Pass-through mortgage securities pass through the promised payments of principal and interest on pools of mortgages created by financial institutions to secondary market participants (mortgage-backed bondholders) holding Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e an interest in these pools. After a financial institution issues mortgages, they pool them and sell interests in these pools to pass-through security holders. Each pass-through mortgage security represents a fractional ownership share in a mortgage pool. Thus, a 1 percent owner of a pass-through mortgage security issue is entitled to a 1 percent share of the principal and interest payments made over the life of the mortgages underlying the pool of securities. The originating financial institutions (e.g., bank or mortgage company) or a third party servicer receives principal and interest payments from the mortgage holder and passes these payments through to the pass-through security holders. 15. The Government National Mortgage Association (GNMA), or Ginnie Mae, began in 1968 when it split off from the Federal National Mortgage Association (FNMA). GNMA is a government-owned agency with two major functions: sponsoring mortgage-backed securities programs by financial institutions such as banks, thrifts, and mortgage bankers and acting as a guarantor to investors in mortgage-backed securities regarding the timely pass-through of principal and interest payments on their sponsored bonds from the financial institution or servicer to the bondholder. In other words, GNMA provides timing insurance. In acting as a sponsor and payment-timing guarantor, GNMA supports only those pools of mortgage loans whose default or credit risk is insured by one of three government agencies; the Federal Housing Administration (FHA), the Veterans Administration (VA), and the Farmers Home Administration (FMHA). Mortgage loans insured by these agencies target groups that might otherwise be disadvantaged in the housing market such as low-income families, young families, and veterans. As such, the maximum mortgage under the FHA/VA/FMHA=GNMA securitization program is capped. 16. Originally created in 1938, the Federal National Mortgage Association (FNMA or Fannie Mae), is the oldest of the three mortgage-backed security-sponsoring agencies. While, since 1968, FNMA has operated as a private corporation owned by shareholders, in the minds of many investors, it has had implicit government backing, which makes it equivalent to a government-owned enterprise. Indeed, the fact that FNMA has historically had a secured line of credit available from the U.S. Treasury should it need funds in an emergency supports this view. FNMA is a more active agency than GNMA in creating pass-through securities. GNMA merely sponsors such programs and guarantees the timing of payments from financial institution servicers to GNMA investors. FNMA actually helps create pass-throughs by buying and holding mortgages on its balance sheet; it also issues bonds directly to finance those purchases. Specifically, FNMA creates mortgage-backed securities (MBSs) by purchasing packages of mortgage loans from banks and thrifts; it finances such purchases by selling MBSs to outside investors such as life insurers or pension funds. In addition, FNMA engages in swap transactions by which it swaps MBSs with a bank or thrift for original mortgages. Since FNMA guarantees securities in regard to the full and timely payment of interest and principal, the financial institution receiving the MBSs can then resell them in the capital market or can hold them in its own portfolio. Unlike GNMA, FNMA securitizes conventional mortgage loans as well as FHA/VA insured loans, as long as the conventional loans have acceptable loan-to-value or collateral ratios not normally exceeding 80 percent. Conventional loans with high loan-to-value ratios usually require that the mortgages be insured with private mortgage insurance before they are accepted into FNMA securitization pools. 17. Together FNMA and FHLMC represent a huge presence in the financial system as they have over 60 percent of the single-family mortgage pools in the United States. Some regulators and politicians have argued that these two government-sponsored enterprises have gained too much of a market share. In the early 2000s, their credit losses increased as did their debt-to-equity ratios. Debt to equity for these two agencies ranged from 30 to 97 percent, depending on the assumptions made about off-balance-sheet exposures. Also, in the early 2000s, these two agencies came under fire for several reasons. First, in September 2002, Fannie Mae was criticized for allowing a sharp increase in interest rate risk to exist on its balance sheet. The Office of Federal Housing Enterprise Oversight (OFHEO), a main regulator of Fannie Mae, required Fannie Mae to submit weekly reports to the OFHEO on the company’s exposure to interest rate risk. The OFHEO also instructed Fannie Mae to keep regulators apprised of any challenges associated with returning its interest rate risk measure to more acceptable levels and warned that additional action would be taken if there were adverse developments with Fannie Mae management’s effectiveness in lowering interest rate risk. In October 2003, Fannie Mae and Freddie Mac came under new criticism for allegedly overcharging lenders for services they provided. The overcharges came in the fees that the companies collect from banks, thrifts, and other lenders for guaranteeing repayment of their mortgages. The overcharges hurt mortgage lenders, squeezing their profit margins, and perhaps home buyers, too, as lenders Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e increased mortgage interest rates to recover the increased fees. Later that same month, Fannie Mae announced that it miscalculated the value of its mortgages, forcing it to make a $1.1 billion restatement of its stockholders’ equity. Earlier in the year, Freddie Mac announced a $4.5 billion misstatement of its earnings. While both were claimed to be computational errors, the episodes reinforced fears that Fannie Mae and Freddie Mac lack the necessary skills to operate their massive and complex businesses, which some investors and political critics worried could pose a risk to the nation’s financial system if not properly managed. Finally, in February 2004, then Federal Reserve Chairman Alan Greenspan stated that Fannie Mae and Freddie Mac pose very serious risks to the U.S. financial system and urged Congress to curb their growth sooner rather than later. Underlying the concerns about the actions of these two GSEs was the widespread perception among investors that neither would be allowed to fail if they got into trouble. This perception created a subsidy for the agencies and allowed them to borrow more cheaply than other firms with similar balance sheets. The fear was that the two agencies used their implicit federal backing to assume more risk and finance expansion through increased debt. Such actions created a source of systemic risk for the U.S. financial system. These fears and concerns became reality during the financial crisis. The turmoil in the housing and credit markets that began in 2007 put extreme financial pressure on Fannie Mae and Freddie Mac. The value of their mortgage assets fell, but the debt they issued to purchase those assets remained on their balance sheets. To maintain a positive net worth in the face of falling asset values, financial firms have several options to raise capital, none of which were readily available to Fannie or Freddie. If they sold assets, they would depress the prices of mortgage loans and MBSs even further, worsening both their own balance sheet positions and those of many other financial firms. They could not use retained earnings to increase capital because their operations had not earned a profit since 2006. Finally, rapidly falling share prices made it difficult to raise capital by selling new common stock. GSE status, however, enabled them to continue to fund their operations by selling debt securities, because the market believed that Fannie and Freddie debt was implicitly guaranteed by the government. In July 2008, however, Fannie and Freddie’s share prices fell sharply, resulting in the possibility that market participants might refuse to extend credit to Fannie and Freddie under any terms. Even though Fannie and Freddie maintained access to the debt markets (albeit at higher than usual interest rates), their inability to raise new capital cast doubts on their long-term viability. As a result, the federal government concluded that “the companies cannot continue to operate safely and soundly and fulfill their critical public mission, without significant action” to address their financial weaknesses. The Housing and Economic Recovery Act of 2008, enacted July 30, 2008, gave the authority for the government’s takeover of the GSEs. The act created a new GSE regulator, the Federal Housing Finance Agency (FHFA), with the authority to take control of either GSE to restore it to a sound financial condition. The act also gave the Treasury emergency authority to purchase an unlimited amount of GSE debt or equity securities if necessary to provide stability to the financial markets, prevent disruptions in the availability of mortgage finance, and protect the taxpayer. On September 7, 2008, the FHFA established a conservatorship for both Fannie and Freddie. As conservator, the FHFA took over the assets and assumed all the powers of the shareholders, directors, and officers. The government lent the two GSEs $188 billion and received a right to acquire almost 80 percent of each company’s stock. Stockholders’ voting rights were suspended during the conservatorship, and both firms replaced their CEOs. Dividends on common and preferred stock were suspended, although the shares continued to trade. (However, in June 2010, the NYSE, through the FHFA, notified Fannie and Freddie that they no longer met NYSE listing standards. The FHFA ordered the two GSEs to transfer trading of their common and preferred shares from the NYSE to the over-the- counter market.) The conservatorship will end when the FHFA finds that a safe and solvent condition has been restored. The takeover of Fannie and Freddie, and specifically the commitment to meet all of the firms’ obligations to debt holders, exposes the U.S. government to a potentially large financial risk. At the time the FHFA took over, debt issued or guaranteed by the GSEs totaled more than $5 trillion. The risks of not acting, however, clearly appeared intolerable to the government. A failure or default by either Fannie or Freddie would have severely disrupted financial markets around the world. If the GSE portfolios of mortgage loans and MBSs had been liquidated, prices would have plunged even further, the secondary market for mortgages would have been decimated, and the supply of new mortgage credit would have been severely restricted. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e In February 2011, the Obama administration recommended phasing out the GSEs and gradually reducing the government’s involvement in the mortgage market. In the proposal, any dismantling of Fannie and Freddie would happen gradually to avoid a shake-up in the mortgage markets, Steps to reduce the government role in the mortgage market likely would raise borrowing costs for home buyers, adding pressure on the still-fragile U.S. housing markets. Consequently, the implementation of the proposal would take years and would be driven by the pace of the housing market’s recovery. Complicating these efforts, as the U.S. economy and housing market slowly recovered, so did the GSEs. In 2012, FNMA and Freddie Mac reported net income of $17.2 billion and $11.0 billion, respectively, the best year ever for both companies. By mid-2016 the companies’ stocks were trading at $2.04 and $1.87, respectively, up from $0.97$0.98 at the beginning of the year. The two GSEs had repaid $66 billion of the loans received in 2008 to the U.S. Treasury and the government projected a total of $238 billion in revenues due to the government from the two, a $50 billion profit. The GSEs were making money and expected to remain profitable. The prospect of steady profits confounded legislative efforts to shrink the federal role in securitizing home loans. 18. A CMO can be viewed as a multiclass pass-through with a number of different bondholder classes or tranches. Unlike a pass-through which has no guaranteed annual “coupon,” each bondholder class has a different guaranteed coupon just as a regular T-bond has, but more importantly, the allocation of any excess cash flows over and above the guaranteed coupon payments due to mortgage prepayments go to retire the principal outstanding of only one class of bondholders, leaving all other classes’ prepayment protected for a period of time. That is, CMOs give investors greater control over the “maturity” of the mortgage-backed securities they buy. By comparison, for passthroughs the mortgage-backed security holder has a highly uncertain maturity date due to the risk of early payments. CMOs can be created either by packaging and securitizing whole mortgage loans or, more usually, re-securitizing pass-through securities. In the latter case a trust or third-party bank holds the GNMA pass-through as collateral against issues of new CMO securities. The trust normally issues a CMO with three or more different classes. 19. MBBs differ from pass-throughs and CMOs in two key dimensions. First, while pass-throughs and CMOs help financial institutions remove mortgages from their balance sheets, MBBs normally remain on the balance sheet. Second, pass-throughs and CMOs have a direct link between the cash flows on the underlying mortgages and the cash flows on the bond instrument issued. By contrast, the relationship for MBBs is one of collateralization; the cash flows on the mortgages backing the bond are not necessarily directly connected to interest and principal payments on the MBB. Essentially, a financial institution issues an MBB to reduce risk to the MBB holders, who have a first claim to a segment of the financial institutionBs mortgage assets. Practically speaking, the financial institution segregates a group of mortgage assets on its balance sheet and pledges this group of assets as collateral against the MBB issue. 20. Figure 7–8 shows the distribution of mortgages outstanding in 1992, 2007, and 2016 by type of mortgage holder —the ultimate investor. Notice in Figure 7–8 the growth in the importance of mortgage securitization pools over the period (40.42 percent of all mortgages outstanding in 1992 versus 55.35 percent in 2007 and 56.40 percent in 2016). By contrast, mortgages held by life insurance companies, households, businesses, and the federal government have fallen as a percentage of the total pool of mortgages outstanding (5.95 percent for life insurance companies in 1992 versus 2.26 percent in 2007 and 3.11 percent in 2016; 10.38 percent for households, businesses, and government in 1992 versus 3.05 percent in 2007 and 5.77 percent in 2016). Actual holdings of mortgages by specialized mortgage companies (such as Sierra Pacific Mortgage Company and Blue Water Mortgage Corp. of New Hampshire) are small (1.49 percent in 1992, 3.65 percent in 2007, and 0.84 percent in 2016). Mortgage companies, or mortgage bankers, are financial institutions 9 that originate mortgages and collect payments on them. Unlike banks or thrifts, mortgage companies typically do not hold on to the mortgages they originate. Instead, they sell the mortgages they originate but continue to service the mortgages by collecting payments and keeping records on each loan. Mortgage companies earn income to cover the costs of originating and servicing the mortgages from the servicing fees they charge the ultimate buyers of mortgages. Figure 7–9 shows the distribution of issuers of GNMA securities by type of originating financial institution. Mortgage companies issued Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e over 71 percent of all GNMA securities in 2016. What should be evident from this figure is that, despite originating such a large volume in the mortgage market, the reason for the small investments in mortgages by mortgage companies (as seen in Figure 7–8) is that, while mortgage companies are major originators of home mortgages, they generally do not hold the mortgage loans in their asset portfolios for a long period of time. Rather, mortgage companies sell or securitize most of the mortgages they originate in the secondary market. From these two figures it should be evident that securitization allows institutional investors (insurance companies, pension plans, mutual funds, hedge funds) to lend indirectly to households through purchases of mortgage-backed securities. Further, it should be noted that in 2011, the three largest banks - Wells Fargo, J.P. Morgan Chase and Bank of America — accounted for 68 percent of GNMA's mortgage-backed securities business. Today, nonbank mortgage lenders are responsible for 71 percent of GNMA MBS issuance. Banks have reduced their GNMA issuance in part due to pressure from the Justice Department and the Department of Housing and Urban Development to enter into major settlements for allegedly careless underwriting of FHA-insured loans.

Problems: 1. You will make a down payment of 20 percent of the purchase price, or you will make a down payment of $20,000 (0.20 × $100,000) at closing and borrow $80,000 through the mortgage. a. For your mortgage: or therefore

$80,000 = PMT{[1 - (1/(1 + 0.0825/12)30(12))]/(0.0825/12)} PMT = $80,000/{[1 - (1/(1 + 0.0825/12)30(12))]/(0.0825/12)} PMT = $80,000/133.1085 = $601.01

Thus, your monthly payment is $601.01. b. The 25th payment (335 payments remaining) of $601.01 is split as follows: $540.88 to interest and $60.13 to principal. c. The 225th payment of $601.01 is split as follows: $364.32 to interest and $236.69 to principal. d. The total payments over the life of the mortgage amount to payments of $216,363.60 ($601.01 × 30 × 12): $80,000 to the repayment of principal and $136,363.60 to the payment of interest. 2. You will make a down payment of 20 percent of the purchase price, or you will make a down payment of $35,000 (0.20 × $175,000) at closing and borrow $140,000 through the mortgage. a. For your mortgage: or therefore

$140,000 = PMT{[1 - (1/(1 + 0.0775/12)15(12))]/(0.0775/12)} PMT = $140,000/{[1 - (1/(1 + 0.0775/12)15(12))]/(0.0775/12)} PMT = $140,000/106.2388 = $1,317.79

Thus, your monthly payment is $1,317.79. b. The 60th payment of $1,317.79 is split as follows: $713.07 to interest and $604.72 to principal. c. The 180th payment of $1,317.79 is split as follows: $8.46 to interest and $1,309.33 to principal. d. The total payments over the life of the mortgage amount to payments of $237,201.48 ($1,317.786 × 15 × 12): $140,000 to the repayment of principal and $97,201.48 to the payment of interest. 3. You will make a down payment of 20 percent of the purchase price, or you will make a down payment of $16,000 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e (0.20 × $80,000) at closing and borrow $64,000 through the mortgage. a. For your mortgage: or therefore

$64,000 = PMT{[1 - (1/(1 + 0.08/12)15(12))]/(0.08/12)} PMT = $64,000/{[1 - (1/(1 + 0.08/12)15(12))]/(0.08/12)} PMT = $64,000/104.6406 = $611.617

Thus, your monthly payment is $611.62. b. The 127th payment of $611.62 is split as follows: $184.39 to interest and $427.23 to principal. c. The 159th payment of $611.62 is split as follows: $83.17 to interest and $528.45 to principal. d. The total payments over the life of the mortgage amount to payments of $110,091.60 ($611.62 × 15 × 12): $64,000 to the repayment of principal and $46,091.60 to the payment of interest. 4. You will make a down payment of 20 percent of the purchase price, or you will make a down payment of $30,000 (0.20 × $150,000) at closing and borrow $120,000 through the mortgage. a. For your mortgage: or therefore

$120,000 = PMT{[1 - (1/(1 + 0.0525/12)15(12))]/(0.0525/12)} PMT = $120,000/{[1 - (1/(1 + 0.0525/12)15(12))]/(0.0525/12)} PMT = $120,000/124.3970 = $964.65

Thus, your monthly payment is $964.65. b.

Amortization Schedule for first 6 payments (months) Beginning Loan Month Balance Payment Interest 1 $120,000.00 $964.65 $525.00 2 119,560.35 964.65 523.08 3 119,118.78 964.65 521.14 4 118,675.27 964.65 519.20 5 118,229.82 964.65 517.26 6 117,782.43 964.65 515.30

Principal $439.65 441.57 443.51 445.45 447.39 449.35

Ending Loan Balance $119,560.35 119,118.78 118,675.27 118,229.82 117,782.43 117,333.08

5. You will make a down payment of 20 percent of the purchase price, or you will make a down payment of $40,000 (0.20 × $200,000) at closing and borrow $160,000 through the mortgage. a. For your mortgage: or therefore

$160,000 = PMT{[1 - (1/(1 + 0.0650/12)30(12))]/(0.0650/12)} PMT = $160,000/{[1 - (1/(1 + 0.0650/12)30(12))]/(0.0650/12)} PMT = $160,000/158.2108 = $1,011.31

Thus, your monthly payment is $1,011.31. b.

Amortization Schedule for first 6 payments (months) Beginning Loan Month Balance Payment Interest 1 $160,000.00 $1,011.31 $866.67 2 159,855.36 1,011.31 865.88

Principal $144.64 145.43

Ending Loan Balance $159,855.36 159,709.93

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 3 4 5 6

159,709.93 159,563.72 159,416.71 159,268.91

1,011.31 1,011.31 1,011.31 1,011.31

6. EXCEL Problem:

Payment = $1,245.62 Payment = $1,286.13 Payment = $1,390.52 Payment = $1,521.40

7. EXCEL Problem:

Payment = $875.36 Payment = $923.58 Payment = $1,048.82 Payment = $1,206.93

865.10 864.30 863.51 862.71

146.21 147.01 147.80 148.60

159,563.72 159,416.71 159,268.91 159,120.31

8. For the either mortgage, you will make a down payment of 20 percent of the purchase price: or a down payment of $40,000 (0.20 × $200,000) at closing and borrow $160,000 through the mortgage. a. Total payments on the 15-year mortgage are $250,878.60, of which $90,878.60 is interest. This compares to interest of $232,932.80 on the 30-year mortgage (a difference of $142,054.20, disregarding time value of money). The mortgage borrower’s interest payments are reduced significantly with the 15-year mortgage relative to the 30year mortgage. b. For the 30-year mortgage: or therefore

$160,000 = PMT{[1 - (1/(1 + 0.0725/12)30(12))]/(0.0725/12)} PMT = $160,000/{[1 - (1/(1 + 0.0725/12)30(12))]/(0.0725/12)} PMT = $160,000/146.5897 = $1,091.48

For the 15-year mortgage: or therefore

$160,000 = PMT{[1 - (1/(1 + 0.0650/12)15(12))]/(0.0650/12)} PMT = $160,000/{[1 - (1/(1 + 0.0650/12)15(12))]/(0.0650/12)} PMT = $160,000/114.7964 = $1,393.77

The borrower must pay $1,393.77 per month with the 15-year mortgage compared to $1,091.48 with the 30-year mortgage, a difference of $302.29 per month. This may be difficult if the borrower’s income level is not very high. 9. For the either mortgage, you will make a down payment of 20 percent of the $240,000 purchase price of a new home, or a down payment of $48,000 (0.20 × $240,000) at closing and borrow $192,000 through the mortgage. a. Total payments on the 15-year mortgage are $273,297.60, of which $81,279.60 is interest. This compares to interest of $211,365.60 on the 30-year mortgage (a difference of $130,068.00, disregarding time value of money). The mortgage borrower’s interest payments are reduced significantly with the 15-year mortgage relative to the 30year mortgage. b. For the 30-year mortgage: or therefore

$192,000 = PMT{[1 - (1/(1 + 0.0575/12)30(12))]/(0.0575/12)} PMT = $192,000/{[1 - (1/(1 + 0.0575/12)30(12))]/(0.0575/12)} PMT = $192,000/171.3582 = $1,120.46

For the 15-year mortgage: or therefore

$192,000 = PMT{[1 - (1/(1 + 0.0500/12)15(12))]/(0.0500/12)} PMT = $192,000/{[1 - (1/(1 + 0.0500/12)15(12))]/(0.0500/12)} PMT = $192,000/114.7964 = $1,518.32

The borrower must pay $1,518.32 per month with the 15-year mortgage compared to $1,120.46 with the 30-year Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e mortgage, a difference of $397.86 per month. This may be difficult if the borrower’s income level is not very high. 10. You will make a down payment of 20 percent of the $115,000 purchase price of a new home, or you will make a down payment of $23,000 (0.20 × $115,000) at closing and borrow $92,000 through the mortgage. a. If Option 2 is chosen you pay $92,000 × 0.02 = $1,840 in points and receive $90,160 at closing ($92,000 $1,840), although the mortgage principal is $92,000. To determine the best option, we first calculate the monthly payments for both options as follows Option 1: Option 2:

$92,000 = PMT {[1 - (1/(1 + 0.0900/12)30(12))]/(0.0900/12)} => PMT = $740.25 $92,000 = PMT {[1 - (1/(1 + 0.0885/12)30(12))]/(0.0885/12)} => PMT = $730.35

In exchange for $1,840 up front, Option 2 reduces your monthly mortgage payments by $9.90. The present value of these savings (evaluated at 8.85 percent) over the 30 years is PV = $9.90 {[1 - (1/(1 + 0.0885/12)30(12))]/(0.0885/12)} = $1,248.06 Option 1 is the better choice. The present value of the monthly savings, $1,248.06, is less than the points paid up front, $1,840. b. If Option 1 is chosen you pay $92,000 × 0.01 = $920 in points and receive $91,080 at closing ($92,000 - $920), although the mortgage principal is $92,000. If Option 2 is chosen you pay $92,000 × 0.025 = $2,300 in points and receive $89,700 at closing ($92,000 - $2,300). The difference in savings on the points is $1,380. To determine the best option, we calculate the monthly payments for both options as follows Option 1: Option 2:

$92,000 = PMT {[1 - (1/(1 + 0.1025/12)30(12))]/(0.1025/12)} => PMT = $824.413 $92,000 = PMT {[1 - (1/(1 + 0.1000/12)30(12))]/(0.1000/12)} => PMT = $807.366

In exchange for $1,380 up front, Option 2 reduces your monthly mortgage payments by $17.047. The present value of these savings (evaluated at 10.00 percent) over the 30 years is PV = $17.047 {[1 - (1/(1 + 0.1000/12)30(12))]/(0.1000/12)} = $1,942.52 Option 2 is the better choice. The present value of the monthly savings, $1,942.52, is greater than the difference in the points paid up front, $1,380. 11. You will make a down payment of 20 percent of the purchase price, or you will make a down payment of $39,000 (0.20 × $195,000) at closing and borrow $156,000 through the mortgage. a. If Option 2 is chosen you pay $156,000 × 0.015 = $2,340 in points and receive $153,660 at closing ($156,000 $2,340), although the mortgage principal is $156,000. To determine the best option, we first calculate the monthly payments for both options as follows Option 1: Option 2:

$156,000 = PMT {[1 - (1/(1 + 0.0550/12)30(12))]/(0.0550/12)} => PMT = $885.75 $156,000 = PMT {[1 - (1/(1 + 0.0535/12)30(12))]/(0.0535/12)} => PMT = $871.13

In exchange for $2,340 up front, Option 2 reduces your monthly mortgage payments by $14.625. The present value of these savings (evaluated at 5.35 percent) over the 30 years is PV = $14.625 {[1 - (1/(1 + 0.0535/12)30(12))]/(0.0535/12)} = $2,619.11 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Option 2 is the better choice. The present value of the monthly savings, $2,619.11, is greater than the points paid up front, $2,340. b. If Option 1 is chosen you pay $156,000 × 0.01 = $1,560 in points and receive $154,440 at closing ($156,000 $1,560), although the mortgage principal is $156,000. If Option 2 is chosen you pay $156,000 × 0.02 = $3,120 in points and receive $152,880 at closing ($156,000 - $3,120). The difference in savings on the points is $1,560. To determine the best option, we calculate the monthly payments for both options as follows Option 1: Option 2:

$156,000 = PMT {[1 - (1/(1 + 0.0535/12)30(12))]/(0.0535/12)} => PMT = $871.125 $156,000 = PMT {[1 - (1/(1 + 0.0525/12)30(12))]/(0.0525/12)} => PMT = $861.438

In exchange for $1,560 up front, Option 2 reduces your monthly mortgage payments by $9.687. The present value of these savings (evaluated at 5.25 percent) over the 30 years is PV = $9.687 {[1 - (1/(1 + 0.0525/12)30(12))]/(0.0525/12)} = $1,754.24 Option 2 is the better choice. The present value of the monthly savings, $1,754.24, is greater than the points paid up front, $1,560. 12. You will make a down payment of 25 percent of the purchase price, or you will make a down payment of $43,750 (0.25 × $175,000) at closing and borrow $131,250 through the mortgage. a. If Option 2 is chosen you pay $131,250 × 0.02 = $2,625 in points and receive $128,625 at closing ($131,250 $2,625), although the mortgage principal is $131,250. To determine the best option, we first calculate the monthly payments for both options as follows Option 1: Option 2:

$131,250 = PMT {[1 - (1/(1 + 0.0500/12)15(12))]/(0.0500/12)} => PMT = $1,037.92 $131,250 = PMT {[1 - (1/(1 + 0.0475/12)15(12))]/(0.0475/12)} => PMT = $1,020.90

In exchange for $2,625 up front, Option 2 reduces your monthly mortgage payments by $17.012. The present value of these savings (evaluated at 4.75 percent) over the 15 years is PV = $17.012 {[1 - (1/(1 + 0.0475/12)15(12))]/(0.0475/12)} = $2,187.14 Option 1 is the better choice. The present value of the monthly savings, $2,187.14, is less than the points paid up front, $2,625. b. If Option 1 is chosen you pay $131,250 × 0.02 = $2,625 in points and receive $128,625 at closing ($131,250 $2,625), although the mortgage principal is $131,250. If Option 2 is chosen you pay $131,250 × 0.03 = $3,937.5 in points and receive $127,312.5 at closing ($131,250 - $3,937.5). The difference in savings on the points is $1,312.5. To determine the best option, we calculate the monthly payments for both options as follows Option 1: Option 2:

$131,250 = PMT {[1 - (1/(1 + 0.0485/12)15(12))]/(0.0485/12)} => PMT = $1,027.69 $131,250 = PMT {[1 - (1/(1 + 0.0468/12)15(12))]/(0.0468/12)} => PMT = $1,016.17

In exchange for $1,312.50 up front, Option 2 reduces your monthly mortgage payments by $11.52. The present value of these savings (evaluated at 4.68 percent) over the 15 years is PV = $11.52 {[1 - (1/(1 + 0.0468/12)15(12))]/(0.0468/12)} = $1,487.94 Option 2 is the better choice. The present value of the monthly savings, $1,487.94, is greater than the difference in Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e points paid up front, $1,312.50. 13. You will make a down payment of 20 percent of the purchase price, or you will make a down payment of $44,000 (0.20 × $220,000) at closing and borrow $176,000 through the mortgage. $176,000 = PMT{[1 - (1/(1 + 0.0475/12)15(12))]/(0.0475/12)} PMT = $176,000/{[1 - (1/(1 + 0.0475/12)15(12))]/(0.0475/12)} PMT = $176,000/128.5625 = $1,368.98

a. For your mortgage: or therefore

Thus, your monthly payment is $1,368.98. b. Total interest paid on the mortgage is $70,416.40 Amortization Schedule 1 2 3 4 5 6 7 8 9 10 11 12

672.31 674.97 677.65 680.33 683.02 685.73 688.44 691.16 693.90 696.65 699.40 702.17

696.67 694.01 691.33 688.65 685.96 683.25 680.54 677.82 675.08 672.33 669.58 666.81

Cumulative Principal 672.31 1,347.28 2,024.93 2,705.26 3,388.28 4,074.01 4,762.45 5,453.61 6,147.51 6,844.16 7,543.56 8,245.73

13 14 15 16 17 18 19 20 21 22 23 24

704.95 707.74 710.54 713.36 716.18 719.02 721.86 724.72 727.59 730.47 733.36 736.26

664.03 661.24 658.44 655.62 652.80 649.96 647.12 644.26 641.39 638.51 635.62 632.72

8,950.68 9,658.42 10,368.96 11,082.32 11,798.50 12,517.52 13,239.38 13,964.10 14,691.69 15,422.16 16,155.52 16,891.78

8,846.06 9,507.30 10,165.74 10,821.36 11,474.16 12,124.12 12,771.24 13,415.50 14,056.89 14,695.40 15,331.02 15,963.74

167,049.32 166,341.58 165,631.04 164,917.68 164,201.50 163,482.48 162,760.62 162,035.90 161,308.31 160,577.84 159,844.48 159,108.22

25 26 27 28 29 30 31 32 33 34

739.18 742.10 745.04 747.99 750.95 753.92 756.91 759.90 762.91 765.93

629.80 626.88 623.94 620.99 618.03 615.06 612.07 609.08 606.07 603.05

17,630.96 18,373.06 19,118.10 19,866.09 20,617.04 21,370.96 22,127.87 22,887.77 23,650.68 24,416.61

16,593.54 17,220.42 17,844.36 18,465.35 19,083.38 19,698.44 20,310.51 20,919.59 21,525.66 22,128.71

158,369.04 157,626.94 156,881.90 156,133.91 155,382.96 154,629.04 153,872.13 153,112.23 152,349.32 151,583.39

Month Principal Interest

Cumulative Interest 696.67 1,390.68 2,082.01 2,770.66 3,456.62 4,139.87 4,820.41 5,498.23 6,173.31 6,845.64 7,515.22 8,182.03

Ending Balance 175,327.69 174,652.72 173,975.07 173,294.74 172,611.72 171,925.99 171,237.55 170,546.39 169,852.49 169,155.84 168,456.44 167,754.27

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 35 36

768.96 772.01

600.02 596.97

Cumulative Principal 25,185.57 25,957.58

37 38 39 40 41 42 43 44 45 46 47 48

775.06 778.13 781.21 784.30 787.41 790.52 793.65 796.79 799.95 803.11 806.29 809.49

593.92 590.85 587.77 584.68 581.57 578.46 575.33 572.19 569.03 565.87 562.69 559.49

26,732.64 27,510.77 28,291.98 29,076.28 29,863.69 30,654.21 31,447.86 32,244.65 33,044.60 33,847.71 34,654.00 35,463.49

23,919.62 24,510.47 25,098.24 25,682.92 26,264.49 26,842.95 27,418.28 27,990.47 28,559.50 29,125.37 29,688.06 30,247.55

149,267.36 148,489.23 147,708.02 146,923.72 146,136.31 145,345.79 144,552.14 143,755.35 142,955.40 142,152.29 141,346.00 140,536.51

49 50 51 52 53 54 55 56 57 58 59 60

812.69 815.91 819.14 822.38 825.63 828.90 832.18 835.48 838.78 842.10 845.44 848.78

556.29 553.07 549.84 546.60 543.35 540.08 536.80 533.50 530.20 526.88 523.54 520.20

36,276.18 37,092.09 37,911.23 38,733.61 39,559.24 40,388.14 41,220.32 42,055.80 42,894.58 43,736.68 44,582.12 45,430.90

30,803.84 31,356.91 31,906.75 32,453.35 32,996.70 33,536.78 34,073.58 34,607.08 35,137.28 35,664.16 36,187.70 36,707.90

139,723.82 138,907.91 138,088.77 137,266.39 136,440.76 135,611.86 134,779.68 133,944.20 133,105.42 132,263.32 131,417.88 130,569.10

61 62 63 64 65 66 67 68 69 70 71 72

852.14 855.52 858.90 862.30 865.72 869.14 872.58 876.04 879.51 882.99 886.48 889.99

516.84 513.46 510.08 506.68 503.26 499.84 496.40 492.94 489.47 485.99 482.50 478.99

46,283.04 47,138.56 47,997.46 48,859.76 49,725.48 50,594.62 51,467.20 52,343.24 53,222.75 54,105.74 54,992.22 55,882.21

37,224.74 37,738.20 38,248.28 38,754.96 39,258.22 39,758.06 40,254.46 40,747.40 41,236.87 41,722.86 42,205.36 42,684.35

129,716.96 128,861.44 128,002.54 127,140.24 126,274.52 125,405.38 124,532.80 123,656.76 122,777.25 121,894.26 121,007.78 120,117.79

73 74 75 76 77 78 79 80

893.51 897.05 900.60 904.17 907.75 911.34 914.95 918.57

475.47 471.93 468.38 464.81 461.23 457.64 454.03 450.41

56,775.72 57,672.77 58,573.37 59,477.54 60,385.29 61,296.63 62,211.58 63,130.15

43,159.82 43,631.75 44,100.13 44,564.94 45,026.17 45,483.81 45,937.84 46,388.25

119,224.28 118,327.23 117,426.63 116,522.46 115,614.71 114,703.37 113,788.42 112,869.85

Month Principal Interest

Cumulative Interest 22,728.73 23,325.70

Ending Balance 150,814.43 150,042.42

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 81 82 83 84

922.20 925.85 929.52 933.20

446.78 443.13 439.46 435.78

Cumulative Principal 64,052.35 64,978.20 65,907.72 66,840.92

85 86 87 88 89 90 91 92 93 94 95 96

936.89 940.60 944.32 948.06 951.81 955.58 959.36 963.16 966.97 970.80 974.64 978.50

432.09 428.38 424.66 420.92 417.17 413.40 409.62 405.82 402.01 398.18 394.34 390.48

67,777.81 68,718.41 69,662.73 70,610.79 71,562.60 72,518.18 73,477.54 74,440.70 75,407.67 76,378.47 77,353.11 78,331.61

48,585.49 49,013.87 49,438.53 49,859.45 50,276.62 50,690.02 51,099.64 51,505.46 51,907.47 52,305.65 52,699.99 53,090.47

108,222.19 107,281.59 106,337.27 105,389.21 104,437.40 103,481.82 102,522.46 101,559.30 100,592.33 99,621.53 98,646.89 97,668.39

97 98 99 100 101 102 103 104 105 106 107 108

982.38 986.26 990.17 994.09 998.02 1,001.97 1,005.94 1,009.92 1,013.92 1,017.93 1,021.96 1,026.01

386.60 382.72 378.81 374.89 370.96 367.01 363.04 359.06 355.06 351.05 347.02 342.97

79,313.99 80,300.25 81,290.42 82,284.51 83,282.53 84,284.50 85,290.44 86,300.36 87,314.28 88,332.21 89,354.17 90,380.18

53,477.07 53,859.79 54,238.60 54,613.49 54,984.45 55,351.46 55,714.50 56,073.56 56,428.62 56,779.67 57,126.69 57,469.66

96,686.01 95,699.75 94,709.58 93,715.49 92,717.47 91,715.50 90,709.56 89,699.64 88,685.72 87,667.79 86,645.83 85,619.82

109 110 111 112 113 114 115 116 117 118 119 120

1,030.07 1,034.15 1,038.24 1,042.35 1,046.47 1,050.62 1,054.78 1,058.95 1,063.14 1,067.35 1,071.58 1,075.82

338.91 334.83 330.74 326.63 322.51 318.36 314.20 310.03 305.84 301.63 297.40 293.16

91,410.25 92,444.40 93,482.64 94,524.99 95,571.46 96,622.08 97,676.86 98,735.81 99,798.95 100,866.30 101,937.88 103,013.70

57,808.57 58,143.40 58,474.14 58,800.77 59,123.28 59,441.64 59,755.84 60,065.87 60,371.71 60,673.34 60,970.74 61,263.90

84,589.75 83,555.60 82,517.36 81,475.01 80,428.54 79,377.92 78,323.14 77,264.19 76,201.05 75,133.70 74,062.12 72,986.30

121 122 123 124 125 126

1,080.08 1,084.35 1,088.64 1,092.95 1,097.28 1,101.62

288.90 284.63 280.34 276.03 271.70 267.36

104,093.78 105,178.13 106,266.77 107,359.72 108,457.00 109,558.62

61,552.80 61,837.43 62,117.77 62,393.80 62,665.50 62,932.86

71,906.22 70,821.87 69,733.23 68,640.28 67,543.00 66,441.38

Month Principal Interest

Cumulative Interest 46,835.03 47,278.16 47,717.62 48,153.40

Ending Balance 111,947.65 111,021.80 110,092.28 109,159.08

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 127 128 129 130 131 132

1,105.98 1,110.36 1,114.76 1,119.17 1,123.60 1,128.05

263.00 258.62 254.22 249.81 245.38 240.93

Cumulative Principal 110,664.60 111,774.96 112,889.72 114,008.89 115,132.49 116,260.54

133 134 135 136 137 138 139 140 141 142 143 144

1,132.51 1,136.99 1,141.49 1,146.01 1,150.55 1,155.10 1,159.68 1,164.27 1,168.87 1,173.50 1,178.15 1,182.81

236.47 231.99 227.49 222.97 218.43 213.88 209.30 204.71 200.11 195.48 190.83 186.17

117,393.05 118,530.04 119,671.53 120,817.54 121,968.09 123,123.19 124,282.87 125,447.14 126,616.01 127,789.51 128,967.66 130,150.47

64,681.29 64,913.28 65,140.77 65,363.74 65,582.17 65,796.05 66,005.35 66,210.06 66,410.17 66,605.65 66,796.48 66,982.65

58,606.95 57,469.96 56,328.47 55,182.46 54,031.91 52,876.81 51,717.13 50,552.86 49,383.99 48,210.49 47,032.34 45,849.53

145 146 147 148 149 150 151 152 153 154 155 156

1,187.49 1,192.19 1,196.91 1,201.65 1,206.41 1,211.18 1,215.98 1,220.79 1,225.62 1,230.47 1,235.34 1,240.23

181.49 176.79 172.07 167.33 162.57 157.80 153.00 148.19 143.36 138.51 133.64 128.75

131,337.96 132,530.15 133,727.06 134,928.71 136,135.12 137,346.30 138,562.28 139,783.07 141,008.69 142,239.16 143,474.50 144,714.73

67,164.14 67,340.93 67,513.00 67,680.33 67,842.90 68,000.70 68,153.70 68,301.89 68,445.25 68,583.76 68,717.40 68,846.15

44,662.04 43,469.85 42,272.94 41,071.29 39,864.88 38,653.70 37,437.72 36,216.93 34,991.31 33,760.84 32,525.50 31,285.27

157 158 159 160 161 162 163 164 165 166 167 168

1,245.14 1,250.07 1,255.02 1,259.99 1,264.97 1,269.98 1,275.01 1,280.06 1,285.12 1,290.21 1,295.32 1,300.44

123.84 118.91 113.96 108.99 104.01 99.00 93.97 88.92 83.86 78.77 73.66 68.54

145,959.87 147,209.94 148,464.96 149,724.95 150,989.92 152,259.90 153,534.91 154,814.97 156,100.09 157,390.30 158,685.62 159,986.06

68,969.99 69,088.90 69,202.86 69,311.85 69,415.86 69,514.86 69,608.83 69,697.75 69,781.61 69,860.38 69,934.04 70,002.58

30,040.13 28,790.06 27,535.04 26,275.05 25,010.08 23,740.10 22,465.09 21,185.03 19,899.91 18,609.70 17,314.38 16,013.94

169 170 171 172

1,305.59 1,310.76 1,315.95 1,321.16

63.39 58.22 53.03 47.82

161,291.65 162,602.41 163,918.36 165,239.52

70,065.97 70,124.19 70,177.22 70,225.04

14,708.35 13,397.59 12,081.64 10,760.48

Month Principal Interest

Cumulative Interest 63,195.86 63,454.48 63,708.70 63,958.51 64,203.89 64,444.82

Ending Balance 65,335.40 64,225.04 63,110.28 61,991.11 60,867.51 59,739.46

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Month Principal Interest 173 174 175 176 177 178 179 180

1,326.39 1,331.64 1,336.91 1,342.20 1,347.51 1,352.85 1,358.20 *1,364.78

42.59 37.34 32.07 26.78 21.47 16.13 10.78 5.40

Cumulative Principal 166,565.91 167,897.55 169,234.46 170,576.66 171,924.17 173,277.02 174,635.22 176,000.00

Cumulative Interest 70,267.63 70,304.97 70,337.04 70,363.82 70,385.29 70,401.42 70,412.20 70,417.60

Ending Balance 9,434.09 8,102.45 6,765.54 5,423.34 4,075.83 2,722.98 1,364.78 0.00

*The final payment has been adjusted to account for payments having been rounded to the nearest cent.

14. You will make a down payment of 20 percent of the purchase price, or you will make a down payment of $60,000 (0.20 × $300,000) at closing and borrow $240,000 through the mortgage. a. For your mortgage: or therefore

$240,000 = PMT{[1 - (1/(1 + 0.0450/12)15(12))]/(0.0450/12)} PMT = $240,000/{[1 - (1/(1 + 0.0450/12)15(12))]/(0.0450/12)} PMT = $240,000/128.5625 = $1,835.98

Thus, your monthly payment is $1,835.98. b. Total interest paid on the mortgage is $90,476.40

1 2 3 4 5 6 7 8 9 10 11 12

935.98 939.49 943.01 946.55 950.10 953.66 957.24 960.83 964.43 968.05 971.68 975.32

900.00 896.49 892.97 889.43 885.88 882.32 878.74 875.15 871.55 867.93 864.30 860.66

Cumulative Principal 935.98 1,875.47 2,818.48 3,765.03 4,715.13 5,668.79 6,626.03 7,586.86 8,551.29 9,519.34 10,491.02 11,466.34

13 14 15 16 17 18 19 20 21 22

978.98 982.65 986.33 990.03 993.75 997.47 1,001.21 1,004.97 1,008.74 1,012.52

857.00 853.33 849.65 845.95 842.23 838.51 834.77 831.01 827.24 823.46

12,445.32 13,427.97 14,414.30 15,404.33 16,398.08 17,395.55 18,396.76 19,401.73 20,410.47 21,422.99

Month Principal Interest

Cumulative Interest 900.00 1,796.49 2,689.46 3,578.89 4,464.77 5,347.09 6,225.83 7,100.98 7,972.53 8,840.46 9,704.76 10,565.42

Ending Balance 239,064.02 238,124.53 237,181.52 236,234.97 235,284.87 234,331.21 233,373.97 232,413.14 231,448.71 230,480.66 229,508.98 228,533.66

11,422.42 12,275.75 13,125.40 13,971.35 14,813.58 15,652.09 16,486.86 17,317.87 18,145.11 18,968.57

227,554.68 226,572.03 225,585.70 224,595.67 223,601.92 222,604.45 221,603.24 220,598.27 219,589.53 218,577.01

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 23 24

1,016.32 819.66 1,020.13 815.85

Cumulative Principal 22,439.31 23,459.44

25 26 27 28 29 30 31 32 33 34 35 36

1,023.95 1,027.79 1,031.65 1,035.52 1,039.40 1,043.30 1,047.21 1,051.14 1,055.08 1,059.03 1,063.01 1,066.99

812.03 808.19 804.33 800.46 796.58 792.68 788.77 784.84 780.90 776.95 772.97 768.99

24,483.39 25,511.18 26,542.83 27,578.35 28,617.75 29,661.05 30,708.26 31,759.40 32,814.48 33,873.51 34,936.52 36,003.51

21,416.11 22,224.30 23,028.63 23,829.09 24,625.67 25,418.35 26,207.12 26,991.96 27,772.86 28,549.81 29,322.78 30,091.77

215,516.61 214,488.82 213,457.17 212,421.65 211,382.25 210,338.95 209,291.74 208,240.60 207,185.52 206,126.49 205,063.48 203,996.49

37 38 39 40 41 42 43 44 45 46 47 48

1,070.99 1,075.01 1,079.04 1,083.09 1,087.15 1,091.23 1,095.32 1,099.43 1,103.55 1,107.69 1,111.84 1,116.01

764.99 760.97 756.94 752.89 748.83 744.75 740.66 736.55 732.43 728.29 724.14 719.97

37,074.50 38,149.51 39,228.55 40,311.64 41,398.79 42,490.02 43,585.34 44,684.77 45,788.32 46,896.01 48,007.85 49,123.86

30,856.76 31,617.73 32,374.67 33,127.56 33,876.39 34,621.14 35,361.80 36,098.35 36,830.78 37,559.07 38,283.21 39,003.18

202,925.50 201,850.49 200,771.45 199,688.36 198,601.21 197,509.98 196,414.66 195,315.23 194,211.68 193,103.99 191,992.15 190,876.14

49 50 51 52 53 54 55 56 57 58 59 60

1,120.19 1,124.40 1,128.61 1,132.84 1,137.09 1,141.36 1,145.64 1,149.93 1,154.24 1,158.57 1,162.92 1,167.28

715.79 711.58 707.37 703.14 698.89 694.62 690.34 686.05 681.74 677.41 673.06 668.70

50,244.05 51,368.45 52,497.06 53,629.90 54,766.99 55,908.35 57,053.99 58,203.92 59,358.16 60,516.73 61,679.65 62,846.93

39,718.97 40,430.55 41,137.92 41,841.06 42,539.95 43,234.57 43,924.91 44,610.96 45,292.70 45,970.11 46,643.17 47,311.87

189,755.95 188,631.55 187,502.94 186,370.10 185,233.01 184,091.65 182,946.01 181,796.08 180,641.84 179,483.27 178,320.35 177,153.07

61 62 63 64 65 66 67 68

1,171.66 1,176.05 1,180.46 1,184.89 1,189.33 1,193.79 1,198.27 1,202.76

664.32 659.93 655.52 651.09 646.65 642.19 637.71 633.22

64,018.59 65,194.64 66,375.10 67,559.99 68,749.32 69,943.11 71,141.38 72,344.14

47,976.19 48,636.12 49,291.64 49,942.73 50,589.38 51,231.57 51,869.28 52,502.50

175,981.41 174,805.36 173,624.90 172,440.01 171,250.68 170,056.89 168,858.62 167,655.86

Month Principal Interest

Cumulative Interest 19,788.23 20,604.08

Ending Balance 217,560.69 216,540.56

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 69 70 71 72

1,207.27 1,211.80 1,216.34 1,220.90

628.71 624.18 619.64 615.08

Cumulative Principal 73,551.41 74,763.21 75,979.55 77,200.45

73 74 75 76 77 78 79 80 81 82 83 84

1,225.48 1,230.08 1,234.69 1,239.32 1,243.97 1,248.63 1,253.31 1,258.01 1,262.73 1,267.47 1,272.22 1,276.99

610.50 605.90 601.29 596.66 592.01 587.35 582.67 577.97 573.25 568.51 563.76 558.99

78,425.93 79,656.01 80,890.70 82,130.02 83,373.99 84,622.62 85,875.93 87,133.94 88,396.67 89,664.14 90,936.36 92,213.35

55,600.61 56,206.51 56,807.80 57,404.46 57,996.47 58,583.82 59,166.49 59,744.46 60,317.71 60,886.22 61,449.98 62,008.97

161,574.07 160,343.99 159,109.30 157,869.98 156,626.01 155,377.38 154,124.07 152,866.06 151,603.33 150,335.86 149,063.64 147,786.65

85 86 87 88 89 90 91 92 93 94 95 96

1,281.78 1,286.59 1,291.41 1,296.25 1,301.12 1,305.99 1,310.89 1,315.81 1,320.74 1,325.69 1,330.67 1,335.66

554.20 549.39 544.57 539.73 534.86 529.99 525.09 520.17 515.24 510.29 505.31 500.32

93,495.13 94,781.72 96,073.13 97,369.38 98,670.50 99,976.49 101,287.38 102,603.19 103,923.93 105,249.62 106,580.29 107,915.95

62,563.17 63,112.56 63,657.13 64,196.86 64,731.72 65,261.71 65,786.80 66,306.97 66,822.21 67,332.50 67,837.81 68,338.13

146,504.87 145,218.28 143,926.87 142,630.62 141,329.50 140,023.51 138,712.62 137,396.81 136,076.07 134,750.38 133,419.71 132,084.05

97 98 99 100 101 102 103 104 105 106 107 108

1,340.66 1,345.69 1,350.74 1,355.80 1,360.89 1,365.99 1,371.11 1,376.26 1,381.42 1,386.60 1,391.80 1,397.02

495.32 490.29 485.24 480.18 475.09 469.99 464.87 459.72 454.56 449.38 444.18 438.96

109,256.61 110,602.30 111,953.04 113,308.84 114,669.73 116,035.72 117,406.83 118,783.09 120,164.51 121,551.11 122,942.91 124,339.93

68,833.45 69,323.74 69,808.98 70,289.16 70,764.25 71,234.24 71,699.11 72,158.83 72,613.39 73,062.77 73,506.95 73,945.91

130,743.39 129,397.70 128,046.96 126,691.16 125,330.27 123,964.28 122,593.17 121,216.91 119,835.49 118,448.89 117,057.09 115,660.07

109 110 111 112 113 114

1,402.25 1,407.51 1,412.79 1,418.09 1,423.41 1,428.74

433.73 428.47 423.19 417.89 412.57 407.24

125,742.18 127,149.69 128,562.48 129,980.57 131,403.98 132,832.72

74,379.64 74,808.11 75,231.30 75,649.19 76,061.76 76,469.00

114,257.82 112,850.31 111,437.52 110,019.43 108,596.02 107,167.28

Month Principal Interest

Cumulative Interest 53,131.21 53,755.39 54,375.03 54,990.11

Ending Balance 166,448.59 165,236.79 164,020.45 162,799.55

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 115 116 117 118 119 120

1,434.10 1,439.48 1,444.88 1,450.30 1,455.74 1,461.19

401.88 396.50 391.10 385.68 380.24 374.79

Cumulative Principal 134,266.82 135,706.30 137,151.18 138,601.48 140,057.22 141,518.41

121 122 123 124 125 126 127 128 129 130 131 132

1,466.67 1,472.17 1,477.69 1,483.24 1,488.80 1,494.38 1,499.99 1,505.61 1,511.26 1,516.92 1,522.61 1,528.32

369.31 363.81 358.29 352.74 347.18 341.60 335.99 330.37 324.72 319.06 313.37 307.66

142,985.08 144,457.25 145,934.94 147,418.18 148,906.98 150,401.36 151,901.35 153,406.96 154,918.22 156,435.14 157,957.75 159,486.07

79,168.50 79,532.31 79,890.60 80,243.34 80,590.52 80,932.12 81,268.11 81,598.48 81,923.20 82,242.26 82,555.63 82,863.29

97,014.92 95,542.75 94,065.06 92,581.82 91,093.02 89,598.64 88,098.65 86,593.04 85,081.78 83,564.86 82,042.25 80,513.93

133 134 135 136 137 138 139 140 141 142 143 144

1,534.05 1,539.81 1,545.58 1,551.38 1,557.19 1,563.03 1,568.89 1,574.78 1,580.68 1,586.61 1,592.56 1,598.53

301.93 296.17 290.40 284.60 278.79 272.95 267.09 261.20 255.30 249.37 243.42 237.45

161,020.12 162,559.93 164,105.51 165,656.89 167,214.08 168,777.11 170,346.00 171,920.78 173,501.46 175,088.07 176,680.63 178,279.16

83,165.22 83,461.39 83,751.79 84,036.39 84,315.18 84,588.13 84,855.22 85,116.42 85,371.72 85,621.09 85,864.51 86,101.96

78,979.88 77,440.07 75,894.49 74,343.11 72,785.92 71,222.89 69,654.00 68,079.22 66,498.54 64,911.93 63,319.37 61,720.84

145 146 147 148 149 150 151 152 153 154 155 156

1,604.53 1,610.54 1,616.58 1,622.65 1,628.73 1,634.84 1,640.97 1,647.12 1,653.30 1,659.50 1,665.72 1,671.97

231.45 225.44 219.40 213.33 207.25 201.14 195.01 188.86 182.68 176.48 170.26 164.01

179,883.69 181,494.23 183,110.81 184,733.46 186,362.19 187,997.03 189,638.00 191,285.12 192,938.42 194,597.92 196,263.64 197,935.61

86,333.41 86,558.85 86,778.25 86,991.58 87,198.83 87,399.97 87,594.98 87,783.84 87,966.52 88,143.00 88,313.26 88,477.27

60,116.31 58,505.77 56,889.19 55,266.54 53,637.81 52,002.97 50,362.00 48,714.88 47,061.58 45,402.08 43,736.36 42,064.39

157 158 159 160

1,678.24 1,684.53 1,690.85 1,697.19

157.74 151.45 145.13 138.79

199,613.85 201,298.38 202,989.23 204,686.42

88,635.01 88,786.46 88,931.59 89,070.38

40,386.15 38,701.62 37,010.77 35,313.58

Month Principal Interest

Cumulative Interest 76,870.88 77,267.38 77,658.48 78,044.16 78,424.40 78,799.19

Ending Balance 105,733.18 104,293.70 102,848.82 101,398.52 99,942.78 98,481.59

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 161 162 163 164 165 166 167 168

1,703.55 1,709.94 1,716.35 1,722.79 1,729.25 1,735.74 1,742.25 1,748.78

132.43 126.04 119.63 113.19 106.73 100.24 93.73 87.20

Cumulative Principal 206,389.97 208,099.91 209,816.26 211,539.05 213,268.30 215,004.04 216,746.29 218,495.07

169 170 171 172 173 174 175 176 177 178 179 180

1,755.34 1,761.92 1,768.53 1,775.16 1,781.82 1,788.50 1,795.20 1,801.94 1,808.69 1,815.48 1,822.28 *1,830.07

80.64 74.06 67.45 60.82 54.16 47.48 40.78 34.04 27.29 20.50 13.70 6.86

220,250.41 222,012.33 223,780.86 225,556.02 227,337.84 229,126.34 230,921.54 232,723.48 234,532.17 236,347.65 238,169.93 240,000.00

Month Principal Interest

Cumulative Interest 89,202.81 89,328.85 89,448.48 89,561.67 89,668.40 89,768.64 89,862.37 89,949.57

Ending Balance 33,610.03 31,900.09 30,183.74 28,460.95 26,731.70 24,995.96 23,253.71 21,504.93

90,030.21 90,104.27 90,171.72 90,232.54 90,286.70 90,334.18 90,374.96 90,409.00 90,436.29 90,456.79 90,470.49 90,477.35

19,749.59 17,987.67 16,219.14 14,443.98 12,662.16 10,873.66 9,078.46 7,276.52 5,467.83 3,652.35 1,830.07 0.00

*The final payment has been adjusted to account for payments having been rounded to the nearest cent.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 8 Questions: 1. This is because stock market movements are sometimes seen as predictors of economic activity in a country. This is also because corporate stocks may be the most widely held of all financial securities. Most individuals own stock securities either directly through stock purchases or indirectly through pension fund and mutual fund investments, and thus their economic wealth fluctuates closely with the market. 2. While common stockholders can potentially receive unlimited dividend payments if the firm is highly profitable, they have no special or guaranteed dividend rights. The payment and size of dividends is determined by the board of directors of the issuing firm. Unlike interest payments on debt, a corporation does not default if it misses a dividend payment to common stockholders. Thus, common stockholders have no legal recourse if dividends are not received, even if a company is highly profitable and chooses to use these profits to reinvest in new projects and firm growth. In fact, many firms pay no dividends, but instead reinvest all of their net earnings in the firm. For example, in 2016 101 of the firms listed in the S&P 500 index paid no dividends. Another characteristic of common stock dividends, from an investor’s viewpoint, is that they are taxed twice--once at the firm level (at the corporate tax rate) and once at the personal level (at the personal income tax rate). Investors can partially avoid this double taxation effect by holding stocks in growth firms that reinvest most of their earnings to finance growth rather than paying larger dividends. 3. Common stockholders have the lowest priority claim on a corporation’s assets in the event of bankruptcy. That is, they have a residual claim. Only after all senior claims are paid (i.e., payments owed to creditors, bondholders, and preferred stockholders) are common stockholders entitled to what assets of the firm are left, i.e., the residual. The residual claim feature associated with common stock makes it riskier than debt or bonds as an investable asset. 4. Dual-class firms are corporations in which two classes of common stock are outstanding with differential voting rights assigned to each class in various ways. For example, inferior voting rights have been assigned by i) limiting the number of votes per share on one class relative to another, ii) limiting the fraction of the board of directors which one class could elect relative to another, or iii) a combination of these two. To offset the reduced voting rights, inferior class shares are often assigned higher dividend rights. Dual-class firms have often been used in corporations owned and controlled by a single family or group turning to the public market to raise capital through the issue of new shares. To retain voting control over the firm, the family or group issues the dual classes of stock, keeping the high voting stock for themselves and selling the limited voting shares to the public. In all other respects the shares of the two classes are often identical. Because dual-classes of stock have often been used by a small group (i.e., family managers) to entrench themselves in the firm, dual-class firms are controversial. 5. Nonparticipating preferred stock means that the preferred stock dividend is fixed regardless of any increase or decrease in the issuing firm’s profits. In contrast, participating preferred stock means that actual dividends paid in any year may be greater than the promised dividends. In some cases, if the issuing firm has an exceptionally profitable year, preferred stockholders may receive some of the high profits in the form of an extra dividend payment. In others, the participating preferred stock pays and changes dividends along the same lines as common stock dividends. 6. Cumulative preferred stock means that any missed dividend payments go into arrears and must be made up before any common stock dividends can be paid. If preferred stock is noncumulative, missed dividend payments do not go into arrears and are never paid. Noncumulative preferred stock is generally unattractive to perspective preferred stockholders. Thus, noncumulative preferred stock generally has some other special features (e.g., voting rights) to make up for this drawback. 7. In a public sale of stock, once the issuing firm and the investment bank have agreed on the details of the stock issue, the investment bank must get SEC approval in accordance with the Securities and Exchange Act of 1934. Registration of a stock can be a lengthy process. The process starts with the preparation of the registration statement to be filed with the SEC. The registration statement includes information on the nature of the issuer’s business, the key provisions and features of the security to be issued, the risks involved with the security, and background on the Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e management. The focus of the registration statement is on full information disclosure about the firm and the securities issued to the public at large. At the same time that the issuer and its investment bank prepare the registration statement to be filed with the SEC, they prepare a preliminary version of the public offering’s prospectus called the red herring prospectus. The red herring prospectus is similar to the registration statement but is distributed to potential equity buyers. It is a preliminary version of the official or final prospectus that will be printed upon SEC registration of the issue and makes up the bulk of the registration statement. Firms use the feedback provided from the distribution of the red herring prospectus to help set the price on the new shares so as to ensure the sale of the full issue. After submission of the registration statement, the SEC has 20 days to request additional information or changes to the registration statement. It generally takes about 20 days for the SEC to declare whether or not a registration statement is effective. First-time or infrequent issuers can sometimes wait up to several months for SEC registration, especially if the SEC keeps requesting additional information and revised red herring prospectuses. However, companies that know the registration process well can generally obtain registration in a few days. This period of review is called the waiting period. Once the SEC is satisfied with the registration statement, it registers the issue. At this point, the issuer (along with its investment bankers) sets the final selling price on the shares, prints the official prospectus describing the issue, and sends it to all potential buyers of the issue. Upon issuance of the prospectus (generally the day following SEC registration), the shares can be sold. The period of time between the company’s filing of the registration statement with the SEC and the selling of shares is referred to as the “quiet period.” Historically, the issuing company could send no written communication to the public during the quiet period other than information regarding the normal course of business. Once a company registered with the SEC for a public offering it could engage in oral communication only. That meant the company executives could go on so-called roadshows to solicit investors or have brokers call potential investors to discuss the offering. But they could not provide any written communication, such as faxes or letters, or give interviews about the company’s offering. These rules, adopted in 1933, did not foresee new technology, such as the Internet and e-mail. Moreover, these outdated rules may have hurt investors by giving them too little information. Thus, in December 2005, the SEC enacted a rule change giving large companies (market capitalization of at least $700 million or with at least $1 billion in debt) more freedom to communicate with investors during the quiet period. Specifically, these companies are now allowed to communicate with investors at any time prior to a public offering through e-mail, letters, or even TV ads, as long as the information is also filed with the SEC. Such communication was previously prohibited. 8. The two major U.S. stock markets are the NYSE Euronext and the NASDAQ system. Prior to its acquisition by the NYSE in 2008, the American Stock Exchange (AMEX) was a third major stock exchange. Figures 8-6 and 8-7 present data comparing the three stock markets. Figure 8-6 shows dollar volume of trading in each market from 1979 through 2016; and Figure 8-7 shows the number of companies listed in each market from 1975 through 2016. Obvious from these trading volume and listing figures is that while historically the NYSE was the premier stock market, the NASDAQ has become a strong second. 9. A market order is an order for the broker and the designated market maker (DMM) to transact at the best price available when the order reaches the post. The floor or commission broker will go to the post and conduct the trade. A limit order is an order to transact only at a specified price (the limit price). When a floor or commission broker receives a limit order, he or she will stand by the post with the order if the current price is near the limit price. When the current price is not near the limit price a floor or commission broker does not want to stand at the post for hours (and even days) waiting for the current price to equal the limit price on this single limit order. In this case the floor broker enters the limit order on the order book of the DMM at the post. The DMM, who is at the post at all times, will monitor the current price of the stock and conduct the trade when, and if, it equals the limit price. Some limit orders are submitted with time limits. If the order is not filled by the time date for expiration it is deleted from the market maker’s book. 10. As a result of the potential for increased volatility created by program trading, in 1990 the New York Stock Exchange introduced trading curbs (or circuit breakers) on trading. Circuit breakers are limitations placed on Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e program trading when the DJIA falls significantly. Circuit breakers are an imposed halt in trading that gives buyers and sellers time to assimilate incoming information and make investment choices. Circuit breakers promote investor confidence by giving investors time to make informed choices during periods of high market volatility. 11. On May 6, 2010, the financial markets experienced a brief but severe drop in prices, falling 998 points (more than 5 percent) in a matter of minutes, only to recover a short time later. This even became known as the “flash crash.” Regardless of how the historic drop started, it was exacerbated by computer trading. The initial trading error triggered a piling-on effect from computerized trading programs designed to sell when the market moves lower. As a result of the flash crash, circuit breakers, termed in this case limit up-limit down (LULD) rules, were instituted for individual stocks. Figure 8-12 shows the rules put in place in 2016. Phase I began in April 2013 for Tier I stocks (S&P 500, Russell 500 stocks, and selected exchange-traded products), while phase II began in August 2013 for Tier II stocks (all other stocks). The LULD band structure is based on percentages away from a “reference price.” Specifically, trading is halted (put in a “limit state”) if the stock price moves outside the price band calculated as follows: Price Band = (Reference Price) ± ((Reference Price) × (Percentage Parameter)) The reference price the mean price of reported transactions over the past 5 minutes. If no trades have occurred in the previous 5 minutes the previous reference price will remain. First reference price of the day is set as the opening price on the stock’s primary listing exchange. When a stock is outside the applicable LULD band, trading is halted for 15 seconds. For example, an S&P 500 stock with a reference price of $5.00 would see trading halted if its price moved outside a range of $4.75-$5.25 ($5.00 ± 0.05 × $5.00). Trading may begin after the halt if the entire size of all limit state quotations is executed or cancelled within 15 seconds of entering the limit state. If the market does not exit the limit state within 15 seconds, then the primary listing market for the security will declare a five minute trading pause. During a trading pause, no trades in the security can be executed, but all bids and offers may be displayed. Percentage parameters are doubled during the first 15 and last 25 minutes of trading. 12. Flash trading is a controversial practice in which, for a fee, traders are allowed to see incoming buy or sell orders milliseconds earlier than general market traders. With this very slight advance notice of market orders, these traders can conduct rapid statistical analysis (with the help of powerful computers) and carry out high-frequency trading (trades involving very short holding periods) ahead of the public market. Critics contend that flash trading creates a market in which certain traders can unfairly exploit others. The Wall Street Reform and Consumer Protection Act of 2010 gave the Commodity Futures Trading Commission (CFTC) expanded powers to investigate and prosecute disruptive trading practices, including those by high-speed flash traders. For example, in 2013, the CFTC investigated whether high frequency traders are routinely distorting stock and futures markets by illegally acting as buyer and seller in the same transactions. Such transactions, known as wash trades, are banned by U.S. law because they can feed false information into the market and be used to manipulate prices. CFTC examiners have found that several hundred thousand potential wash trades occur daily on futures exchanges. Regulators are also requiring exchanges to improve their oversight of high-speed trading in the wake of computer-driven glitches in 2012, including the case of Knight Capital Group, which incurred losses of more than $450 million when a highspeed trading algorithm malfunctioned. Naked access trading allows some traders and others to rapidly buy and sell stocks directly on exchanges using a broker’s computer code without exchanges or regulators always knowing who is making the trades. The firms, usually high-frequency traders, are then able to shave microseconds from the time it takes to trade. A report says that 38 percent of all U.S. stock trading is now done by firms that have “naked sponsored access” to markets. The SEC, fearing that a firm trading anonymously in this way could trigger destabilizing losses and threaten market stability if its rapid-fire trades go awry, banned naked access trading in late 2010. Dark pools of liquidity are trading networks that provide liquidity but that do not display trades on order books. This is useful for traders such as institutional traders who wish to buy and sell large numbers of shares without revealing their trades to the overall market. In 2016, nearly 42 percent of daily stock trading was processed through dark pools, up from 3 percent in 2008. Dark pool trading offers institutional investors many of the efficiencies associated with trading on the NYSE or NASDAQ, but it does not require that they show their transactions to others. Dark pool trades are recorded to a national database. However, they are recorded as over-the-counter transactions. Thus, Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e detailed information about the volume and type of transaction is left to the trading network to report to its clients if they so desire. Dark pool trading has been criticized as unfair. With dark pool trading, traders who use trading strategies based on liquidity do not have access to all trading information. Critics contend that activities such as flash trading, naked access, and dark pool trading create a market in which certain traders can unfairly exploit others. The Wall Street Reform and Consumer Protection Act of 2010 gave the Commodity Futures Trading Commission (CFTC) expanded powers to investigate and prosecute disruptive trading practices, including those by high speed flash traders. For example, in 2013, the CFTC investigated whether high frequency traders are routinely distorting stock and futures markets by illegally acting as buyer and seller in the same transactions. Such transactions, known as wash trades, are banned by U.S. law because they can feed false information into the market and be used to manipulate prices. CFTC examiners show that several hundred thousand potential wash trades occur daily on futures exchanges. Regulators are also requiring exchanges to improve their oversight of high speed trading in the wake of computer driven glitches in 2012 last year, including the case of Knight Capital Group which incurred losses of more than $450 million when a high speed trading algorithm malfunctioned. Also, as a result of the Wall Street Reform and Consumer Protection Act, in 2013 the SEC approved a plan for new rules requiring dark pools to disclose and detail trading activity on their platforms. Specifically, the SEC called for dark pools and other alternative trading systems to provide more information on how they work. The new rules require such systems to file detailed information about their operations including trading by broker dealer operators on the ATS, which could pose conflicts of interest. What regulators have focused on are the promises the dark pool operators have made to customers about how their orders are being handled and whether high-speed trading firms have the opportunity to trade against those orders. For example, in January 2016, the SEC announced that Barclays Capital and Credit Suisse Securities agreed to settle separate cases finding that they violated federal securities laws while operating dark pools. Barclays agreed to settle the charges by admitting wrongdoing and paying $35 million penalties to the SEC and the NYAG for a total of $70 million. Credit Suisse agreed to settle the charges by paying a $30 million penalty to the SEC, a $30 million penalty to the NYAG, and $24.3 million in disgorgement and prejudgment interest to the SEC for a total of $84.3 million. 13. The Dow Jones Industrial Average (the DJIA or the Dow) is the most widely reported stock market index. The DJIA, first established in 1896, is an index based on the values of 30 large (in terms of sales and total assets) corporations selected by the editors of the Wall Street Journal (owned by Dow Jones & Company). In choosing companies to be included in the DJIA, the editors look for the largest industrial companies with a history of successful growth and with interest among stock investors. Dow indexes are price-weighted averages meaning that the stock prices of the companies in the indexes are added together and divided by an adjusted value. In 1966, the NYSE established the NYSE Composite Index to provide a comprehensive measure of the performance of the overall NYSE market. The index consists of all common stocks listed on the NYSE. In addition to the composite index, NYSE stocks are divided into four subgroups: industrial, transportation, utility, and financial companies. The indexed value of each group is also reported daily. The NYSE is a value-weighted index meaning that the current market values of all stocks in the index are added together and divided by their value during a base period. Standard & Poor’s established the S&P 500 index (a value-weighted index) consisting of the stocks of 500 of the largest U.S. corporations listed on the NYSE and the NASDAQ. The NYSE stocks included in the S&P 500 index account for over 80 percent of the total market value of all stocks listed on the NYSE. Thus, movements in the S&P 500 Index are highly correlated with those of the NYSE Composite Index. Standard & Poor’s also reports subindexes consisting of industrials and utilities in the S&P 500 Index. First established in 1971, the NASDAQ Composite Index (a value-weighted index) consists of three categories of NASDAQ companies: industrials, banks, and insurance companies. All stocks traded through the NASDAQ in these three industries are included. NASDAQ also reports separate indexes based on industrials, banks, insurance companies, computers, and telecommunications companies. The Wilshire 5000 index was created in 1974 (when computers made the daily computation of such a large index possible) to track the value of the entire stock market. It is the broadest stock market index and possibly the most accurate reflection of the overall stock market. The Wilshire 5000 index contains virtually every stock that meets Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e three criteria: the firm is headquartered in the U.S.; the stock is actively traded in a U.S.-based stock market; and the stock has widely available price information (which rules out the smaller OTC stocks from inclusion). Though the index started with 5000 firms, it currently includes over 7,000 stocks. Like the NYSE Composite index, the S&P 500 index, and the NASDAQ Composite index, the Wilshire 5000 index is a value-weighted index. The Wilshire 5000 index has the advantage that it is the best index to track the path of the U.S. stock market. Since it includes essentially every public firm, it is highly representative of the overall market. However, because it is so diverse, it is impossible to tell which sectors or asset classes are moving the market (technology, industrial, small-cap, large-cap, etc.). 14. In a price-weighted index the stock prices of the companies in the indexes are added together and divided by an adjusted value, (or divisor). Dow indexes are price-weighted averages. The divisor was set at 30 in 1928, but due to stock splits, stock dividends, and changes in the 30 firms included in the index, this value dropped to 0.14602128057775 by July 2016. In a value-weighted index the current market values (stock price × number of shares outstanding) of all stocks in the index are added together and divided by their value on a base date. Any changes in the stocks included in the index are incorporated by adjusting the base value of the index. The NYSE, established in 1966, is a value-weighted index. To modernize and align the index methodology with those used in other indexes, the NYSE revised its NYSE Composite Index in January 2003. At this time the composite was recalculated to reflect a new base value of 5,000 rather than the original base value of 50 set in December 1965. The S&P 500 index and the Wilshire 5000 index are also value-weighted 15. Households are the single largest holders of corporate stock (holding 39.0 percent of all corporate stock outstanding in 2016). Mutual funds and foreign investors are also prominent in the stock markets (holding 24.2 percent and 15.7 percent of the $35.5 trillion in corporate stock outstanding, respectively). Households indirectly invest in corporate stock through investments in mutual funds and pension funds. Together, these holdings totaled approximately 80 percent in 2016. As a result of the tremendous increase in stock values in the 1990s, most individuals in the United States either directly own corporate stock or indirectly own stock via investments in mutual funds and pension funds. Figure 8– 14 shows the percent of Americans with investments in the stock market from 1998 through 2016. Ownership peaked at 65 percent in 2007 as stock markets reached record highs. As the stock market plummeted in value during the financial crisis, so did ownership. However, as the stock market recovered in 2010-2016, individual investors did not reenter the market, falling to a low of 52 percent in April 2016. Despite an improving economy overall, unemployment remained above 6.0 percent throughout much of this period (not falling to below 5.0 percent until January 2016), a level still too high to support wide-ranging stock ownership. Table 8–5 reports characteristics of adult investors in the stock markets, in April 2007 and 2016. Note that in every category, percentages have dropped over this period. Older investors are the most active. In 2016, sixty-two percent of individuals 35 to 54 years old are invested, compared to just 38 percent of those 18 to 34 years old. These numbers are down from 2007 when 73 percent and 62 percent, respectively, were invested in the stock market. The higher the income, the higher the percentage of individuals investing in stocks. In 2016, 79 percent of individuals earning $75,000 and over were invested in stocks, while just 23 percent of individuals earning less than $30,000 were invested. 16. Figure 8-15 shows the relation between stock market movements and economic cycles in the U.S. Notice some recessionary periods were indeed, preceded by a decline in stock market index values; other recessionary periods were not preceded by a decline in stock market index values; and still other declines in stock market indexes were not followed by recessionary periods. Figure 8-15 suggests that stock market movements are not consistently accurate predictors of economic activity. In fact, of the 14 major stock market predicted recessions since 1942, only eight actually occurred. 17. The degree to which financial security prices adjust to “news” and the degree (and speed) with which stock prices reflect information about the firm and factors that affect firm value is referred to as market efficiency. Three measures (weak form, semistrong form, and strong form market efficiency) are commonly used to measure the Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e degree of stock market efficiency. According to the weak form market efficiency, current stock prices reflect all historical public information. Thus, historical price trends are of no help in predicting future stock price movements. Under weak form market efficiency, historical news and trends are already impounded in historical prices and are of no use in predicting today’s or future stock prices. Thus, weak from market efficiency concludes that investors cannot make more than the fair (required) return using information based on historical price movements. The semistrong market efficiency focuses on the speed with which public information is impounded into stock prices. According to the concept of semistrong market efficiency, as public information arrives about a company it is immediately impounded into its stock price. For example, semistrong form market efficiency states that a common stock’s value should respond immediately to unexpected news announcements by the firm regarding its expected future earnings. Thus, if an investor calls his or her broker just as the earnings news is released, he or she cannot earn an abnormal return. Prices immediately adjust. According to semistrong form market efficiency investors cannot make more than the fair (required) return by trading on public news releases. The strong form of market efficiency states that stock prices fully reflect all information: both public and private. Thus, according to strong form market efficiency even learning insideA information about the firm is of no help in earning more than the required rate of return. As insiders get private information about a firm, the market has already reacted to it and has fully adjusted the firm’s common stock price to its new equilibrium level. Thus, strong form market efficiency implies that there is no set of information that allows investors to make more than the fair (required) rate of return on a stock. 18. Stock markets and stock market participants are subject to regulations imposed by the Securities and Exchange Commission (SEC) as well as the exchanges on which stocks are traded. The main emphasis of SEC regulations is on full and fair disclosure of information on securities issues to actual and potential investors. The two major regulations that were created to prevent unfair and unethical trading practices on security exchanges are the Securities Act of 1933 and the Securities Exchange Act of 1934. The 1933 act required listed companies to file a registration statement and to issue a prospectus that details the recent financial history of the company when issuing new stock. The 1934 act established the SEC as the main administrative agency responsible for the oversight of secondary stock markets by giving the SEC the authority to monitor the stock market exchanges and administer the provisions of the 1933 act. SEC regulations are not intended to protect investors against poor investment choices but rather to ensure that investors have full and accurate information available when making their investment decisions. For example, in the early 2000s, a number of securities firms received tremendous publicity concerning conflicts of interest between analysts’ research recommendations on buying or not buying stocks and whether the firm played a role in underwriting the securities of the firm the analysts were recommending. After an investigation by the New York State’s attorney general, Merrill Lynch agreed to pay a fine of $100 million and to follow procedures more clearly separating analysts’ recommendations (and their compensation) from the underwriting activities of the firm. Major Wall Street firms were also investigated. This investigation was triggered by the dramatic collapse of many new technology stocks while analysts were still making recommendations to buy or hold them. Subsequent to these investigations, the SEC instituted rules requiring Wall Street analysts to vouch that their stock picks have not been influenced by investment banking colleagues and to disclose details of their compensation that would flag investors to any possible conflicts. Evidence that analysts have falsely attested to the independence of their work could be used to institute enforcement actions. Violators could face a wide array of sanctions, including fines and penalties such as a suspension or a bar from the securities industry. In addition, the SEC proposed that top officials from all public companies sign off on financial statements. Along with these changes instituted by the SEC, the U.S. Congress passed the Sarbanes-Oxley Act in July 2002. This act created an independent auditing oversight board under the SEC, increased penalties for corporate wrongdoers, forced faster and more extensive financial disclosure, and created avenues of recourse for aggrieved shareholders. Further, in 2002 the NYSE took actions intended to heighten corporate governance standards on domestic NYSE-listed companies. Key changes included requirements on companies to have a majority of independent directors, to adopt corporate governance guidelines and codes of ethics and business conduct, to have shareholders’ approval of all equity-based compensation plans, and to have CEOs annually certify information given to investors. The goal of the legislation was to prevent deceptive accounting and management practices and to bring Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e stability to jittery stock markets battered in the summer of 2002 by the corporate governance scandals of Enron, Global Crossings, Tyco, WorldCom, and others. The SEC came under fire during the financial crisis for its failure to uncover Bernie Madoff’s Ponzi scheme. The SEC apparently had evidence as early as 1994 (in relation to another case) that Madoff, a former chairman of the NASDAQ stock market who was a member of SEC advisory committees, was conducting illegal activities. Further, Harry Markopolos, who worked for a rival company of Bernard L. Madoff Investment Securities, had written to the SEC in May 1999, informing them of Madoff’s Ponzi scheme. Markopolos examined the options markets that Madoff told investors he used to produce his steady stream of returns and concluded that Madoff’s results were impossible. On May 19, 2006, when the Securities and Exchange Commission questioned Madoff under oath, he falsely described how he would buy and sell stock and options contracts in Europe on behalf of his clients. The SEC asked Madoff: “Is there any documentation generated?” Madoff said yes. But the SEC failed to pursue this further. Eventually, the SEC recommended closing the investigation “because those violations were not so serious as to warrant an enforcement action.” Making things worse for the SEC, Madoff’s family had close ties with the SEC. Madoff’s sons, brother, and niece worked with or advised the SEC on various matters. Madoff’s niece is married to a former SEC attorney who was part of a team that examined Madoff’s securities brokerage operation in 1999 and 2004. Neither review resulted in an action against Madoff. In the end, it was not the SEC that discovered Madoff’s Ponzi scheme. Because of large redemption claims that his clients filed during the financial crisis, Madoff’s Ponzi scheme began to collapse. Madoff admitted to his sons what he had done and they turned him in to authorities. The SEC’s internal watchdog, Inspector General H. David Kotz, stated that he was so concerned about the agency’s failure to uncover Madoff’s alleged Ponzi scheme that he expanded an inquiry called for by SEC Chair- man Christopher Cox. However, in July 2010, nearly 18 months after Madoff’s Ponzi scheme was exposed, lawmakers were still questioning how the SEC staffers who reviewed the Madoff firm and investigated fraud allegations were being punished. SEC Chairman Mary Schapiro told Congress during an oversight hearing that 15 of 20 enforcement attorneys and 19 of 36 examination staffers that dealt with the Madoff matter had left the agency, but the SEC was still conducting a disciplinary process. Schapiro also said the Madoff incident did change the culture of the SEC. For example, SEC examiners are now verifying custody of assets with third parties, something the SEC failed to do in its review of Madoff and something Madoff later told SEC officials he was sure would have led to his scheme’s unraveling. The SEC has delegated certain regulatory responsibilities to the markets (e.g., NYSE or NASDAQ). In these matters, the NYSE and NASDAQ are self-regulatory organizations. Specifically, the NYSE has primary responsibility for the day-to-day surveillance of trading activity. It monitors specialists to ensure adequate compliance with their obligation to make a fair and orderly market; monitors all trading to guard against unfair trading practices; monitors broker-dealer activity with respect to minimum net capital requirements, standards, and licensing; and enforces various listing and disclosure requirements. For example, in October 2007 NYSE regulators censured and fined several NYSE member firms for failure to deliver prospectuses to a large number of customers. The Financial Industry Regulatory Authority (FINRA) is the largest independent regulator for all securities firms doing business in the United States. FINRA was formed in July 2007 as a result of the merger of the National Association of Securities Dealers’ (NASD) with the enforcement arm of the New York Stock Exchange. FINRA oversees all aspects of the securities business, including registering and educating industry participants, examining securities firms, writing rules, enforcing those rules and the federal securities laws, informing and educating the investing public, providing trade reporting and other industry reports, and administering the largest dispute resolution forum for investors and registered firms. The Wall Street Reform and Consumer Protection Act of 2010 (passed in response to the financial crisis), gave the SEC and other regulators new powers to oversee the operations of stock markets. Among these are rules empowering the SEC to disseminate a fiduciary standard for broker-dealers that provide personalized investment services, allowing the SEC to require disclosures on broker-dealers that sell only proprietary products, allowing the SEC to review rule changes of self-regulatory organizations that affect custody of customer securities or funds, allowing the SEC to facilitate the provision of simple and clear investor disclosures regarding the terms of Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e relationships with broker-dealers and investment advisers, and requiring the SEC to undertake a study on conflicts of interest − involving analysts. Six years after the passage of the Wall Street Reform and Consumer Protection Act 271 rulemaking deadlines have passed. Of these, 204 (75.3 percent) have been met with finalized rules and rules have been proposed that would meet 34 (12.5 percent) more. Rules have not yet been proposed to meet 33 (12.2 percent) passed rulemaking requirements. Of the 390 total rulemaking requirements, 267 (68.46 percent) have been met with finalized rules and rules have been proposed that would meet 40 (10.26 percent) more. Rules have not yet been proposed to meet 83 (21.28%) rulemaking requirements. The enormity of the act has taken up the vast amounts of SEC’s resources and has left many pressing issues affecting investor confidence unaddressed. 19. The U.S. stock markets are the world’s largest. However, with the full implementation of a common currency— the euro—in 2002, European markets grew in importance during the 2000s. Further, economic growth in Pacific Basin countries, China, and other emerging market countries has resulted in significant growth in their stock markets. Figure 8–16 shows the proportion of stock market capitalization among various countries in 1990, 2000, 2009, and 2016. The U.S. dominance in the stock markets is best seen in 2000. However, U.S. market capitalization decreased in size in 2009. Factors behind the U.S. dominance in world stock markets changed in the mid-2000s. Strict new regulations in the U.S. such as Sarbanes-Oxley (discussed earlier) increased the cost of operating in the U.S. and resulted in a significant drop in IPOs of foreign firms in the U.S. Further, U.S. economic growth slowed from an annual rate of over 4 percent in the first two quarters of 2006 to 1¼ percent in the first quarter of 2007. A sharp downturn in the U.S. subprime housing market was a major factor for the slow U.S. growth. During this period growth strengthened in most other major countries, including the euro area, China, the United Kingdom, and Canada. Indeed, in early 2007, growth in the euro area exceeded that in the United States for the first time since 2002. Further, China’s economy continued to expand. Note also the stock market developments in Europe, the Pacific Basin, and the emerging market countries from 1990 to 2016. European markets increased their market share (from 21.1 percent in 1990 to 30.5 percent of the total in 2000). However, as the U.S. financial crisis spread and Europe then fell into a deep sovereign debt crisis in the late 2010s, European markets fell to just 23.1 percent of the world total. Issues got worse in Europe in 2016 as the United Kingdom voted to leave the European Union sending British and European markets down further, to 19.8 percent by June 2016. The Asian economic problems that started in 1997 reduced the value of these markets significantly (for example, Pacific Basin and emerging markets stock markets decreased from 4.6 percent and 2.4 percent in 1990 to 4.4 percent and 1.5 percent in 2000 of the worldwide stock markets, respectively). However, these regions were less affected by the financial crisis that hit the U.S. and Europe. Thus, they recovered and grew to 20.4 percent and 9.3 percent, respectively, in 2016. 20. An American Depositary Receipt (ADR) is a certificate that represents ownership of a foreign stock. An ADR is typically created by a U.S. bank who buys stock in foreign corporations in their domestic currencies and places them in its vault. The bank then issues dollar ADRs backed by the shares of stock. These ADRs are then traded in the U.S. on and off the organized exchanges. The major attraction to U.S. investors is that ADRs are claims to foreign companies that trade on domestic (U.S.) exchanges and in dollars. There are three main types of ADR issuances: Level 1, 2, and 3. Level 1 ADRs are the most common and most basic of the ADRs. Level 1 ADRs are only traded on the over the counter (OTC) market and have the least amount of regulatory requirements as stipulated by the SEC. The companies issuing these ADRs do not have to abide by U.S. accounting (GAAP) standards, nor do they have to issue annual reports. Companies with shares trading under a Level 1 program may decide to upgrade their program to a Level 2 or Level 3 program to gain better exposure in U.S. markets. Level 2 ADRs can be listed on the major stock exchanges (NYSE and NASDAQ), but they have more regulatory requirements than Level 1 ADRs. Issuers of Level 2 ADRs are required to register with the SEC, to file a form 20-F (the basic equivalent to the regular 10-K filing by companies in the U.S.), and to file an annual report that complies with GAAP standards. Due to their listing on the NYSE and Nasdaq markets, Level 2 ADRs have much higher trading volumes than level 1 ADRs. While listed on these exchanges, the company must meet the exchange’s listing requirements. If it fails to do so, it may be delisted and forced to downgrade its ADR program. Level 3 ADRs is the most respected level a foreign company can achieve in the US markets. Like Level 2 ADRs, Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e companies that issue Level 3 ADRs are required register with the SEC, to file a form 20-F, and to file annual reports that comply with GAAP standards. Level 3 ADR companies, however, are allowed to issue shares directly into the U.S. markets, rather than simply allowing the indirect purchase of already created shares. Thus, the foreign company can actually issue shares to raise capital. Foreign companies with Level 3 programs are required to share any news that it distributes within its home country to U.S. investors. Thus, foreign companies with a Level 3 program set up are the easiest on which to find information. Most ADR programs are subject to possible termination, which results in the cancellation of all the depositary receipts, and a subsequent delisting from all exchanges on which they trade. The termination can be at the discretion of the foreign issuer or the depositary bank but is typically at the request of the issuer. In most cases, some type of reorganization or merger is the reason for termination of an ADR program. The major attraction to U.S. investors is that ADRs are claims to foreign companies that trade on domestic (U.S.) exchanges and in dollars. Further, fees on ADRs are lower than those on many international mutual funds. Additionally, as mentioned above, investments in foreign securities help diversify a stock portfolio with companies that spread risk around throughout the globe. However, like all international investments there are unique risks that are associated with them that are not usually present with domestic securities. For example, investors must consider country risk, foreign exchange risk, and other attributes when evaluating ADRs. Further, international companies and their underlying countries are not subject to as strict financial reporting standards as are companies in the U.S. Thus, investors may experience trouble understanding financial reports, terms, and definitions due to differing accounting standards as well as language barriers. Problems: 1. a. With cumulative voting, the total number of votes available is 75,000,000 (= 15 million shares outstanding × 5 directors). If there are six candidates for the five board positions, the five candidates with the highest number of votes will be elected to the board and the candidate with the least total votes will not be elected. In this example, the minimum number of votes needed to ensure election is one sixth of the 75 million votes available, or 12,500,000 votes. If one candidate receives 12,500,000, the remaining votes together total 62,500,000. No matter how these votes are spread over the remaining 5 director candidates, it is mathematically impossible for each of the 5 to receive more than 12,500,000. This would require more than 5 × 12,500,000 votes, or more than the 62,500,000 votes that remain. b. With straight voting, the vote on the board of directors occurs one director at a time. Thus, the number of votes eligible for each director is 15,000,000, the number of shares outstanding. The minimum number of votes needed to ensure election is one half 15 million votes available, or 7.5 million. 2. a. With cumulative voting, the total number of votes available is 300,000,000 (= 50 million shares outstanding × 6 directors). If there are eight candidates for the six board positions, the six candidates with the highest number of votes will be elected to the board and the two candidates with the least total votes will not be elected. In this example, the minimum number of votes needed to ensure election is one eighth of the 300 million votes available, or 37,500,000 votes. If one candidate receives 37,500,000, the remaining votes together total 262,500,000. No matter how these votes are spread over the remaining 7 director candidates, it is mathematically impossible for each of the 7 to receive more than 37,500,000. This would require more than 7 × 37,500,000 votes, or more than the 262,500,000 votes that remain. b. With straight voting, the vote on the board of directors occurs one director at a time. Thus, the number of votes eligible for each director is 50,000,000, the number of shares outstanding. The minimum number of votes needed to ensure election is one half 50 million votes available, or 25 million. 3. You own 50,000 shares of common stock in a firm with 2.5 million total shares outstanding. The firm announces its plan to sell an additional 1 million shares through a rights offering. Thus, each shareholder will be sent 0.4 rights for each share of stock owned. One right can then be exchanged for one share of common stock in the new issue.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e a. Your current ownership interest is 2.0 percent (50,000/2.5 million) prior to the rights offering and you receive 20,000 rights (50,000 × 0.4) allowing you to purchase 20,000 of the new shares. If you exercise your rights (buying the 20,000 shares) your ownership interest in the firm after the rights offering is still 2 percent ((50,000 + 20,000)/ (2.5 million + 1 million)). b. The market value of the common stock is $35 before the rights offering, or the total market value of the firm is $87.5 million ($35 × 2.5 million), and the 1 million new shares are offered to current stockholders at a $5 discount, or for $30 per share. The firm receives $30 million. The market value of the firm after the rights offering is $117.5 million (the original $87.5 million plus the $30 million from the new shares), or $33.571 per share ($117.5 million / 3.5 million). c. Your 50,000 shares are worth $1.75 million ($35 × 50,000) before the rights offering, and you can purchase 20,000 additional shares for $600,000 ($30 × 20,000). Thus, your total investment in the firm after the rights offering is $2.35 million, or $33.571 per share ($2.35 million / 70,000). d. Your 50,000 shares are worth $1.75 million ($35 × 50,000) before the rights offering. Since each right allows a stockholder to buy a new share for $30 per share when the shares are worth $33.571, the value of one right should be $3.571. Should you sell your rights rather than exercise them, you maintain your original 50,000 shares of stock. These have a value after the rights offering of $1.679 million (50,000 × 33.571). You also sell your rights for $0.071 million (20,000 × $3.57). You have a total of $1.75 million, or have lost no wealth. 4. You own 100,000 shares of common stock in a firm with 12.5 million total shares outstanding. The firm announces its plan to sell an additional 2.5 million shares through a rights offering. Thus, each shareholder will be sent 0.2 rights for each share of stock owned. One right can then be exchanged for one share of common stock in the new issue. a. Your current ownership interest is 0.80 percent (100,000/12.5 million) prior to the rights offering and you receive 20,000 rights (100,000 × 0.2) allowing you to purchase 20,000 of the new shares. If you exercise your rights (buying the 20,000 shares) your ownership interest in the firm after the rights offering is still 0.80 percent ((100,000 + 20,000)/(12.5 million + 2.5 million)). b. The market value of the common stock is $22.50 before the rights offering, or the total market value of the firm is $281.25 million ($22.50 × 12.5 million), and the 2.5 million new shares are offered to current stockholders at a $2.40 discount, or for $20.10 per share. The firm receives $50.25 million. The market value of the firm after the rights offering is $331.50 million (the original $281.25 million plus the $50.25 million from the new shares), or $22.10 per share ($331.50 million / 15 million). c. Your 100,000 shares are worth $2.25 million ($22.50 × 100,000) before the rights offering, and you can purchase 20,000 additional shares for $402,000 ($20.10 × 20,000). Thus, your total investment in the firm after the rights offering is $2.652 million, or $22.10 per share ($2.652 million / 120,000). d. Your 100,000 shares are worth $2.25 million ($22.50 × 100,000) before the rights offering. Since each right allows a stockholder to buy a new share for $20.10 per share when the shares are worth $22.10, the value of one right should be $2.00. Should you sell your rights rather than exercise them, you maintain your original 100,000 shares of stock. These have a value after the rights offering of $2.210 million (100,000 × 22.10). You also sell your rights for $0.04 million (20,000 × $2.00). You have a total of $2.25 million, or have lost no wealth. 5. a. Celldex Therapeutics closed at $3.07 per share on February 21, 2020. b. The percentage change in Dropbox’s stock price from February 20, 2020 to February 21, 2020 was 19.96%. c. On February 21, 2020, 9.1 million shares of California Resources Corp. were traded. 6. a. Genprex Inc. stock closed at $5.33 per share on February 21, 2020.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e b. The dollar change in Oncolytics Biotech’s stock price from February 20, 2020 to February 21, 2020 was $0.40. c. On February 21, 2020, 328.0 thousand shares of Universal Electronics Inc. were traded. 7. a. Return = $2.75/$35.00 + ($30.00 - $35.00)/$35.00) = -6.43% b. Return = $2.75/$35.00 + ($40.00 - $35.00)/$35.00) = 22.14% 8. EXCEL Problem:

Return = -11.00% Return = 5.00% Return = 9.00% Return = 19.00%

9. (1)

(2)

(3)

(4)

(5)

(6)

(7)

Symbol

Open

High

Low

Net Chg

McKesson

MCK

61.00

61.14

60.28

60.60

-1.01

(8)

(9)

(10)

(11)

%Chg

Vol

52 Week High

52 Week Low

(12) Div

-1.64

2,719,785

71.49

53.57

0.72

(13)

(14)

(15)

Yield

YTD %Chg

1.19

13.00

-3.04

Column 14 is the McKesson’s P/E ratio, 13.00; Column 6 reports McKesson’s price—the numerator of the P/E ratio—as $60.60. Thus, McKesson’s earnings per share—the denominator of the P/E ratio—over the period August 2009 through August 2010 must have been $4.66 per share: E = P @ P/E = $60.60  13.00). 10. (1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

(10)

(11)

(12)

(13)

(14)

(15)

Symbol

Open

High

Low

Net Chg

%Chg

Vol

52 Week High

52 Week Low

Div

Yield

YTD %Chg

Abercrombie&Fitch

ANF

37.89

38.41

37.20

37.60

-1.21

-3.12

2,323,747

51.12

28.76

0.70

1.86

55.29

7.89

Column 14 is the Abercrombie & Fitch’s P/E ratio, 55.29; Column 6 reports Abercrombie & Fitch’s price—the numerator of the P/E ratio—as $37.60. Thus, Abercrombie & Fitch’s earnings per share—the denominator of the P/E ratio—over the period August 2009 through August 2010 must have been $0.68 per share: E = P  P/E = $37.60  55.29).

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 9 Questions: 1. Cash flows from the sale of products, services, or assets denominated in a foreign currency are transacted in foreign exchange (FX) markets. A foreign exchange rate is the price at which one currency (e.g., the U.S. dollar) can be exchanged for another currency (e.g., the Swiss franc) in the foreign exchange markets. These transactions expose U.S. corporations and investors to foreign exchange risk as the cash flows are converted into and out of U.S. dollars. In addition to understanding the operations of domestic financial markets, a financial manager must also understand the operations of foreign exchange markets and foreign capital markets. Today’s U.S.–based companies operate globally. It is therefore essential that financial managers understand how events and movements in financial markets in other countries affect the profitability and performance of their own companies. 2. The U.S. FI would prefer to be net short (liabilities greater than assets) in its asset position. The depreciation of the Swiss franc relative to the dollar means that the U.S. FI would pay back the net liability position with fewer dollars. In other words, the decrease in the foreign assets in dollar value after conversion will be less than the decrease in the value of the foreign liabilities in dollar value after conversion. 3. In this case, the insurance company is worried about the value of the £ falling. If this happens, the insurance company would be able to buy fewer dollars with the £s received. This would happen if the exchange rate rose to say £1.48/$ since now it would take more £s to buy one dollar, but the bond contract is paying a fixed amount of interest and principal. 4. From 1944 to 1971, the Bretton Woods Agreement called for the exchange rate of one currency for another to be fixed within narrow bands around a specified rate with the help of government intervention. The Bretton Woods Agreement, however, led to a situation in which some currencies (such as the U.S. dollar) became very overvalued and others (such as the German mark) became very undervalued. The Smithsonian Agreement of 1971 sought to address this situation. Under this agreement, major countries allowed the dollar to be devalued and the boundaries in which exchange rates could fluctuate were increased from 1 percent to 2 percent. In 1973 under the so-called Smithsonian Agreement II, the exchange rate boundaries were eliminated altogether. This change effectively allowed exchange rates of major currencies to float freely. This free floating foreign exchange rate system is still partially in place. However, central governments may still intervene in the foreign exchange markets by altering interest rates to affect the value of their currency relative to others, and the major European countries have chosen to peg (fix) their exchange rates with each other as they move towards a single currency and full monetary union in the year 2002. Indeed, on January 1, 1999, 12 major European countries pegged their currency values to a single currency, called the European Currency Unit. While these individual countries continue to issue their own currency, their currencies values are pegged to each other. Similar to the government intervention under the Bretton Woods agreement, European governments intervene to insure that exchange rates between the European Union countries are maintained. 5. Since 1982 when Singapore opened its market, foreign exchange markets have operated 24 hours a day: when the New York market closes, operations in the San Francisco area are still open; when the San Francisco operations close, the Hong Kong and Singapore markets open; when Tokyo and Singapore close the Frankfurt market opens; an hour later the London market opens; and before these markets close the New York market reopens. 6. The spot market for foreign exchange involves transactions for immediate delivery of a currency, while the forward market involves agreements to deliver a currency at a later time for a price or exchange rate that is determined at the time the agreement is reached. The net exposure of a foreign currency is the net foreign asset position plus the net foreign currency position. Net long in a currency means that the amount of foreign assets exceeds the amount of foreign liabilities. 7. Managers hedge to manage their exposure to currency risks, not to eliminate it. As in the case of interest rate risk exposure, it is not necessarily an optimal strategy to completely hedge away all currency risk exposure. By its very definition, hedging reduces a firm’s risk by reducing the volatility of possible future returns. This narrowing of the

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e probability distribution of returns reduces possible losses, but also reduces possible gains (i.e., it shortens both tails of the distribution). A hedge would be undesirable, therefore, if the firm wants to take a speculative position in a currency in order to benefit from some information about future currency rate movements. The hedge would reduce possible gains from the speculative position. 8. On-balance-sheet hedging involves making changes in the on-balance-sheet assets and liabilities to protect the FI’s profits from FX risk. Off-balance-sheet hedging involves no on-balance-sheet changes, but rather involves taking a position in forward or other derivative securities to hedge FX risk. By directly matching its foreign asset and liability book, an FI can lock in a positive return or profit spread whichever direction exchange rates change over the investment period. For example, even if domestic U.S. banking is a relatively low-profit activity (i.e., there is a low spread between the return on assets and the cost of funds), the FI could be very profitable overall. Specifically, it could lock in a large positive spread—if it exists—between deposit rates and loan rates in foreign markets. For such imbalances in domestic spreads and foreign spreads to continue over long periods of time, financial service firms would have to face significant barriers to entry into foreign markets. Specifically, if real and financial capital were free to move, FIs would increasingly withdraw from the U.S. market and reorient their operations toward the foreign currency. Reduced competition would widen loan deposit interest spreads in the United States, and increased competition would contract foreign investment spreads until the profit opportunities from overseas activities disappeared. Advantages of off-balance-sheet FX hedging: The use of off-balance-sheet hedging devices, such as forward contracts, enables an FI to reduce or eliminate its FX risk exposure without forfeiting potentially lucrative transactions. On-balance-sheet transactions result in immediate cash flows, whereas off-balance-sheet transactions result in contingent future cash flows. Therefore, the up-front cost of hedging using off-balance-sheet instruments is lower than the cost of on-balance-sheet transactions. Moreover, since on-balance-sheet transactions are fully reflected in financial statements, there may be additional disclosure costs to hedging on the balance sheet. Disadvantages of off-balance-sheet FX Hedging: There is some credit risk associated with off-balance-sheet hedging instruments since there is some possibility that the counterparty will default on its obligations. This credit risk exposure is exacerbated in negotiated markets such as the forward market, but mitigated for exchange-traded hedging instruments such as futures contracts. 9. If there are no real or financial barriers to international capital and goods flows, FIs can eliminate all foreign exchange rate risk exposure. Sources of foreign exchange risk exposure include international differentials in real prices, cross-country differences in the real rate of interest (perhaps, as a result of differential rates of time preference), regulatory and government intervention, and restrictions on capital movements, trade barriers, and tariffs. 10. A financial institution’s position in the foreign exchange markets generally reflects four trading activities: • The purchase and sale of foreign currencies to allow customers to partake in and complete international commercial trade transactions. • The purchase and sale of foreign currencies to allow customers (or the financial institution itself) to take positions in foreign real and financial investments. • The purchase and sale of foreign currencies for hedging purposes to offset customer (or financial institution) exposure in any given currency. • The purchase and sale of foreign currencies for speculative purposes through forecasting or anticipating future movements in foreign exchange rates. 11. If interest rate parity holds, then it is not possible for FIs to borrow and lend in different currencies to take advantage of the differences in interest rates between countries. This is because the spot and forward rates will adjust to ensure that no arbitrage can take place through cross-border investments. If a disparity exists, then the sale and purchase of spot and forward currencies by arbitragers will ensure that in equilibrium interest rate parity is maintained. If U.S. interest rates are higher than foreign rates, the forward dollar value of the foreign currency will be greater than the spot dollar value since investors can earn more over the investment horizon in the United States

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e than in the foreign market. If U.S. interest rates are lower than foreign rates, the forward dollar value of the foreign currency will be less than the spot dollar value since investors can earn more in foreign markets than in U.S. markets. 12. As relative inflation rates (and interest rates) change, foreign currency exchange rates that are not constrained by government regulation should also adjust to account for relative differences in the price levels (inflation rates) between the two countries. According to purchasing power parity (PPP), foreign currency exchange rates between two countries adjust to reflect changes in each country’s price levels (or inflation rates and implicitly interest rates) as consumers and importers switch their demands for goods from relatively high inflation (interest) rate countries to low inflation (interest) rate countries. Specifically, the PPP theorem states that the change in the exchange rate between two countries’ currencies is proportional to the difference in the inflation rates in the two countries. 13. Interest rate parity argues that the discounted spread between domestic and foreign interest rates is equal to the percentage spread between forward and spot exchange rates. If interest rate parity holds, then it is not possible for FIs to borrow and lend in different currencies to take advantage of the differences in interest rates between countries. This is because the spot and forward rates will adjust to ensure that no arbitrage can take place through cross-border investments. If a disparity exists, the sale and purchase of spot and forward currencies by arbitragers will ensure that in equilibrium interest rate parity is maintained. 14. Among the impediments to its holding are the impediments to arbitrage: unequal borrowing and lending rates, bid ask spreads, other transactions costs, tax differentials, and even central bank intervention in the foreign exchange markets. 15. In this case, the equation would be written as (1 + rDust) = (1/Ft) × (1 + rLukt) × St 16. The U.S. has had a substantial trade deficit resulting from imports of foreign goods relative to exports of domestic goods, $762.564 billion in 2015. This deficit has increased in the 1990s and 2000s. For example, the deficit in the trade of foreign goods was just $19.350 billion in 1991. This is mainly due to the relatively high economic growth rate in the U.S. As an economy grows relative to other countries, its currency appreciates relative to other currencies. This makes domestic goods relatively expensive and foreign goods relatively cheap. In contrast, the U.S. ran a surplus in the services component of the balance of payments current accounts, $262.203 billion in 2015 versus $13.830 billion in 1991. The U.S. service sector (e.g., financial services, transportation fares, defense expenditures) generally generates a substantial positive balance. Thus, these services have a positive impact on the overall U.S. balance of payment accounts. 17. Transactions recorded to the balance of payment accounts use standard double-entry bookkeeping. Thus, any payment of funds by a U.S. citizen to a foreign country, such as payment for the purchase of a foreign car (a debit to a balance of payment current account), must be offset with a receipt credit received from the foreign country, such as a reduction in U.S. international reserves (a credit to a balance of payment capital account). Any receipt of funds by a U.S. citizen to a foreign country, such as payment on the sale of a domestic car (a credit to a balance of payment current account), must be offset with a recording of credit given to the foreign country, such as an increase in U.S. international reserves (a debit to a balance of payment capital account). Therefore, when all transactions are summed, total debits recorded must equal total credits. Problems: 1. a. The spot exchange rate of Canadian dollars for U.S. dollars (USD/CAD) was C$1.3807/US$1 on March 13, 2020. b. The 6-month forward exchange rate of Canadian dollars for U.S. dollars (USD/CAD) was C$1.3984/US$1 on March 13, 2020. c. The 3-month forward exchange rate of U.S. dollars for Japanese yen (JPY/USD) was $0.00938/¥1 on March 13, 2020.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 2. a. The exchange rate of British pounds for U.S. dollars on February 13, 2020 was £0.8226/US$1. The U.S. dollar has depreciated in value relative to the pound. b. Initial investment was $1 million × 0.8226 = £822,600 Exchanging the funds back to dollars on March 13, 2020 you will have £822,600 / 0.8141 = $1,010,441 Your gain is $1,010,441 - $1,000,000 = $10,441. 3. At the beginning of the month you convert $500,000 to yen at a rate of 107.98 yen per dollar, or you will have $500,000 × 107.98 = ¥53,990,000. The 6-month forward rate for the U.S. dollar for Japanese yen on March 13, 2020 was $0.00941/¥1. So, at the end of the month you will convert ¥53,990,000 to dollars at $0.00941 per ¥, or you will have ¥53,990,000 × 0.00941 = $508,045.90 4. a. Bank USA is exposed to an appreciation of the dollar relative to the euro. b. Bank USA converts the $10 million to euros as follows: $10m/1.104 = €9,057,971 At the end of the year Bank USA gets back principal and interest on €9,057,971 CDs and converts them to dollars as follows: €9,057,971 × (1.1) × 1.004 = $10,003,623 The resulting return is ($10,003,623 - $10,000,000)/$10,000,000 = 0.036% c. Bank USA converts the $10 million to euros as follows: $10m/1.104 = €9,057,971 At the end of the year Bank USA gets back principal and interest on €9,057,971 CDs and converts them to dollars as follows: €9,057,971 × (1.1) × 1.204 = $11,996,377 The resulting return is ($11,996,377 - $10,000,000)/$10,000,000 = 19.963% 5 a. Bankone is exposed to a depreciation of the dollar relative to the euro. b. Bankone receives the $200 million from reals as follows: $200m/0.305 = Br 655,737,705 At the end of the year Bankone converts dollars to reals and pays back principal and interest on Br655,737,705 CDs as follows: Br655,737,705 × (1.065) × 0.325 = $226,967,213 The resulting percentage cost is ($226,967,213 - $200,000,000)/$200,000,000 = 13.48% c. Bankone receives the $200 million from reals as follows: $200m/0.305 = Br 655,737,705 At the end of the year Bankone converts dollars to reals and pays back principal and interest on Br655,737,705 CDs as follows: Br655,737,705 × (1.065) × 0.285 = $199,032,787

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e The resulting percentage cost is ($199,032,787 - $200,000,000)/$200,000,000 = -0.48% 6. a. Loan amount = A$16m × 0.757 = $12,112,000 Deposit amount = $12,112,000/1.320 = £9,175,758 Interest income at the end of the year = A$16m × 0.12 = A$1,920,000 × 0.715 = $1,372,800 Interest expense at the end of the year = £9,175,758 × 0.10 = £917,576 × 1.520 = $1,394,715 Net interest income = $1,372,800 - $1,394,715 = -$21,915 b. The net cost of deposits should be $1,372,800 - $200,000 = $1,172,800. Rate of U.S. dollars for BPs = $1,172,800 / £917,576 = 1.27815. Thus, the spot rate of U.S. dollars for BPs should be $1.27815/£1 in order for the bank to earn $200,000. 7. a. Loan amount = SF5m × 1.0175 = $5,087,500 Deposit amount = $5,087,500/0.7710 = C$6,598,573 Interest income at the end of the year = SF5m × 0.06 = SF300,000 × 1.0310 = $309,300 Interest expense at the end of the year = C$6,598,573 × 0.04 = C$263,943 × 0.7680 = $202,708 Net interest income = $309,300 - $202,708 = $106,592 b. The net cost of deposits should be $309,300 - $108,000 = $201,300 Rate of U.S. dollars for C$s = $201,300 / C$263,943 = 0.76266. Thus, the spot rate of U.S. dollars for C$s should be $0.76266/C$ in order for the bank to earn $108,000. 8. a. Amount of loan in £ = $2 million / 1.32 = £1,515,152. Interest and principal at year-end in dollars = £1,515,152 × 1.08 = £1,636,364 × 1.30 = $2,127,272 Interest and principal of CDs = $2m × 1.06 = $2.12m Net income = $2,127,272 - $2,120,000 = $7,273 Spread = $7,273/2,000,000 = 0.36% In order to maintain a 2% spread, the interest and principal earned at 1.30 U.S. dollars for £s should be: £1,515,152 (1 + x) × 1.30 = $2.16m (Because ($2.16m - $2.12m)/2.00m = 2% spread) => x = ($2.16m / 1.30) / £1,515,152 = 1.0966, or 9.66% That is, a loan rate of 9.66% will produce a spread of 2%. b. If hedged, net interest income = £1,515,152 × 1.08 = £1,636,364 =>£1,636,364 × 1.33 = $2,176,364 => $2,176,364 - $2.12m = $56,364 Net interest margin = $56,364/$2m = 2.82% c. To maintain a 2% spread: £1,515,152(1 + x) × 1.33 = $2.16m => x = 7.188% The bank should increase the rate on the loan to 7.188% and hedge with the sale of forward £s to maintain a 2% spread.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 9. a. Amount of loan in ¥ = $5 million / 0.00950 = ¥526,315,790. Interest and principal at year-end in dollars = ¥526,315,790 × 1.06 = ¥557,894,737 × 0.009483 = $5,290,516 Interest and principal of CDs = $5m × 1.04 = $5.20m Net income = $5,290,516 - $5,200,000 = $90,516 Spread = $90,516/5,000,000 = 1.81% In order to maintain a 2% spread, the interest and principal earned at 0.009483 U.S. dollars for ¥s should be: ¥526,315,790(1 + x) × 0.009483 = $5.30m (Because ($5.30m - $5.20m)/5.00m = 2% spread) => x = ($5.30m / 0.009483) / ¥526,315,790 = 1.0619, or 6.19% That is, a loan rate of 6.19% will produce a spread of 2%. b. If hedged, net interest income = ¥526,315,790 × 1.06 = ¥557,894,737 =>¥557,894,737 × 0.009493 = $5,296,095 => $5,296,095 - $5.20m = $96,095 Net interest margin = $96,095/$5m = 1.92% c. To maintain a 2% spread: ¥526,315,790 (1 + x) × 0.009493 = $5.30m => x = 6.078% The bank should increase the rate on the loan to 6.078% and hedge with the sale of forward ¥s to maintain a 2% spread. 10. a. At the beginning of the year, the FI sells $200 million for euros on the spot currency markets at an exchange rate of $1.10 to € => $200 million/1.10 = €181,818,182. At the end of the year, euro revenue from these loans will be €181,818,182(1.10) = €200 million. Then the dollar proceeds from the German loan are: €200 million × $1.10/€1 = $220 million or as a return $220 million - $200 million = 10% $200 million Given this, the weighted return on the FI’s portfolio of investments would be: (300m/500m)(0.06) + (200m/500m)(0.10) = 0.076, or 7.60% This exceeds the cost of the FI’s CDs by 3.4 percent (7.6% - 4%). b. At the end of the year, euro revenue from these loans will be €181,818,182(1.10) = €200 million. Then the dollar proceeds from the German loan are: €200 million × $1.00/€1 = $200 million or as a return $200 million - $200 million = 0.00% $200 million Given this, the weighted return on the FI’s portfolio of investments would be: (300m/500m)(0.06) + (200m/500m)(0.00) = 0.036, or 3.60% This is less than the cost of the FI’s CDs by 0.04 percent (3.6% - 4% = -0.04%). c. At the end of the year, euro revenue from the loans will be €181,818,182(1.10) = €200 million.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Then the dollar proceeds from the German loan are: €200 million × $1.20/€1 = $240 million or as a return $240 million - $200 million = 20.0% $200 million Given this, the weighted return on the FI’s portfolio of investments would be: (300m/500m)(0.06) + (200m/500m)(0.200) = 0.1160, or 11.60% This exceeds the cost of the FI’s CDs by 7.60 percent (11.60% - 4%). 11. a. As in part b in question 10, when the euro falls in value to $1.00/€1 at the end of the year, euro revenue from the German loans is be €181,818,182(1.10) = €200 million. Then the dollar proceeds from the German loan are: €200 million × $1.00/€1 = $200 million or as a return $200 million - $200 million = 0.00% $200 million and the weighted return on the FI’s portfolio of investments would be: (300m/500m)(0.06) + (200m/500m)(0.00) = 0.0360, or 3.60% On the liability side of the balance sheet, at the beginning of the year, the FI borrows $200 million equivalent in euro CDs for one year at a promised interest rate of 7 percent. At an exchange rate of $1.10/€1, this is a euro equivalent amount of borrowing of $200 million/1.10 = €181,818,182. At the end of the year, the FI must pay the pound CD holders their principal and interest, €181,818,182 (1.07) = €194,545,455. If the euro falls to $1.00/€1 over the year, the repayment in dollar terms would be €194,545,455 × $1.00/€1 = $194,545,455 or as a return $194,545,455 - $200 million = -2.73% $200 million Thus, at the end of the year, Average cost of funds: (300m/500m)(0.04) + (200m/500m)(-0.0273) = 0.02509, or 2.509% Net return: Average return on assets - Average cost of funds 3.60% - 2.509% = 1.091% b. As in part c in question 10, when the euro rises in value to $1.20/€1 at the end of the year, euro revenue from the German loans is be €181,818,182(1.10) = €200 million. Then the dollar proceeds from the German loan are: €200 million × $1.20/€1 = $240 million or as a return $240 million - $200 million = 20.00% $200 million and the weighted return on the FI’s portfolio of investments would be: (300m/500m)(0.06) + (200m/500m)(0.200) = 0.116, or 11.60% On the liability side of the balance sheet, at the beginning of the year, the FI borrows $200 million equivalent in euro

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e CDs for one year at a promised interest rate of 7 percent. At an exchange rate of $1.10/€1, this is a euro equivalent amount of borrowing of $200 million/1.10 = €181,818,182. At the end of the year, the FI must pay the pound CD holders their principal and interest, €181,818,182 (1.07) = €194,545,455. If the euro increases to $1.20/€1 over the year, the repayment in dollar terms would be €194,545,455 × $1.20/€1 = $233,454,546 or as a return $233,454,546 - $200 million = 16.73% $200 million Thus, at the end of the year, Average cost of funds: (300m/500m)(0.04) + (200m/500m)(0.1673) = 0.10292, or 10.292% Net return: Average return on assets - Average cost of funds 11.6% - 10.295% = 1.308% 12. EXCEL Problem:

Gain/loss = $300,000 Gain/loss = $0 Gain/loss = -$150,000 Gain/loss = -$330,000

13. Net foreign exposurei = (FX assetsi - FX liabilitiesi) + (FX boughti - FX soldi) = Net foreign assetsi + Net FX boughti a. Thus, for Citibank, net foreign assets = $23 million - $18 million = $5 million. b. Citibank’s net foreign exchange bought = $5 million - $12 million = -$7 million. c. Citibank’s net foreign exposure = $5 million + (-$7 million) = -$2 million. 14. Net foreign exposurei = (FX assetsi - FX liabilitiesi) + (FX boughti - FX soldi) = Net foreign assetsi + Net FX boughti a. Thus, for P.J. Chase Stanley, net foreign assets = $75 million - $68 million = $7 million. b. P.J. Chase Stanley’s net foreign exchange bought = $165 million - $128 million = $37 million. c. P.J. Chase Stanley’s net foreign exposure = $7 million + $37 million = $44 million. 15. The net exposure would be ¥14 million – ¥23 million – ¥8 million = - ¥17 million. This negative exposure puts the bank at risk of an appreciation of the yen against the dollar. A stronger yen means that repayment of the net position would require more dollars. 16. a. Net exposure in stated in Sfs = Sf127,500 – Sf51,000 + Sf10,200 – Sf15,300 = Sf71,400 Net exposure in stated in $s = $125,000 - $50,000 + $10,000 - $15,000 = $70,000 b. Net exposure in £ = £38,168 - £16,794 + £11,450 - £15,267 = £17,557 Net exposure in $ = $50,000 - $22,000 + $15,000 - $20,000 = $23,000 c. Net exposure in ¥ = ¥7,869,885 - ¥3,147,954 + ¥1,259,181 - ¥9,233,998 = - ¥3,252,886 Net exposure in $ = $75,000 - $30,000 + $12,000 - $88,000 = -$31,000 d. If assets are greater than liabilities, then an appreciation of the foreign exchange rates will generate a gain = SF71,400 × 0.01 = SF714, or $70,000 × 0.01 = $700. e. Gain = £17,557 × 0.01 = $176, or $23,000 × 0.01 = $230 f. Loss = - ¥3,252,886 × 0.02 = -$65,058 or -$31,000 × 0.02 = -$620

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e

17. According to PPP, the 5 percent rise in the price of Australian goods relative to the 3 percent rise in the price of U.S. goods results in a depreciation of the Australian dollar (by 2 percent). Specifically, the exchange rate of Australian dollars to U.S. dollars should fall, so that: iUS - iA = ΔSUS$/A$/SUS$/A$ Plugging in the inflation and exchange rates, we get: 0.03 - 0.05 = ΔSUS$/A$/SUS$/A$ = ΔSUS$/A$/0.757 or:

-0.02 = ΔSUS$/A$/0.757

and:

ΔSUS$/A$ = -(0.02) × 0.757 = -0.01514

Thus, it costs 1.514 cents less to receive an Australian dollar (or $0.74186 ($0.757 - $0.01514), can be received for 1 Australian dollar). The Australian dollar depreciates in value by 2 percent against the U.S. dollar as a result of its higher inflation rate. 18. Since direct exchange rates are being used, (1+rUS) = 1/S × (1+rUK) × F 1.10 = 1/1.35 × 1.08 × F F = 1.10 /(1/1.35 × 1.08) = 1.10 × 1.35 / 1.08 = $1.375/£1 19. In this case, interest rates in the U.S. are "too high" relative to the U.K. An investor could take advantage of this by borrowing pounds, converting to dollars in the spot market while simultaneously selling dollars in the forward market. In one year, the investor could deliver the dollars for pounds, pay off the loan, and have extra pounds left over. 20. The current exchange rate is $40,000/¥4,000,000 or $0.01/¥1. Next year, the Japanese goods will cost ¥4,240,000, and the U.S. goods will cost $44,000. Thus, the dollar will depreciate against the yen. 21. a. Borrow $1,000,000 in U.S. by issuing CDs: Interest and principal at year-end = $1,000,000 × 1.08 = $1,080,000 Make a loan in Switzerland: Interest earned = ($1,000,000/1.02) = Sf980,392 × 1.04 = Sf1,019,608 Purchase U.S. dollars at the forward rate of $1.08 × Sf1,019,608= $1,101,176 Spread = ($1,101,176 - $1,080,000)/1,000,000 = $21,176/$1,000,000 = 2.12% b. Forward rate that will prevent any arbitrage: Ft = [(1 + 0.08) × 1.02]/(1.04) = $1.05923/Sf => Interest earned = ($1,000,000/1.02) = Sf980,392 × 1.04 = Sf1,019,608 Purchase U.S. dollars at the forward rate of $1.05923 × Sf1,019,608 = $1.08 m

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Spread = ($1.08m - $1.08m)/1.0m = 0.00% 22. a. Borrow $5,000,000 in U.S. by issuing CDs: Interest and principal at year-end = $5,000,000 × 1.05 = $5,250,000 Make a loan in Turkey: Interest earned = ($5,000,000/0.3310) = TL15,105,740 × 1.04 =TL15,709,970 Purchase U.S. dollars at the forward rate of $0.3420 × TL15,709,970 = $5,372,810 Spread = ($5,372,810 - $5,250,000)/5,000,000 = $122,810/$5,000,000 = 2.456% b. Forward rate that will prevent any arbitrage: Ft = [(1 + 0.05) × 0.3310]/(1.04) = $0.33418/TL Interest earned = ($5,000,000/0.3310) = TL15,105,740 × 1.04 = TL15,709,970 Purchase U.S. dollars at the forward rate of $0.33418 × TL15,709,970 = $5.25m Spread = ($5.25m - $5.25m)/5,000,000 = 0.00% 23. a. Total current accounts = $168,953 - $160,357 = $8,596 b. Balance on goods = lines 2 + 6 = $92,543 - $93,528 = -$985 c. Balance on services = lines 3 + 7 = $45,689 - $31,689 = $14,000 d. Balance on investment income = lines 4 + 8 = $30,721 - $35,140 = -$4,419

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 10 Questions: 1. A derivative security is a financial security whose payoff is linked to another, previously issued security. Derivative securities generally involve an agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future. As the value of the underlying security to be exchanged changes, the value of the derivative security changes. 2. A spot contract is an agreement between a buyer and a seller at time 0, when the seller of the asset agrees to deliver it immediately and the buyer agrees to pay for that asset immediately. Thus, the unique feature of a spot market is the immediate and simultaneous exchange of cash for securities, or what is often called delivery versus payment. A forward contract is a contractual agreement between a buyer and a seller at time 0, to exchange a prespecified asset for cash at some later date at a price set at time 0. Market participants take a position in forward contracts because the future (spot) price or interest rate on an asset is uncertain. Rather than risk that the future spot price will move against them—that the asset will become more expensive to buy in the future—forward traders pay a financial institution a fee to arrange a forward contract. Such a contract lets the market participant hedge the risk that future spot prices on an asset will move against him or her by guaranteeing a future price for the asset today. A futures contract, like a forward contract, is an agreement between a buyer and a seller at time 0 to exchange a standardized, prespecified asset at some later date at a price set at time 0. Thus, a futures contract is very similar to a forward contract. The difference relates to the contract’s price, which in a forward contract is fixed over the life of the contract, whereas a futures contract is marked to market daily. This means that the contract’s price is adjusted each day as the futures price for the contract changes and the contract approaches maturity. Therefore, actual daily cash settlements occur between the buyer and seller in response to these price changes (this is called marking to market). 3. Trades from the public are placed with a floor broker. When an order is placed, a floor broker may trade with another floor broker or with a professional trader. Professional traders are similar to designated market makers on the stock exchanges in that they trade for their own account. Professional traders are also referred to as position traders, day traders, or scalpers. Position traders take a position in the futures market based on their expectations about the future direction of prices of the underlying assets. Day traders generally take a position within a day and liquidate it before day’s end. Scalpers take positions for very short periods of time, sometimes only minutes, in an attempt to profit from this active trading. Scalpers do not have an affirmative obligation to provide liquidity to futures market but do so in expectation of earning a profit. Scalper’s profits are related to the bid-ask spread and the length of time a position is held. Specifically, it has been found that scalper trades held longer than 3 minutes, on average, produce losses to scalpers. Thus, this need for a quick turnover of a scalper’s position enhances futures market liquidity and is therefore valuable. 4. Clearinghouses perform their function as guarantor of an exchange’s futures contracts by requiring all member firms to deposit sufficient funds (called margins) to ensure the firm’s customers will meet the terms of any futures contract entered into on the exchange. In turn, brokerage firms require their customers to post an initial margin any time they request a trade. The amount of the margin varies according to the type of contract traded and the quantity of futures contracts traded. Minimum margin levels are set by each exchange. If losses on the customer’s futures position occur and the level of the funds in the margin account drop below a stated level (called the maintenance margin), the customer is required to deposit additional funds into his or her margin account, bringing the balance back up to the initial level. The maintenance margin is generally about 75 percent of the initial margin. If the margin is not maintained, the broker closes out the customer’s futures position. Any amount above the initial margin may be withdrawn from a customer’s account. 5. A long position is an order for a purchase of the futures or option contract. A short position is an order for a sale of the futures contract. 6. A quote of 103-13 = 103 13/32% of the face value. Since Treasury bond futures contracts have a face value of $100,000, the quoted price is $103,406.25.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 7. a. If T-note futures prices fall a short position would be the profitable one to take. b. If inflation in Japan increases by more than inflation in the U.S., the yen depreciates in value relative to the U.S. dollar so the value of the Japanese yen currency futures contract falls. Thus, a short position would be the profitable one to take. c. If you think stock prices will fall in the next three months, you would expect the value of S&P 500 futures contract will also fall. Thus, a short position is the profitable one to take. If stock prices actually rise over this period, a short position will result in financial losses. 8. An option is a contract that gives the holder (buyer) the right, but not the obligation, to buy or sell an underlying asset at a prespecified price for a specified period of time. The lack of an obligation to exercise the option means that, unlike futures where losses are unlimited, losses on options are limited to the upfront cost paid for the option, the option premium. 9. A call option gives the purchaser (or buyer) the right to buy an underlying security (e.g., a stock) at a prespecified price called the exercise or strike price (X). In return, the buyer of the call option must pay the writer (or seller) an up-front fee known as a call premium (C). This premium is an immediate negative cash flow for the buyer of the call option. However, he or she potentially stands to make a profit should the underlying stock’s price be greater than the exercise price (by an amount exceeding the premium). If the price of the underlying stock is greater than X (the option is referred to as “in the money”), the buyer can exercise the option, buying the stock at X and selling it immediately in the stock market at the current market price, greater than X. If the price of the underlying stock is less than X (the option is referred to as “out of the money”), the buyer of the call would not exercise the option (i.e., buying the stock at X when its market value is less than X). If this case when the option matures, the option expires unexercised. The call buyer incurs a cost C for the option, and no other cash flows result. A put option gives the option buyer the right to sell an underlying security (e.g., a stock) at a prespecified price to the writer of the put option. In return, the buyer of the put option must pay the writer (or seller) the put premium (P). If the underlying stock’s price is less than the exercise price (X) (the put option is “in the money”), the buyer will buy the underlying stock in the stock market at less than X and immediately sell it at X by exercising the put option. If the price of the underlying stock is greater than X (the put option is “out of the money”), the buyer of the put option would not exercise the option (i.e., selling the stock at X when its market value is more than X). If this is the case when the option matures, the option expires unexercised. The put option buyer incurs a cost P for the option, and no other cash flows result. 10. The call option on a T-bond futures contract allows the owner to buy the T-bond futures contract at a specified price. For the owner of the option to make money, he should be able to immediately sell the bond at a higher price. Thus, if the T-bond futures contract price increases, the writer of the call option makes a premium form the sale of the option. If the option is not exercised, the writer maximizes profit in the amount of the premium. If the option is exercised, the writer stands to lose a portion or the entire premium and may lose additional money if the price on the underlying asset moves sufficiently far. 11. The put option on a stock allows the owner to sell the stock at a specific price. For the owner of the option to make money, he should be able to buy the stock at a lower price immediately prior to exercising the option. Thus, if the stock price decreases, the writer of the put option makes a premium from the sale of the option. If the option is not exercised, the writer maximizes profit in the amount of the premium. If the option is exercised, the writer stands to lose a portion or the entire premium and may lose additional money if the price on the underlying asset movers sufficiently far. 12. First, if conditions are never profitable for an exercise (the option remains “out of the money”), the option holder can let the option mature unused. Second, if conditions are right for exercise (the option is “in the money”), the holder can take the opposite side of the transaction. Thus, an option buyer can sell options on the underlying asset with the same exercise price and the same maturity date. Third, if conditions are right for exercise, the option holder can exercise the option, enforcing the terms of the option. For an American option this exercise can occur any time before the option expires, while for a European option this exercise can occur only as the option matures.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 13. The Black-Scholes model examines five factors that affect the price of an option: 1) the spot price of the underlying asset, 2) the exercise price on the option, 3) the option’s exercise date, 4) price volatility of the underlying asset, and 5) the risk-free rate of interest. The profit and loss on an option was a function of the spot price of the option’s underlying asset and the exercise price on the option. The difference between the underlying asset’s spot price and an option’s exercise price is called the option’s intrinsic value. For a call option, the intrinsic value is: Stock price - Exercise price

if Stock price $ Exercise price (option is in the money)

Zero

if Stock price < Exercise price (option is out of the money)

For a put option, the intrinsic value is: Exercise price - Stock price Zero

if Stock price # Exercise price (option is in the money) if Stock price > Exercise price (option is out of the money)

At expiration, an option’s value is equal to its intrinsic value. The time value of an option is the value associated with the probability that the intrinsic value (i.e., the stock price) could increase (if the underlying asset’s price moves favorably) between the option’s purchase and the option’s expiration date itself. The time value of an option is a function of the price volatility of the underlying asset and the time until the option matures (its expiration date). As price volatility increases, the chance that the stock will go way up or way down increases. The owner of the call option benefits from price increases but has limited downside risk if the stock price decreases since the value of an option can never be less than zero. Thus, over any given period of time, the greater the price volatility of the underlying asset, the greater the chance the stock price will increase (and possibly by a lot) and the greater the time value of the option. Further, the greater the time to maturity the greater (longer) the opportunity for the underlying stock price to increase. Thus, the time value of the option increases. Conversely, as an option moves towards expiration, the less time is available for the underlying stock to move favorably. Thus, the time value goes to zero. It is this “time value” that allows an out-of-the-money option to have value and trade on the option markets. As noted above, a call option is out of the money if the exercise price is greater than the underlying stock’s price, or the intrinsic value of the option is zero. This option still has “time” value and will trade at a positive price or premium, however, if investors believe that prior to the option’s expiration, the stock price will increase (to a value greater than the exercise price). At any point in time, the time value of an option can be calculated by subtracting its intrinsic value (e.g., $10) from its current market price or premium (e.g., $12.50). The risk free rate of interest affects the value of an option in a less clear cut way. As the risk free rate increases, the growth rate of the stock price increases. However, the present value of any future cash flows received by the option holder decreases. For a call option, the first effect tends to increase the price of the option, while the second effect tends to decrease the price. It can be shown that the first effect always dominates the second effect. That is, the price of a call option always increases as the risk free rate increases. The two effects both tend to decrease the value of a put option. Thus, the price of a put option decreases as the risk free rate increases. 14. The Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) are often viewed as “functional” regulators. The SEC regulates all securities traded on national securities exchanges, including several exchange-traded derivatives. The SEC’s regulation of derivatives includes price reporting requirements, antimanipulation regulations, position limits, audit trail requirements, and margin requirements. The CFTC has exclusive jurisdiction over all exchange-traded derivative securities. It therefore regulates all national futures exchanges, as well as all futures and options contracts. The CFTC’s regulations include minimum capital requirements for traders, reporting and transparency requirements, antifraud and antimanipulation regulations, and minimum standards for clearinghouse organizations. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Since January 1, 2000, the main regulator of accounting standards (the Financial Accounting Standards Board, or FASB) has required all FIs (and nonfinancial firms) to reflect the mark to market value of their derivative positions in their financial statements. This means that FIs must immediately recognize all gains and losses on such contracts and disclose those gains and losses to shareholders and regulators. Further, firms must show whether they are using derivatives to hedge risks connected to their business or whether they are just taking an open (risky) position. The main bank regulators—the Federal Reserve, the FDIC, and the Comptroller of the Currency—also have issued uniform guidelines for banks that trade in futures and forwards. These guidelines require a bank to (1) establish internal guidelines regarding its hedging activity, (2) establish trading limits, and (3) disclose large contract positions that materially affect bank risk to shareholders and outside investors. Overall, the policy of regulators is to encourage the use of futures for hedging and discourage their use for speculation, although on a practical basis it is often difficult to distinguish between the two. Further, exchange traded derivative securities such as futures contracts are not subject to risk-based capital requirements. By contrast, OTC derivative securities such as forward contracts are potentially subject to capital requirements. 15. A swap is an agreement between two parties (called counterparties) to exchange assets or a series of cash flows over a specific period of time and at specified intervals during that time period. 16. Interest rate swaps are long-term contracts that can be used to hedge interest rate risk exposure. Currency swaps can immunize against foreign exchange rate risk when firms mismatch the currencies of their assets and liabilities. 17. In an interest rate swap contract, the swap buyer agrees to make a number of fixed interest rate payments based on a principal contractual amount on periodic settlement dates to the swap seller. The swap seller, in turn, agrees to make floating-rate payments, tied to some interest rate, to the swap buyer on the same periodic settlement dates. 18. The bank could go “off the balance sheet” and buy a swap; that is, take the fixed-payment side of a swap agreement. 19. The firm would want to enter into a currency swap by which it sends annual payments in pounds to a swap dealer and receives dollar payments from the swap agent. As a result of the swap, the firm transforms its fixed-rate dollar liabilities into fixed-rate sterling liabilities that better match the fixed-rate sterling cash flows from its asset portfolio. 20. Caps, floors, and collars are derivative securities that restrict the interest rate variation on borrowed funds, i.e., they are options on interest rates. A cap guarantees that the rate on a loan will never go above a stated level. A floor guarantees that the rate on a loan will never go below a stated level. A collar guarantees that the rate will never go above one level or below another stated level. In general, firms purchase interest rate caps if they are exposed to losses when interest rates rise. Usually, this happens if firms are funding assets with floating-rate liabilities such as notes indexed to the London Interbank Offering Rate (or some other cost of funds) and they have fixed rate assets or they are net long in bonds. By contrast, firms purchase floors when they have fixed costs of debt and have variable rates (returns) on assets or they are net short in bonds. Finally, financial institutions purchase collars to finance cap or floor positions. Problems: 1. a. The settlement price is 110.1445 percent (110’045) of the face value of the contract ($1 million). b. A total of 1,489,041 5-year Treasury note futures contracts with June 2020 expiration were traded on March 13, 2020. c. The face value on a British pound currency futures contract was 62,500 British pounds on March 13, 2020 (see contract specs from CME Group website www.cmegroup.com). Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e d. The settlement price on June 2020 E-Mini Russell 2000 futures contracts was 1,105.50 on March 13, 2020. 2. a. You are obligated to take delivery of a $100,000 face value Treasury bond at a price of $95,000 at contract maturity. b. Your loss is $1,000 since you must pay $95,000 for bonds that have a market value of only $94,000. c. In this case you gain $2,000 since you pay only $95,000 for bonds that have a market value of $97,000. 3. EXCEL Problem:

Profit/loss = -$1,875 Profit/loss = $250 Profit/loss = $1,875 Profit/loss = $3,687.5

4. a. If interest rates increase over the period of investment, Treasury bond prices will decrease. Thus, Tree Row should take a short position in the futures contracts on the Treasury bonds. As T-bond prices go down, so will T-bond futures prices. b. Given a short position:

Sale price of futures = 95-040 = 95 4/32% × $100,000 = $95,125 - Purchase price of futures = 94-280 = 94 28/32% × $100,000 = $94,875 Net profit = $ 250

c. Given a short position:

Sale price of futures = 95-040 = 95 4/32% × $100,000 = $95,125.00 - Purchase price of futures = 95-210 = 95 21/32% × $100,000 = $95,656.25 Net profit = -$ 531.25

5. a. If interest rates decrease over the period of investment, Treasury bond prices will increase. Thus, Dudley Savings Bank should take a long position in the futures contracts on the Treasury bonds. As T-bond prices go up, so will T-bond futures prices. b. Given a long position: - Purchase price of futures = 105-100 = 105 10/32% × $100,000 = $105,312.50 Sale price of futures = 105-220 = 105 22/32% × $100,000 = $105,687.50 Net profit = $ 375.00 c. Given a long position: - Purchase price of futures = 105-100 = 105 10/32% × $100,000 = $105,312.50 Sale price of futures = 104-280 = 104 28/32% × $100,000 = $104,875.00 Net profit = - $ 437.50 6. a. The investor has $40,000 ($1m. × 0.04) in his account. As a result of the decrease in value, the investor will now be required to hold $38,000 ($950,000 × 0.04) in his account (or he has a $2,000 surplus). However, because futures contracts are marked to market, the investor’s broker will make a margin call to the investor requiring him to immediately send a check for $50,000 - $2,000, leaving him with an account balance of $38,000 at his broker for the $950,000 T-bond futures position. b. The investor is now required to hold $36,400 ($910,000 × 0.04) in his account. He has a $1,600 surplus ($38,000 - $36,400). But, because futures contracts are marked to market, the investor’s broker will make a margin call to the investor requiring him to immediately send a check for $40,000 - $1,600, leaving him with an account balance of $36,400 at his broker for the $910,000 T-bond futures position. c. The investor is now required to hold $39,000 ($975,000 × 0.04) in his account. He has a $2,600 deficit. Marking the account to market, to maintain the appropriate margin the investor may have is broker send him a check for $65,000 - $2,600, leaving him with an account balance of $39,000 at his broker for the $975,000 T-bond futures position.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e d. The investor has $40,000 ($1m. × 0.04) in his account. As a result of the increase in value, the investor will now be required to hold $42,000 ($1,050,000 × 0.04) in his account (or he has a $2,000 deficit). Because futures contracts are marked to market, the investor’s broker will make a margin call to the investor requiring him to immediately send a check for $50,000 + $2,000, leaving him with an account balance of $42,000 at his broker for the $1,050,000 T-bond futures position. 7. a. The intrinsic value of the option is $4 (= $180 - $176). Thus, the time value of the option is $1 (= $5 - $4). b. Total profit = ($190 - $176) - $5 = $9 per share. c. If the price of the underlying stock is $170 (less than the exercise price), you will not exercise the option. Thus, your profit is -$5 per share (the cost of the option). 8. a. If the price of the underlying stock is $72 (less than the exercise price), the option is out of the money. Thus, the intrinsic value of the option is $0. In this case, the option premium is equal to the time value of the option is $1.25. b. If the price of the underlying stock is $70 (less than the exercise price) and stays there until the option expires, the option holder will not exercise the option. Thus, your profit is $1.25 per share (the cost of the option). c. The option holder will come to you to exercise the option. So, you must by the shares at their current market price of $80 and then sell them to the option holder at the exercise price of $74. Total profit = ($74 - $80) + $1.25 = -$4.75 per share. 9. a. If the price of the underlying stock is $29 (greater than the exercise price), you will not exercise the option. Thus, your profit is -$0.50 per share (the cost of the option). b. Total profit = ($27 - $23) - $0.50 = $3.50 per share. 10. a. If the price of the underlying stock is $32 (greater than the exercise price) and stays there until the option expires, the option holder will not exercise the option. Thus, your profit is $0.75 per share (the cost of the option). b. The option holder will come to you to exercise the option. So, you must by the shares from the option holder at the exercise price of $28 when their current market price is only $25. Total profit = ($25 - $28) + $0.75 = -$2.25 per share. 11. a. On March 13, 2020, 502 May 2020 $40.00 put options on Exxon Mobil stock were outstanding at the open of trading. b. The settlement price of the May 138.00 10-year Treasury note futures call option was 1’45, or $1.7031 on March 13, 2020. c. The closing price of the May 2,710 call option on the S&P 500 Stock Index futures contract was 201.80 on March 13, 2020. Thus, the dollar price was 100 × $201.80 = $20,180. d. The open interest on the May 2020 put options (with an exercise price of 235) on DJ Industrial Average stock index was 3 on March 13, 2020. 12. a. Purchase option: Buy stock by exercising option: Sell stock at market price: Net profit

-$2.17 × 100 shares -89.00 × 100 shares 94.00 × 100 shares $2.83 × 100 shares = $283

-$2.17 × 100 shares

Purchase option:

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Buy stock by exercising option: Sell stock at market price: Net profit

-89.00 × 100 shares 89.50 × 100 shares - $1.67 × 100 shares = -$167

c. With no exercise: purchase price = -$2.17 × 100 shares = loss of -$217 versus a loss over -$167 if you exercise the option. By exercising the option, you are able to recoup $0.50 ($89.50 - $89.00) per share, or $50, that would be lost if you do not exercise. 13. a. Purchase option: Buy stock to exercise option: Sell stock by exercising option: Net profit

-$1.25 × 100 shares -93.00 × 100 shares 95.00 × 100 shares $0.75 × 100 shares = $75

b. The option never moves into the money, so it would never be exercised. Purchase option: Net profit

-$1.25 × 100 shares -$1.25 × 100 shares = -$125

14. You will make a profit on the option if the MMC stock price rises above 17.83, i.e., $15 + 2.83. 15. The intrinsic value of the call option is $5, i.e., $75 - $70. 16. a. Premium for purchasing the cap = 0.0065 × $200 million = $1,300,000. If interest rates rise to 10 percent, cap purchasers receive $200 million × 0.01 = $2,000,000. The net savings is $700,000. b. If the FI also purchases the floor: Premium = 0.0069 × $200 million = $1,380,000, and the total premium = $1,380,000 + $1,300,000 = $2,680,000. If interest rates rise to 11 percent, the cap purchaser receives 0.02 × $200m = $4,000,000, and the net savings = $4,000,000 - $2,680,000 = $1,320,000. If interest rates fall to 3 percent, the floor purchaser receives 0.01 × $200 million = $2,000,000, and the net savings = $2,000,000 - $2,680,000 = -$680,000. c. If the FI sells the floor, it receives net $1,380,000 minus the cost of the cap of $1,300,000 = +$80,000. If interest rates rise to 11 percent, cap purchasers receive 0.02 × $200m = $4,000,000. The net the net savings = $4,000,000 + $80,000 = $4,080,000. If interest rates fall to 3 percent, floor purchasers receive 0.01 × $200 million = $2,000,000. The net savings to the FI = $-2,000,000 + 80,000 = -$1,920,000. 17. a. The insurance company (IC) is exposed to falling interest rates on the asset side of the balance sheet. b. The finance company (FC) is exposed to rising interest rates on the liability side of the balance sheet. c. The IC wishes to convert the fixed rate liabilities into variable rate liabilities by swapping the fixed rate payments for variable rate payments. The FC wishes to convert variable rate liabilities into fixed rate liabilities by swapping the variable rate payments for fixed rate payments. d. The FC will make fixed rate payments and therefore is the buyer in the swap. The IC will make variable rate payments and therefore is the seller in the swap. e. A possible diagram is as follows: Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Insurance Company

Swap Cash Flows

Finance Company

Floating-rate bonds (LIBOR plus 1 percent)

fixed rate swap payments

Fixed-rate auto loans (fixed rate, 14%)

Fixed-rate GICs (fixed rate, 10%)

variable rate swap payments

Variable-rate CDS (LIBOR plus 4%)

Note that the fixed rate swap payments from the FC to the IC will offset the payments on the fixed rate liabilities which the insurance company has incurred. The reverse situation occurs for the variable rate swap payments from the IC to the FC. Depending on the rates negotiated and the maturities of the assets and liabilities, both companies now have cash flows from interest income and interest expense that much closer match. 18. a. The commercial bank is exposed to a decrease in rates that would lower interest income, while the savings bank is exposed to an increase in rates that would increase interest expense. In either case, profit performance would suffer. b. One feasible swap would be for the bank to send variable rate payments of the T-bill rate + 1% to the savings bank and to receive fixed rate payments of 9% from the savings bank. A possible diagram is as follows: Savings Bank

Swap Cash Flows

Commercial Bank

Fixed-rate mortgages (Fixed rate, 13%)

9% swap payments

Floating-rate loans (variable rate, T-bill + 2%)

Floating rate CDs (variable rate, T-bill + 3%)

T-bill +1% swap payments

Fixed-rate CDs (Fixed rate, 9%)

c. As a result of the swap, the commercial bank has transformed its fixed rate liability CDs into a variable-rate liability matching the variability of returns on its loans. Further, through the interest rate swap, the commercial bank effectively pays T-bill rate plus 1 percent for its financing. The savings bank has also transformed its variable rate CDs into fixed-rate payments similar to those received on its fixed-rate mortgages. 19. a. Cash outflows from balance sheet financing Cash inflows from swap Cash outflows from swap Net cash flows Rate available on: Variable-rate debt Fixed-rate debt Gain over market

Money Center Bank

Savings Bank

-8% × $400m 8% × $400m -(CD rate + 1%) × $400m -(CD rate + 1%) × $400m

-(CD rate) × $400m (CD rate + 1%) × $400m -8% × $400m -7% × $400m

CD rate + 2% 9% 2%

As a result of the swap, the money center bank has transformed its four-year, fixed-rate liability notes into a variable-rate liability matching the variability of returns on its C&I loans. Further, through the interest rate swap, the Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e money center bank effectively pays CD rate + 1% for its financing. Had it gone to the debt market, the money center bank would pay CD rate plus 2% (a savings of 1% with the swap). Further, the savings bank also has transformed its variable-rate CDs into fixed-rate payments (of 7%) similar to those received on its fixed-rate mortgages. Had it gone to the debt market, the savings bank would pay 9% (a savings of 2%). b. End of Year 1 2 3 4

One-Year CD rate 8% 7 6 4.5

One-Year Cash Payment Cash Payment by CD rate + 1% by MCB Savings Bank 9% × $400m $ 36m (8%×$400m) $ 32m 8 32m 32m 7 28m 32m 5.5 22m 32m $118m $128m

Net Payment Made by MCB $ 4m 0m -4m -10m -$10m

The savings bank’s net gains from the swap in year 1 are $4 million per year. The enhanced cash flow offsets the increased cost of refinancing its CDs in a higher interest rate environment; that is, the savings bank is hedged against rising rates. By contrast, the money center bank makes net gains on the swap in years 3, 4, and 5 when rates fall; thus, it is hedged against falling rates. The positive cash flow from the swap offsets the decline in the variable returns on the money center bank’s asset portfolio. Overall, the savings bank made a net dollar gain on the swap of $10.0 million in nominal dollars and the money center bank made a net payment of $10.0 million. c. The money center bank receives income of CD rate + 4% on its assets and pays CD rate + 1% on its existing debt and the swap. The savings bank receives 9.5% on its assets and pays 7% on its existing debt and the swap. Year 1 2 3 4

NI MCB (12% - 9%) × $400m = $12m (11% - 8%) × $400m = $12m (10% - 7%) × $400m = $12m (8.5% - 5.5) × $400m = $12m

NI Thrift (9.5% - 7%) × $400m = $10m (9.5% - 7%) × $400m = $10m (9.5% - 7%) × $400m = $10m (9.5% - 7%) × $400m = $10m

Both FIs have completely insulated their net income against changes in interest rates. The money center bank’s net income is $12 million each year. The savings bank’s net income is $10 million each year. 20. a. Cash outflows from balance sheet financing Cash inflows from swap Cash outflows from swap Net cash flows

Bank

Savings Association

-9% × $200m 10% × $200m -(T-bill + 2¼ %) × $200m -(T-bill + 1¼%) × $200m

-(T-bill + 3%) × $200m (T-bill + 2¼%) × $200m -10% × $200m -10.75 × $200m

Rate available on: Variable-rate debt Fixed-rate debt Gain over market

T-bill + 2½% 11% 0.25%

1¼%

As a result of the swap, the money center bank has transformed its four-year, fixed-rate liability notes into a variable-rate liability matching the variability of returns on its C&I loans. Further, through the interest rate swap, the money center bank effectively pays T-bill + 1¼% for its financing. Had it gone to the debt market, the money center bank would pay T-bill plus 2 ½ % (a savings of 1¼% percent with the swap). Further, the savings bank also has transformed its variable-rate T-bill deposits into fixed-rate payments (of 10.75%) similar to those received on its fixed-rate mortgages. Had it gone to the debt market, the savings bank would pay 11% (a savings of 0.25%). b. End of

One-Year

Cash Payment

Cash Payment by

Net Payment

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Year 1 2 3 4 5

T-bill rate 4% 3 5 6 5

T-bill + 2¼% 6¼% × $200m 5¼ 7¼ 8¼ 7¼

by Bank Savings Association Made by Bank $12.5m (10%×$200m) $20m -$7.5m 10.5m 20m -9.5m 14.5m 20m -5.5m 16.5m 20m -3.5m 14.5m 20m -5.5m $68.5m $100m -$31.5m

Overall, the bank made a net dollar gain on the swap of $31.5 million in nominal dollars and the savings association made a net payment of $31.5 million. c. The money center bank receives income of T-bill + 4% on its assets and pays T-bill + 1¼% on its existing debt and the swap. The savings bank receives 13% on its assets and pays 10.75% on its existing debt and the swap. Year 1 2 3 4 5

NI Bank (8% - 5¼%) × $200m = $5.5m (7% - 4¼%) × $200m = $5.5m (9% - 6¼%) × $200m = $5.5m (10% - 7¼%) × $200m = $5.5m (9% - 6¼%) × $200m = $5.5m

NI Savings Association . (13% - 10.75%) × $200m = $4.5m (13% - 10.75%) × $200m = $4.5m (13% - 10.75%) × $200m = $4.5m (13% - 10.75%) × $200m = $4.5m (13% - 10.75%) × $200m = $4.5m

Both FIs have completely insulated their net income against changes in interest rates. The bank’s net income is $5.5 million each year. The savings bank’s net income is $4.5 million each year.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 11 Questions: 1. A depository institution is a financial intermediary that obtains a significant proportion of its funds from customer deposits. Industrial corporations tend to obtain a greater proportion of their funds from stockholders, bondholders, and other types of creditors. 2. The major sources of funds for commercial banks in the U.S. are reported on the liability side of the balance sheet: Deposits: Transaction accounts (demand deposit and NOW accounts); and time deposits (small savings accounts and time deposits over $100,000). Borrowed funds: Federal funds; notes; long-term bonds. Equity: Common stock. The major uses of funds for commercial banks in the U.S. are reported on the asset side of the balance sheet: Loans: Commercial and industrial, real estate, and consumer. Securities: Government (Federal and municipal) securities. Cash: Vault cash; reserves at the Federal Reserve Bank. 3. Loans and investment securities continue to be the primary assets of the banking industry. Commercial loans are relatively more important for the larger banks, while consumer, small business loans, and residential mortgages are more important for small banks. Each of these types of loans creates credit, and to varying extents, liquidity risks for the banks. The security portfolio normally is a source of liquidity and interest rate risk, especially with the increased use of various types of mortgage-backed securities and structured notes. In certain environments, each of these risks can create operational and performance problems for a bank. Over the last several decades, the four principal earning asset areas of commercial banks: business loans (or commercial and industrial loans, (C&I), securities, mortgages, and consumer loans. Although business loans were the major asset on bank balance sheets between 1965 and 1987, they have dropped in importance (as a proportion of the balance sheet) since 1987. The major reason for this has been the rise in nonbank loan substitutes, especially commercial paper. As discussed in Chapter 5, commercial paper is a short-term debt instrument issued by corporations either directly or via an underwriter to institutional investors in the financial markets, such as money market mutual funds. By using commercial paper, a corporation can sidestep banks and the loan market to raise funds, often at rates below those that banks charge. 2 Moreover, since only the largest corporations can access the commercial paper market, banks are often left with a pool of increasingly smaller and riskier borrowers in the commercial and industrial (C&I) loan market. This makes credit risk evaluation more important today than ever before. 4. Investment securities consist of items such as interest-bearing deposits purchased from other FIs, federal funds sold to other banks, repurchase agreements, U.S. Treasury and agency securities, municipal securities issued by states and political subdivisions, mortgage-backed securities, and other debt and equity securities. Investment securities generate interest income for the bank and are also used for trading and liquidity management purposes. Many investment securities held by banks are highly liquid, have low default risk, and can usually be traded in secondary markets. 5. According to Table 11-1, the principal sources were deposits, borrowings, and other liabilities. Of these, deposits comprised 76.1% of total assets. Of the total stock of deposits, transaction accounts represented 15.5 percent of total deposits (and 11.8 percent of total assets), or $1,797.2 billion. Transaction accounts are checkable deposits that are either demand deposits or NOW accounts (negotiable order of withdrawal accounts). Since their introduction in 1980, NOW accounts have dominated the transaction accounts of banks. Nevertheless, since limitations are imposed on the ability of corporations to hold such accounts, demand deposits are still held. NOW accounts may only be held by individuals, sole proprietorships, nonprofit organizations, governmental units, and pension funds. Historically,

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e demand deposits were prohibited from paying interest. Thus, businesses could not earn interest on their bank demand deposits. However, as of July 2011, the federal prohibition against the payment of interest on demand deposits, including business checking accounts, was repealed. The second major segment of deposits is retail or household savings and time deposits, normally individual account holdings of less than $100,000. Important components of bank retail savings accounts are small nontransaction accounts, which include passbook savings accounts and retail time deposits. Small nontransaction accounts compose 76.7 percent of total deposits (and 58.4 percent of total assets). However, this disguises an important trend in the supply of these deposits to banks. Specifically, the amount held of retail savings and time deposits has been falling in recent years, largely as a result of competition from money market mutual funds. These funds pay a competitive rate of interest based on wholesale money market rates by pooling and investing funds while requiring relatively small-denomination investments. The third major segment of deposit funds is large time deposits ($100,000 or more); these deposits amounted to $895.0 billion, or approximately 7.7 percent of total deposits (and 5.9 percent of total assets) in 2016. These are primarily negotiable certificates of deposit (deposit claims with promised interest rates and fixed maturities of at least 14 days) that can be resold to outside investors in an organized secondary market. As such, they are usually distinguished from retail time deposits by their negotiability and secondary market liquidity. Nondeposit liabilities comprise borrowings and other liabilities that total 12.6 percent of total assets, or $1,914.3 billion. These categories include a broad array of instruments, such as purchases of federal funds (bank reserves) on the interbank market and repurchase agreements (temporary swaps of securities for federal funds) at the short end of the maturity spectrum, to the issuance of notes and bonds at the longer end. Overall, the liability structure of banks’ balance sheets tends to reflect a shorter maturity structure than that of their asset portfolio. Further, relatively more liquid instruments such as deposits and interbank borrowings are used to fund relatively less liquid assets such as loans. Thus, interest rate risk—or maturity mismatch risk—and liquidity risk are key exposure concerns for bank managers. 6. Transaction accounts are checkable deposits that are either demand deposits or NOW accounts (negotiable order of withdrawal accounts). Since their introduction in 1980, NOW accounts have dominated the transaction accounts of banks. Nevertheless, since limitations are imposed on the ability of corporations to hold such accounts, demand deposits are still held. NOW accounts may only be held by individuals, sole proprietorships, nonprofit organizations, governmental units, and pension funds. Historically, demand deposits were prohibited from paying interest. Thus, businesses could not earn interest on their bank demand deposits. However, as of July 2011, the federal prohibition against the payment of interest on demand deposits, including business checking accounts, was repealed. 7. Of the total stock of deposits, transaction accounts represented 15.5 percent of total deposits (and 11.8 percent of total assets), or $1,797.2 billion. Transaction accounts are checkable deposits that are either demand deposits or NOW accounts (negotiable order of withdrawal accounts). Since their introduction in 1980, NOW accounts have dominated the transaction accounts of banks. Nevertheless, since limitations are imposed on the ability of corporations to hold such accounts, demand deposits are still held. NOW accounts may only be held by individuals, sole proprietorships, nonprofit organizations, governmental units, and pension funds. Historically, demand deposits were prohibited from paying interest. Thus, businesses could not earn interest on their bank demand deposits. However, as of July 2011, the federal prohibition against the payment of interest on demand deposits, including business checking accounts, was repealed. The second major segment of deposits is retail or household savings and time deposits, normally individual account holdings of less than $100,000. Important components of bank retail savings accounts are small nontransaction accounts, which include passbook savings accounts and retail time deposits. Small nontransaction accounts compose 76.7 percent of total deposits (and 58.4 percent of total assets). However, this disguises an important trend in the supply of these deposits to banks. Specifically, the amount held of retail savings and time deposits has been falling in recent years, largely as a result of competition from money market mutual funds. These funds pay a competitive

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e rate of interest based on wholesale money market rates by pooling and investing funds while requiring relatively small-denomination investments. The third major segment of deposit funds is large time deposits ($100,000 or more); these deposits amounted to $895.0 billion, or approximately 7.7 percent of total deposits (and 5.9 percent of total assets) in 2016. These are primarily negotiable certificates of deposit (deposit claims with promised interest rates and fixed maturities of at least 14 days) that can be resold to outside investors in an organized secondary market. As such, they are usually distinguished from retail time deposits by their negotiability and secondary market liquidity. 8. Overall, the liability structure of banks’ balance sheets tends to reflect a shorter maturity structure than that of their asset portfolio. Further, relatively more liquid instruments such as deposits and interbank borrowings are used to fund relatively less liquid assets such as loans. Thus, interest rate risk—or maturity mismatch risk—and liquidity risk are key exposure concerns for bank managers. 9. An off-balance-sheet activity is a transaction, contract, or commitment that a bank enters into but is not directly accounted for on the bank’s balance sheet. An item or activity is an off-balance-sheet asset if, when a contingent event occurs, the item or activity moves onto the asset side of the balance sheet or an income item is realized on the income statement. Conversely, an item or activity is an off-balance-sheet liability if, when a contingent event occurs, the item or activity moves onto the liability side of the balance sheet or an expense item is realized on the income statement. They are often reported in the notes to the financial statement or on a separate schedule. Examples of these are letters of credit, lines of credit, options, forwards, and swaps. Their increase has been a result of increased competition from other financial institutions as well as other risk management and regulatory incentives to move these activities off the balance sheet. 10. An off-balance-sheet (OBS) asset is an OBS in which an event occurs that moves this item onto the asset side of the balance sheet. An off-balance-sheet liability is an OBS in which an event occurs that moves this item onto the liability side of the balance sheet. 11. OBS activities include issuing various types of guarantees (such as letters of credit), which often have a strong insurance underwriting element, and making future commitments to lend. Both services generate additional fee income for banks. Off-balance-sheet activities also involve engaging in derivative transactions—futures, forwards, options, and swaps. a. The OBS activity becomes an asset or a liability upon the occurrence of a contingent event, which may not be in the control of the bank. In most cases, the other party involved with the original agreement will call upon the bank to honor its original commitment. b. By undertaking off-balance-sheet activities, banks hope to earn additional fee income to complement declining margins or spreads on their traditional lending business. At the same time, they can avoid regulatory costs or “taxes” since reserve requirements and deposit insurance premiums are not levied on off-balance-sheet activities. Thus, banks have both earnings and regulatory “tax-avoidance” incentives to undertake activities off their balance sheets. c. The primary risk to OBS activities on the asset side of the bank involves the credit risk of the borrower. In many cases the borrower will not utilize the commitment of the bank until the borrower faces a financial problem that may alter the credit worthiness of the borrower. Moving the OBS activity to the balance sheet may have an additional impact on the interest rate and foreign exchange risk of the bank. Further, at the very heart of the financial crisis were losses associated with off-balance-sheet mortgage-backed securities created and held by FIs. Losses resulted in the failure, acquisition, or bailout of some of the largest FIs and a near meltdown of the world’s financial and economic systems. 12. OBS activities include issuing various types of guarantees (such as letters of credit), which often have a strong insurance underwriting element, and making future commitments to lend. Both services generate additional fee income for banks. Off-balance-sheet activities also involve engaging in derivative transactions—futures, forwards, options, and swaps.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 13.

Assets Cash Fed funds sold Investment securities Net loans Intangible assets Other assets Premises Total assets

$ 2,660 110 5,334 29,981 758 1,633 1,078 $41,554

Liabilities and Equity Demand deposits NOW accounts Savings deposits Certificates of deposit Other time deposits Short-term borrowing Other liabilities Long-term debt Equity

$ 5,939 12,816 3,292 9,853 2,333 2,080 778 1,191 3,272

Total liab. and equity

$41,554

This bank has funded the assets primarily with transaction and savings deposits. The certificates of deposit could be either retail or corporate (negotiable). The bank has very little (5 percent) borrowed funds. On the asset side, about 72 percent of total assets is in the loan portfolio, but there is no information about the type of loans. The bank actually is a small regional bank with $41.6 billion in assets, but the asset structure could easily be a community bank if the numbers were denominated in millions, e.g., $41.6 million in assets. 14. The number of commercial banks has declined from 14,483 in 1984 to 5,289 in 2016. Consolidations in the form of mergers and acquisitions and departures due to bank failures explain the decline. Many of the acquired banks were banks that had failed or were failing. 15. Challenges have come from industrial loan corporations and shadow banks. For example, in mid-2005, WalMart filed an application with the FDIC to open a Utah-based “nonbank” bank (called an industrial loan bank), stating that it wanted to use the bank to reduce the costs of processing electronic payments. Target, the retail chain, made a similar banking license application stating that it would use the “bank” to issue business credit cards. Target’s application was approved in 2005. However, Wal-Mart’s application led to an unprecedented wave of opposition from regulators, the banking industry, and others, leading to the FDIC holding its first public hearings on an application. In July 2006, the FDIC declared a six-month moratorium on approving any new ILC licenses, saying it wanted to provide time to assess developments in the sector, including any need to improve regulatory oversight. In October 2006, a bill was introduced before the U.S. Congress that would keep Wal-Mart and other retailers out of the banking sector. Specifically, the bill would prohibit nonfinancial firms from owning industrial banks or ILCs, thus barring Wal-Mart from obtaining ILC charters. At the end of 2006, the FDIC was considering an extension of its moratorium, a move that would give Congress time to move forward with the bill. However, in March 2007, WalMart announced that it was withdrawing its application to open a bank. More recently activities of nonfinancial service firms that perform banking services have been termed shadow banking. In the shadow banking system savers place their funds with money market mutual and similar funds, which invest these funds in the liabilities of shadow banks. Borrowers get loans and leases from shadow banks rather than from banks. Like the traditional banking system, the shadow banking system intermediates the flow of funds between net savers and net borrowers. However, instead of the bank serving as the middleman, it is the nonbank financial service firm, or shadow bank, that intermediates. Further, unlike the traditional banking system, where the complete credit intermediation is performed by a single bank, in the shadow banking system it is performed through a series of steps involving many nonbank financial service firms. Finally, unlike shadow banks face significantly reduced regulation than traditional banks. Because of the specialized nature involved in the credit intermediation process performed shadow banks, these nonbank financial service firms can often perform the process more cost efficiently than traditional banks. Further, because of the lower costs and lack of regulatory controls, shadow banks can take on risks that traditional banks either cannot or are unwilling to take. Thus, the shadow banking system allows credit to be available that might not otherwise have been generated through the traditional banking system. The 2010 Wall Street Reform and Consumer Protection Act called for regulators to be given broad authority to monitor and regulate nonbank financial firms that pose risks to the financial system. As of 2016, U.S. regulators had

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e outlined a process to identify nonbank financial services firms that should receive increased oversight. However, as of 2016, these shadow banks remain unregulated by the federal government. 16. Money center banks operate in the global banking market. They are active in international lending and lending to multinational corporations and usually have operations abroad. Moreover, they access international money markets for funds to finance their global asset portfolios. Therefore, money center banks perform intermediation services on a global scale. Regional banks tend to concentrate more on domestic business than do money center banks. They are often market makers for smaller commercial banks in their regions (correspondent banks), providing them with intermediation and information services. They also service the large domestic corporations operating in their region. Size alone, however, does not distinguish money center banks from regional banks. Money center banks tend to be located in the major cities and are also net borrowers of funds in the interbank market. Thus, even though Bank of America is large and located in Los Angeles, it is not classified as a money center because its extensive retail outlet makes it a net supplier of funds in the interbank market. Small commercial banks tend to focus more on local customers. They offer highly personalized service to smaller corporate and individual clients. They rely on regionals and money center banks to obtain more sophisticated money management and information services on behalf of their customers. 17. Small or community banks —with less than $1 billion in asset size—tend to specialize in retail or consumer banking, such as providing residential mortgages and consumer loans and accessing the local deposit base. Clearly, this group of banks is decreasing both in number and importance. In 2016, 92.9 percent of the banks in the United States were classified as community banks. However, these banks held only 7.1 percent of the assets of the banking industry. The relative asset share of the largest banks (over $1 billion in size), on the other hand, increased from 63.4 percent in 1984 to 92.9 percent in 2016. The largest 10 U.S. banks as of 2016 are listed in Table 11–3. The ranking is by size of assets devoted to banking services. The table also lists the assets at the holding company level. Many of these large depository institutions (e.g., J. P. Morgan Chase and Bank of America) operate in other financial service areas (e.g., investment banking and security brokerage) as well. Thus, assets held at the holding company level can be much larger than those devoted to banking services only. Notice that several of these large depository institutions manage assets of over $1 trillion. The majority of banks in the two largest size classes are often either regional or superregional banks. Regional or superregional banks range in size from several billion dollars to several hundred billion dollars in assets. The banks normally are headquartered in larger regional cities and often have offices and branches in locations throughout large portions of the United States. They engage in a more complete array of wholesale commercial banking activities, encompassing consumer and residential lending as well as commercial and industrial lending (C&I loans), both regionally and nationally. Although these banks provide lending products to large corporate customers, many of the regional banks have developed sophisticated electronic and branching services to consumer and residential customers. Regional and superregional banks utilize retail deposit bases for funding, but also develop relationships with large corporate customers and international money centers. These banks have access to the markets for purchased funds, such as the interbank or federal funds market, to finance their lending and investment activities. Some of the very biggest banks are often classified as being money center banks. U.S.–based money center banks include: Bank of New York Mellon, Deutsche Bank (through its U.S. acquisition of Bankers Trust), Citigroup, J. P. Morgan Chase, and HSBC North America (formerly Republic NY Corporation). It is important to note that asset or lending size does not necessarily make a bank a money center bank. For example, Bank of America Corporation, with $2,189.8 billion in assets in 2016, is not a money center bank, but HSBC North America (with only $295.5 billion in assets) is a money center bank. Classification as a money center bank is based in part on location of the bank and in part on the bank’s heavy reliance on nondeposit or borrowed sources of funds. Specifically, a money center bank is a bank located in a major financial center (e.g., New York) that heavily relies on both national and international money markets for its source of funds. In fact, because of its extensive retail branch network, Bank of America tends to be a net supplier of funds on the interbank market (federal funds market). By

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e contrast, money center banks have fewer retail branches and rely heavily on wholesale and borrowed funds as sources of funds. Money center banks are also major participants in foreign currency markets and are therefore subject to foreign exchange risk 18. Small banks generally concentrate on the retail side of the businesslending and issuing deposits to consumers and small businesses. In contrast, large banks engage in both retail and wholesale banking and often concentrate on the wholesale side of the business. Further, small banks generally hold fewer off-balance-sheet assets and liabilities than large banks. For example, while small banks issue some loan commitments and letters of credit, they rarely hold derivative securities. Large banksC relatively easy access to purchased funds and capital markets compared to small banks’ access is a reason for many of these differences. For example, large banks with easier access to capital markets operate with lower amounts of equity capital than do small banks. Also, large banks tend to use more purchased funds (such as fed funds) and have fewer core deposits (deposits such as demand deposits that are stable over short periods of time) than do small banks. At the same time, large banks lend to larger corporations. This means that their interest rate spreads (i.e., the difference between their lending rates and deposit rates) and net interest margins (i.e., interest income minus interest expense divided by earning assets) have usually been narrower than those of smaller regional banks, which were more sheltered from competition in highly localized markets and lend to smaller, less sophisticated customers. In addition, large banks tend to pay higher salaries and invest more in buildings and premises than small banks do. Thus, their noninterest expenses are generally higher than small banks. They also tend to diversify their operations and services more than small banks do. Large banks generate more noninterest income (i.e., fees, trading account, derivative security, and foreign trading income) than small banks. Although large banks tend to hold less equity, they do not necessarily return more on their assets. However, as the barriers to regional competition and expansion in banking have fallen in recent years, the largest banks have generally improved their return on equity (ROE) and return on asset (ROA) performance relative to small banks. 19. Bank size has traditionally affected the types of activities and financial performance of commercial banks. Small banks generally concentrate on the retail side of the business—making loans and issuing deposits to consumers and small businesses. In contrast, large banks engage in both retail and wholesale banking and often concentrate on the wholesale side of the business. Further, small banks generally hold fewer off-balance-sheet assets and liabilities than large banks. For example, while small banks issue some loan commitments and letters of credit, they rarely hold derivative securities. Large banks’ relatively easy access to purchased funds and capital markets compared to small banks’ access is a reason for many of these differences. For example, large banks with easier access to capital markets operate with lower amounts of equity capital than do small banks. Also, large banks tend to use more purchased funds (such as fed funds) and have fewer core deposits than do small banks. At the same time, large banks lend to larger corporations. This means that their interest rate spreads have usually been narrower than those of smaller regional banks, which were more sheltered from competition in highly localized markets and lend to smaller, less sophisticated customers. In addition, large banks tend to pay higher salaries and invest more in buildings and premises than small banks do. They also tend to diversify their operations and services more than small banks do. Large banks generate more noninterest income than small banks. Although large banks tend to hold less equity, they do not necessarily return more on their assets. However, as the barriers to regional competition and expansion in banking have fallen in recent years the largest banks’ have generally improved their return on equity (ROE) and return on asset (ROA) performance relative to small banks. Both the ROAs and ROEs of banks of all sizes dropped significantly during the financial crisis of 2008-2009. As the economy recovered in 2010-2016, ROA and ROE returned closer to their pre-crisis levels. The recovery occurred quicker for bigger banks that received more government assistance and monitoring throughout the crisis. The biggest banks’ ROAs and ROEs returned to positive by 2009, while the smaller banks’ ROAs and ROEs remained negative until 2010. 20. With the economic expansion in the U.S. economy and falling interest rates throughout most of the 1990s, U.S. commercial banks have flourished for most of the 1990s. In 1999 commercial bank earnings were a record $71.6 billion. More than two-thirds of all U.S. banks reported an ROA of 1 percent or higher, and the average ROA for all banks was 1.31 percent, up from 1.19 percent for the year 1998. With the economic downturn in the early 2000s, however, bank performance deteriorated slightly. For example, commercial banks’ string of eight consecutive years of record earnings ended in 2000 as their net income fell to $71.2 billion. Banks’ provision for loan losses rose to

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e $9.5 billion in the fourth quarter of 2000, an increase of $3.4 billion (54.7 percent) from the level of a year earlier. This was the largest quarterly loss provision since the fourth quarter of 1991. Finally, the average ROA was 1.19 percent in 2000, down from 1.31 percent in 1999. This downturn was short-lived, however. In 2001, net income of $74.3 billion easily surpassed the old record of $71.6 billion and net income rose further to $106.3 billion in 2003. Moreover, in 2003, both ROA and ROE reached all-time highs of 1.40 percent and 15.34 percent, respectively. The two main sources of earnings strength in 2003 were higher noninterest income (up $18.9 billion, 10.3 percent) and lower loan loss provisions (down $14.2 billion, or 27.6 percent). The greatest improvement in profitability occurred at large institutions, whose earnings had been depressed in the early 2000s by credit losses on loans to corporate borrowers and by weakness in market sensitive noninterest income. Only 5.7 percent of all institutions were unprofitable in 2003, the lowest proportion since 1997. In 2004, a combination of continued strength in consumer loan demand and growing demand for commercial loans added to the growth of earnings. The third quarter of 2004 saw the sixth time in seven quarters that industry earnings set a new record. Further, at the end of September noncurrent loans fell to their lowest level since the end of 2000. Several explanations have been offered for the strong performance of commercial banks during the early 2000s. First, the Federal Reserve cut interest rates 13 times during this period. Lower interest rates made debt cheaper to service and kept many households and small firms borrowing. Second, lower interest rates made home purchasing more affordable. Thus, the housing market boomed throughout the period. Third the development of new financial instruments such as credit derivatives and mortgage backed securities helped banks shift credit risk from their balance sheets to financial markets and other FIs such as insurance companies. Finally improved information technology helped banks manage their risk better. As interest rates rose in the mid-2000s, performance did not initially deteriorate significantly. Third quarter 2006 earnings represented the second highest quarterly total ever reported by the industry and more than half of all banks reported higher earnings in the third quarter of 2006 than in the second quarter. However, increased loan loss provisions, reduced servicing income, and lower trading revenue kept net income reported by commercial banks from setting a new record for the full year. Further, mortgage delinquencies, particularly on subprime mortgages, surged in the last quarter of 2006 as home owners who stretched themselves financially to buy a home or refinance a mortgage in the early 2000s fell behind on their loan payments as interest rates rose. Despite these weaknesses, the industry’s core capital ratio increased to 10.36 percent, the highest level since new, risk-based capital ratios were implemented in 1993. Finally, no FDIC-insured banks failed during 2005 or 2006. Both the number and assets of “problem” banks were at historical lows. Commercial banks’ performance deteriorated again in the late 2000s as the U.S. economy experienced its strongest recession since the Great Depression. For all of 2007, net income was $105.5 billion, a decline of $39.8 billion (27.4 percent) from 2006. Less than half of all institutions (49.2 percent) reported increased earnings in 2007, the first time in 23 years that a majority of institutions had not posted full year earnings increases. The average ROA for the year was 0.93 percent, the lowest yearly average since 1991, and the first time in 15 years that the industry’s annual ROA had been below 1 percent. The ROA for the year was 0.13 percent, the lowest since 1987. Almost one in four institutions (23.6 percent) was unprofitable in 2008, and almost two out of every three institutions (62.8 percent) reported lower full-year earnings than in 2007. As the economy improved in the second half of 2009, so did commercial bank performance. While loan loss provisions continued to surge, growth in operating revenues, combined with appreciation in securities values, helped the industry post a net profit. Commercial banks earned $2.8 billion in net income in the third quarter of 2009, more than three times the $879 million from 2008. However, the industry was still feeling the effects of the long recession. Provisions for loan and lease losses totaled $62.5 billion, the fourth consecutive quarter that industry provisions had exceeded $60 billion. Net charge-offs continued to rise, for an 11th consecutive quarter. Commercial banks charged off $50.8 billion in the quarter, an increase of $22.6 billion (80.5 percent) over the third quarter of 2008. Net charge-offs were higher than 2008 at 60 percent of all institutions. Further, 140 commercial banks failed in 2009. This is the largest number of failures since 1992.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e As the economy continued to slowly recover in 2010 through 2016, so did bank performance. The 2010 industry ROA and ROE increased to 0.65 percent and 5.86 percent, respectively. By 2015, industry ROA and ROE increased to 1.04 percent and 9.26 percent, respectively. Full-year earnings totaled $163.7 billion, an increase of $11.4 billion over 2014. Over 60 percent of all banks reported higher net income in 2015. Net operating income increased $14.9 billion in 2015, as net interest income rose by $9.4 billion and noninterest income increased by $5.5 billion. Total noninterest expenses were $5.5 billion lower than in 2014. However, on a negative note, loan-loss provisions showed an increase for the first time in six years, rising by $7.2 billion. The number of insured institutions on the FDIC’s “Problem List” declined from 203 to 183 during the quarter and there were only eight banks failures. Performance deteriorated slightly in 2016 as ROA and ROE fell to 0.95 percent and 8.43 percent, respectively. Higher expenses for loan losses and lower noninterest income from trading and asset servicing contributed to a $765 million decline in quarterly earnings in first quarter. Most of the year-over-year drop in net income was concentrated among the largest banks. More than half of all banks—61.4 percent—reported higher quarterly earnings compared with first quarter 2015. Banks set aside $12.5 billion in provisions for loan losses in the first quarter, a year-overyear increase of $4.2 billion. This was the largest quarterly increase since fourth quarter 2012. Further, the amount of loan balances that were noncurrent—90 days or more past due or in nonaccrual status—rose by $3.3 billion during the first three months of 2016. This was the first quarterly increase in total noncurrent loan balances in 24 quarters (driven by a $9.3 billion increase in noncurrent C&I loans and was the largest quarterly increase in noncurrent C&I loans since first quarter 1987. 21. Small banks generally concentrate on the retail side of the business—making loans and issuing deposits to consumers and small businesses. In contrast, large banks engage in both retail and wholesale banking and often concentrate on the wholesale side of the business. Further, small banks generally hold fewer off-balance-sheet assets and liabilities than large banks. For example, while small banks issue some loan commitments and letters of credit, they rarely hold derivative securities. Large banks’ relatively easy access to purchased funds and capital markets compared to small banks’ access is a reason for many of these differences. For example, large banks with easier access to capital markets operate with lower amounts of equity capital than do small banks. Also, large banks tend to use more purchased funds (such as fed funds) and have fewer core deposits than do small banks. At the same time, large banks lend to larger corporations. This means that their interest rate spreads have usually been narrower than those of smaller regional banks, which were more sheltered from competition in highly localized markets and lend to smaller, less sophisticated customers. In addition, large banks tend to pay higher salaries and invest more in buildings and premises than small banks do. They also tend to diversify their operations and services more than small banks do. Large banks generate more noninterest income than small banks. Although large banks tend to hold less equity, they do not necessarily return more on their assets. However, as the barriers to regional competition and expansion in banking have fallen in recent years the largest banks’ have generally improved their return on equity (ROE) and return on asset (ROA) performance relative to small banks. Both the ROAs and ROEs of banks of all sizes dropped significantly during the financial crisis of 2008-2009. As the economy recovered in 2010-2016, ROA and ROE returned closer to their pre-crisis levels. The recovery occurred quicker for bigger banks that received more government assistance and monitoring throughout the crisis. The biggest banks’ ROAs and ROEs returned to positive by 2009, while the smaller banks’ ROAs and ROEs remained negative until 2010. 22. The key regulators are the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Federal Reserve System (FRS), and state bank regulators. Established in 1933, the Federal Deposit Insurance Corporation (FDIC) insures the deposits of commercial banks. In so doing, it levies insurance premiums on banks, manages the deposit insurance fund (which is generated from those premiums and their reinvestment), and conducts bank examinations. In addition, when an insured bank is closed, the FDIC acts as the receiver and liquidator, although the closure decision itself is technically made by the bank’s chartering or licensing agency. Because of problems in the thrift industry and the insolvency of the savings association insurance fund (FSLIC) in 1989, the FDIC now manages the insurance fund for both commercial banks and savings associations; the fund is called the Depositors Insurance Fund or DIF.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e The Office of the Comptroller of the Currency (OCC) is the oldest U.S. bank regulatory agency. Its primary function is to charter so-called national banks as well as to close them. In addition, the OCC examines national banks and has the power to approve or disapprove their merger applications. Instead of seeking a national charter, however, banks can seek to be chartered by 1 of 50 individual state bank regulatory agencies. Historically, state chartered banks have been subject to fewer regulations and restrictions on their activities than national banks. This lack of regulatory oversight was a major reason many banks chose not to be nationally chartered. Many more recent regulations (such as the Depository Institutions Deregulation and Monetary Control Act of 1980) attempted to level the restrictions imposed on federal and state chartered banks. Not all discrepancies, however, were changed and state chartered banks are still generally less heavily regulated than nationally-chartered banks. In addition to being concerned with the conduct of monetary policy, the Federal Reserve, as this country’s central bank, also has regulatory power over some banks and, where relevant, their holding company parents. Since 1980, all banks have had to meet the same noninterest-bearing reserve requirements whether they are members of the FRS or not. The primary advantage of FRS membership is direct access to the federal funds wire transfer network for nationwide interbank borrowing and lending of reserves. Finally, many banks are often owned and controlled by parent holding companies—for example, Citigroup is the parent holding company of Citibank (a national bank). Because the holding company’s management can influence decisions taken by a bank subsidiary and thus influence its risk exposure, the FRS regulates and examines bank holding companies as well as the banks themselves. State-chartered commercial banks are regulated by state agencies. State authorities perform similar functions as the OCC performs for national banks. 23. Established in 1933, the Federal Deposit Insurance Corporation (FDIC) insures the deposits of member banks. In so doing, it levies insurance premiums on member banks, manages the deposit insurance fund, and conducts bank examinations. In addition, when an insured bank is closed, the FDIC acts as the receiver and liquidator, although the closure decision itself is technically made by the bank chartering or licensing agency such as the OCC. Because of the problems in the thrift industry and the insolvency of the savings institutions’ fund (the FSLIC) in 1989, the FDIC now manages both the commercial bank insurance fund and the S&L insurance fund. The Deposit Insurance fund is called DIF. 24. The primary advantages of FRS membership are direct access to the federal funds wire transfer network for nationwide interbank borrowing and lending of reserves. 25.

Bank Type (a) (b) (c) (d) (e)

OCC

FRB

Yes Yes

Yes Yes Yes Yes

FDIC Yes Yes Yes Yes Yes

SB Comm Yes Yes Yes

26. International expansion has six major advantages: Risk Diversification. As with domestic geographic expansions, an FI=s international activities potentially enhance its opportunity to diversify the risk of its earning flows. Often domestic earnings flows from financial services are strongly linked to the state of that economy. Therefore, the less integrated the economies of the world are, the greater is the potential for earnings diversification through international expansions. Economies of Scale. To the extent that economies of scale exist, an FI can potentially lower its average operating costs by expanding its activities beyond domestic boundaries. Innovations. An FI can generate extra returns from new product innovations if it can sell such services internationally rather than just domestically. For example, consider complex financial innovations, such as securitization, caps, floors, and options, that FIs have innovated in the United States and sold to new foreign markets with few domestic competitors until recently.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Funds Source. International expansion allows an FI to search for the cheapest and most available sources of funds. This is extremely important with the very thin profit margins in domestic and international wholesale banking. It also reduces the risk of fund shortages (credit rationing) in any one market. Customer Relationships. International expansions also allow an FI to maintain contact with and service the needs of domestic multinational corporations. Indeed, one of the fundamental factors determining the growth of FIs in foreign countries has been the parallel growth of foreign direct investment and foreign trade by globally oriented multinational corporations from the FI=s home country. Regulatory Avoidance. To the extent that domestic regulations such as activity restrictions and reserve requirements impose constraints or taxes on the operations of an FI, seeking low regulatory tax countries can allow an FI to lower its net regulatory burden and to increase its potential net profitability. Disadvantages. International expansion has three major disadvantages: Information/Monitoring Costs. Although global expansions allow an FI the potential to better diversify its geographic risk, the absolute level of exposure in certain areas such as lending can be high, especially if the FI fails to diversify in an optimal fashion. For example, the FI may fail to choose a loan portfolio combination on the efficient portfolio frontier. Foreign activities may also be riskier for the simple reason that monitoring and information collection costs are often higher in foreign markets. For example, Japanese and German accounting standards differ significantly from the generally accepted accounting principles that U.S. firms use. In addition, language, legal, and cultural issues can impose additional transaction costs on international activities. Finally, because the regulatory environment is controlled locally and regulation imposes a different array of net costs in each market, a truly global FI must master the various rules and regulations in each market. Nationalization/Expropriation. To the extent that an FI expands by establishing a local presence through investing in fixed assets such as branches or subsidiaries, it faces the political risk that a change in government may lead to the nationalization of those fixed assets. If foreign FI depositors take losses following a nationalization, they may seek legal recourse from the FI in U.S. courts rather than from the nationalizing government. For example, the resolution of the outstanding claims of depositors in Citicorp=s branches in Vietnam following the Communist takeover and expropriation of those branches took many years. Fixed Costs. The fixed costs of establishing foreign organizations may be extremely high. For example, a U.S. FI seeking an organizational presence in the Tokyo banking market faces real estate prices some five to six times higher than in New York. Such relative costs can be even higher if an FI chooses to enter by buying an existing Japanese bank rather than establishing a new operation, because of the considerable cost of acquiring Japanese FI equities measured by price-earnings ratios. These high acquisition costs exist despite the significant bank loan problems of Japanese banks in recent years and the secular decline in Japanese share prices. These relative cost considerations become even more important if the expected volume of business to be generated and, thus the revenue flows from foreign entry are uncertain. The failure of U.S. acquisitions to realize expected profits following the 1986 deregulation in the United Kingdom is a good example of unrealized revenue expectations vis à vis the high fixed costs of entry and the costs of maintaining a competitive position.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 12 Questions: 1. The Report of Condition refers to the bank's balance sheet which presents information a bank’s assets, liabilities, and equity capital. The balance sheet reports a bank’s condition at a single point in time. The Report of Income refers to the bank's income statement which presents information about the flow of revenues and expenses (or costs) and the net profit or loss for a bank over a period of time. 2. Institutions in CAMELS group 2 are fundamentally sound but may reflect modest weaknesses correctable in the normal course of business. Institutions in CAMELS group 4 have an immoderate volume of serious financial weaknesses or a combination of other conditions that are unsatisfactory. 3. a-3; b-1; c-2. 4. a-5,6,12; b-2,10; c-3, 13; d-1,8,15; e-9,14; f-4,7,11. 5. Generally, the assets near the top of the balance sheet, cash accounts, represent the most liquid and lowest expected return assets. Those near the bottom, loans and leases, are less liquid and yield higher expected returns. 6. A repurchase agreement is an asset if the bank-1 "purchased" securities from (or sent excess reserves to) some other bank-2 with the understanding that the bank-2 would repurchase these securities from (or send the reserves to) bank-1 in the near future. If the bank-1 had instead "sold" the securities to (or received excess reserves from) bank-2 and promised to repurchase them from (or send the reserves to) bank-2 in the near future, then this would represent a liability for bank-1. 7. A NOW account is a checking account that pays interest; a demand deposit is a checking account that generally pays no interest. 8. A retail CD has a denomination less than $100,000 and is non-negotiable. A wholesale CD has a minimum denomination of $100,000 and can be bought and sold in a secondary market. 9. Stable deposits of the bank are referred to as core deposits. These deposits are not expected to be withdrawn over short periods of time and are therefore a more permanent source of funding for the bank. Core deposits are also the cheapest funds banks can use to finance their assets. Because they are both a stable and low-cost source of funding, core deposits are the most frequently used source of funding by commercial banks. Core deposits generally are defined as demand deposits, NOW accounts, MMDAs, retail CDs, and other accounts that are not expected to be withdrawn in the very near future. Purchased funds are more expensive and/or volatile sources of funds because they are highly rate sensitive—these funds are more likely to be immediately withdrawn or replaced as rates on competitive instruments change. Further, interest rates on these funds, at any point in time, are generally higher than rates on core deposits. Purchased funds are generally defined as brokered deposits, wholesale CDs, deposits at foreign offices, fed funds purchased, RPs, and subordinated notes and debentures. 10. The four categories are: 1. loan commitments 2. letters of credit 3. loans sold 4. derivative securities 11. Because of the presence of noncash expenses on the income statement such as provision for loan losses, we should expect the cash flow to exceed the reported net income. 12. End-of-year balance sheets reflect the position of the bank at one point in time, while the income statements reflect activity for the entire year. If the activity position at the end of the year is not representative of activity during

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e the year, then the ratios may not properly represent the financial position of the bank. The use of these data may bias ratios in that they are data for one day in the year, whereas income statement data cover the full year. To avoid this bias, average values for balance sheet data are often used to calculate ratios. 13. Asset utilization measures a bank’s ability to generate income from its assets. The more income generated per dollar of assets, the more profitable the bank. The breakdown of the AU ratio separates the total revenue generated into interest income and noninterest income. For a retail company, the asset turnover is most comparable to the asset utilization ratio. As service firms, banks use few fixed assets, while retail companies hold the majority of their total assets as fixed assets. Furthermore, retail companies finance their assets with much more debt and less equity than banks. Thus, the asset utilization ratios are much smaller and the equity multiplier ratios are much larger for banks compared to a retail company. 14. Both the interest income ratio and the noninterest income ratio are measures of profitability and, to some extent, efficiency. A bank that is able to generate profitable loans is also likely to be able to generate profits from its other areas of operation such as earnings from trust department, trading gains, and off balance sheet activities. When comparing across banks, we should expect banks able to attract talent into one area of operations should be able to attract comparable talent (and profits) to its other areas 15. Although ratio analysis is an imprecise and subjective way to analyze a firm, a few ratios seem to stand out. Although bank B has a higher ROE, this seems to be a consequence of a much higher leverage level. One may wonder about the capital adequacy of Bank B. Bank B also has a higher provision for loan losses. This indicates that its loans may be riskier than those of bank A. Generally, bank B seems more profitable, but riskier, than bank B. 16. An increase in the asset utilization ratio will increase ROA and, thus, ROE. 17. Ratio analysis allows managers, regulators, analysts, and investors to look at the bank’s overall profitability as a function of the profit the bank earns per dollar of operating income (operating efficiency) and the dollar of operating income produced per dollar of assets on the balance sheet (efficiency in asset use). With this tool, managers, regulators, analysts, and investors can see the reason for any changes in ROA in more detail. For example, if ROA increases, ratio analysis may show that the net profit margin was constant, but the total asset turnover (efficiency in using assets) increased, or that total asset turnover remained constant, but profit margins (operating efficiency) increased. Managers, regulators, analysts, and investors can more specifically identify the reasons for an ROA change by using the ratios described above to further break down operating efficiency and efficiency in asset use. 18. Net interest margin measures the net return on the bank’s earning assets (investment securities and loans and leases). Thus, this ratio is a measure of the net return on a bank’s assets. The spread measures the difference between the average yield on earning assets and the average cost of interest-bearing liabilities and is thus another measure of return on the bank’s assets. Thus, this ratio looks at the difference between the gross return on assets and the cost of financing these assets 19. The more focused orientation of HBT relative to BOA can best be seen by looking at the composition of the asset, and particularly the loan, portfolios (ratios 84 through 97) and the liabilities (ratios 32 through 44) of the two banks. HBT held 55.42 percent of its total assets in the form of real asset loans. Thus, consistent with its niche, a large majority of HBT’s assets were tied up in real estate related assets. BOA, on the other hand, had its asset investments more evenly distributed: 16.06 percent in C&I loans, 18.94 percent in real estate loans, 9.25 percent in consumer loans, and 7.80 percent in other loans. On the liability side of the balance sheet, HBT issued mainly retail-oriented deposits: demand deposits were 7.86 percent, MMDAs were 15.80 percent of total assets, other savings were 44.49 percent, and retail CDs were 7.91 percent. BOA again used a broader array of deposits: demand deposits were 10.19 percent, MMDAs were 31.08 percent, other savings were 26.58 percent, foreign deposits were 4.84 percent, and retail CDs were 1.18 percent of total assets.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 20. Bank size has traditionally affected the financial ratios of commercial banks, resulting in significant differences across size groups. Large banks’ relatively easy access to purchased funds and capital markets compared to small banks’ access is a reason for many of these differences. For example, large banks with easier access to capital markets operate with lower amounts of equity capital than do small banks. Also, large banks tend to use more purchased funds (such as fed funds and RPs) and fewer core deposits than do small banks. Large banks tend to put more into salaries, premises, and other expenses than small banks do, and they tend to diversify their operations and services more than small banks do. Large banks also generate more noninterest income (i.e., trading account, derivative security, and foreign trading income) than small banks do and when risky loans pay off, they earn more interest income. As a result, although large banks tend to hold less equity than small banks do, large banks do not necessarily return more on their assets. Problems: 1. The treasury security offers 7% before tax and 4.9% (= 7% × (1 – 0.30)) after tax. This is less than the 5% offered by the municipal. Alternatively, the municipal offers a 7.14% (= 5%/(1 – 0.30)) tax equivalent yield. Of course, the treasury security should have less risk than the municipal. 2. The tax equivalent yield is 0.06/(1 - 0.35) = 0.0923 or 9.23%. 3. a. Earning assets = investment securities + net loans = $4,050 + $2,025 + $15,525 – $1,125 = $20,475 b. ROA = ($2,600 – $1,650 – $180 + $140 – $420 – $90)/$23,960 = 1.67% c. Asset utilization = ($2,600 + $140)/$23,960 = 11.44% d. Spread = ($2,600/$20,475) – ($1,650/($10,800 + $3,200 + $2,250)) = 2.54% 4. a. Earning assets = investment securities + net loans = $3,100 + $1,664 + $9,120 = $13,884 b. Interest-bearing liabilities = $4,020 + $4,680 + $312 = $9,012 c. Total operating income = $1,150 + $260 = $1,410 d. Asset utilization ratio = $1,410/$15,600 = 9.038% e. Net interest margin = ($1,150 - $475)/$13,884 = 4.862% 5. During the month, management estimates that an additional $5,200 of loans will not be paid as promised. Accordingly, the bank records an expense to loan loss provision (which reduces net income and thus retained earnings and equity of the bank) and increases the allowance for loan losses to $188,200 on the balance sheet (see Panel B below). Notice that the loan is still listed as an asset on the bank’s balance sheet at this time. After another month, management feels there is no chance of recovering the loan and writes the $5,200 loan off its books. At this time, loans are reduced by $5,200 as is the allowance for loan losses (see Panel C below). Notice when the loan is considered unrecoverable and actually removed from the balance sheet, there is no impact on the bank’s income or equity value. Panel A: Beginning of Month 1 Assets

Liabilities and Equity

Securities Gross Loans Less: Allowance

Deposits $17,088,000 Common Stock 500,000 Ret. Earnings 1,612,000

$960,000 15,141,000

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e for Loan Losses $183,000 Net Loans 14,958,000 Other Assets 3,282,000 Total Assets $19,200,000 Panel B: End of Month 1 Assets Securities $960,000 Gross Loans 15,141,000 Less: Allowance for Loan Losses $188,200 Net Loans 14,952,800 Other Assets 3,282,000 Total Assets $19,194,800 Panel C: End of Month 2 Securities $960,000 Gross Loans 15,135,800 Less: Allowance for Loan Losses $183,000 Net Loans 14,952,800 Other Assets 3,282,000 Total Assets $19,194,800

Total Equity Total

2,112,000 $19,200,000

Liabilities and Equity Deposits $17,088,000 Common Stock 500,000 Ret. Earnings 1,606,800 Total Equity 2,106,800 Total $19,194,800

Deposits $17,088,000 Common Stock 500,000 Ret. Earnings 1,606,800 Total Equity 2,106,800 Total $19,194,800

6. a. Earning assets = investment securities + net loans = $6,080 + $2,990 + $20,040 = $29,110 b. Interest bearing liabilities = $10,350 + $7,670 + $470 = $18,490 c. Spread = ($4,048/$29,110) – ($2,024/$18,490) = 2.959% d. Interest expense ratio = $2,024/($4,048 + $700) = 42.628% 7. a. Earning assets = investment securities + net loans = $1,800 + $900 + $6,900 – $500 = $9,100 b. ROA = ($2,450 – $1,630 – $80 + $240 – $410 – $40)/$10,650 = 4.977% c. Total operating income = $2,450 + $240 = $2,690 d. Spread = ($2,450/$9,100) – ($1,630/($4,800 + $1,425 + $1,000)) = 4.363% 8. Revenues (in thousands) = 22,000 × 0.08 + 12,000 × 0.06 + 80,000 × 0.10 + 4,000 × 0.09 = $10,840 Expenses (in thousands) = 69,000 × 0.05 + 18,000 × 0.07 + 14,000 × 0.08 = 5,830 Net income = 10,840,000 - 5,830,000 + 120,000 - 80,000 - 2,500,000 = $2,550,000 9. Revenues (in thousands) = 29,600 × 0.015 + 15,960 × 0.0115 + 106,400 × 0.0725 = $8,341,540 Expenses (in thousands) = 90,700 × 0.005 + 23,940 × 0.0120 + 15,000 × 0.055 = 1,565,780

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Net income = $8,341,540 – 1,565,780 + 159,000 - 306,000 - 3,320,000 = $3,308,760 10. (in millions of dollars) a. return on equity = 5,000/28,000 = 17.86% b. return on assets = 5,000/183,000 = 2.73% c. asset utilization = (20,000 + 2,000)/183,000 = 12.02% d. equity multiplier = 183,000/(12,000 + 4,000 + 12,000) = 6.54X e. profit margin = 5,000/(20,000 + 2,000) = 22.73% f. interest expense ratio = 11,000/(20,000 + 2,000) = 50.00% g. provision for loan loss ratio = 2,000/(20,000 + 2,000) = 9.09% h. noninterest expense ratio = 1,000/(20,000 + 2,000) = 4.55% i. tax ratio = 3,000/(20,000 + 2,000) = 13.64% 11. (in millions of dollars) a. return on equity = 2,275/(5,000 + 4,000 + 6,125) = 15.04% b. return on assets = 2,275/137,500 = 1.65% c. asset utilization = (8,623 + 950)/137,500 = 6.96% d. equity multiplier = 137,500/(5,000 + 4,000 + 6,125) = 9.09X e. profit margin = 2,275/(8,623 + 950) = 23.76% f. interest expense ratio = 4,158/(8,623 + 950) = 43.43% g. provision for loan loss ratio = 200/(8,623 + 950) = 2.09% h. noninterest expense ratio = 1,720/(8,623 + 950) = 17.97% i. tax ratio = 1,220/(8,623 + 950) = 12.74% j. overhead efficiency = 950/1,720 = 55.23% 12. ROA = PM × AU = 0.21 × 0.11 = 0.0231 = 2.31% ROE = ROA × EM = 0.0231 × 12 = 0.2772 = 27.72% 13. ROA = PM × AU = 0.05 × 0.20 = 0.0100 = 1.00% ROE = ROA × EM = 0.0100 × 7.75 = 0.0775 = 7.75% 14. Debt ratio = 0.55 = $2.5m / Total assets => Total assets = $2.5m / 0.55 = $4.545m => Total equity = $4.545m - $2.5m = $2.045m => ROE = $250,000 / $2.045m = 12.22% 15. Debt to equity = 1.75 = Total debt / Total equity = Total debt / (Total assets – Total debt) 1.75 = Total debt / ($25m – Total debt) => 1.75 × ($25m – Total debt) = Total debt => (1.75 × $25m) – (1.75 × Total debt) = Total debt => $43.75m = 2.75 × Total debt => Total debt = $43.75m / 2.75 = $15.909m => Total equity = $25m - $15.909m = $9.091m

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 13 Questions: 1. Regulators have issued several guidelines to insure the safety and soundness of CBs: i. CBs are required to diversify their assets and not concentrate their holdings of assets. For example, banks cannot lend more than 15% of their equity to a single borrower.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e ii. CBs are required to maintain minimum amounts of capital to cushion any unexpected losses. The higher the proportion of capital contributed by owners, the greater the protection against insolvency risk for liability claimholders such as depositors. iii. Regulators have set up guaranty funds such as DIF for commercial banks. Deposit insurance mitigates a rational incentive depositors otherwise have to withdraw their funds at the first hint of trouble. iv. Regulators also engage in periodic monitoring and surveillance, such as on-site examinations, and request periodic information from the firms. 2. The United States has experienced several phases of regulating the links between the commercial and investment banking industries. After the 1929 stock market crash, the United States entered a major recession and approximately 10,000 banks failed between 1930 and 1933. A commission of inquiry (the Pecora Commission) established in 1932 began investigating the causes of the crash. Its findings resulted in new legislation, the 1933 Banking Act, or the Glass-Steagall Act. The Glass-Steagall Act sought to impose a rigid separation between commercial bankingtaking deposits and making commercial loansCand investment bankingCunderwriting, issuing, and distributing stocks, bonds, and other securities. The act defined three major securities underwriting exemptions. First, banks were to continue to underwrite new issues of Treasury bills, notes, and bonds. Second, banks were allowed to continue underwriting municipal general obligation (GO) bonds. Third, banks were allowed to continue engaging in private placements of all types of bonds and equities, corporate and noncorporate. For most of the 1933-1963 period, commercial banks and investment banks generally appeared to be willing to abide by the letter and spirit of the Glass-Steagall Act. Between 1963 and 1987, however, banks challenged restrictions on municipal revenue bond underwriting, commercial paper underwriting, discount brokerage, managing and advising open- and closed-end mutual funds, underwriting mortgage-backed securities, and selling annuities. In most cases, the courts eventually permitted these activities for commercial banks. With this onslaught and the de facto erosion of the Glass-Steagall Act by legal interpretation, the Federal Reserve Board in April 1987 allowed commercial bank holding companies to establish separate Section 20 securities affiliates. Through these Section 20 affiliates, banks can conduct all their "ineligible" or gray area securities activities, such as commercial paper underwriting, mortgage-backed securities underwriting, and municipal revenue bond underwriting. Significant changes occurred in 1997 as the Federal Reserve and the Office of the Comptroller of the Currency (OCC) took action to expand bank holding companiesC permitted activities. In particular, the Federal Reserve allowed commercial banks to directly acquire existing investment banks rather than establish completely new investment bank subsidiaries. The result was a number of mergers and acquisitions between commercial and investment banks in 1997 through 2000. In 1999, after years of “homemade” deregulation by banks and securities firms, regulators passed the Financial Services Modernization Act which eliminated the Glass-Steagall barriers between commercial banks and investment banks (as well as insurance companies). The bill allowed national banks to place certain activities, including securities underwriting, in bank subsidiaries regulated by the Office of the Comptroller of the Currency. Thus, after over 70 years of separation between investment banking and commercial banking the Financial Services Modernization Act of 1999 opened the door for the recreation of the full service financial institution. After the passage of FSMA, the two industries came together to a degree. Commercial banks like Bank of America and Wachovia tried to build up their own investment-banking operations, but they did not have much success in eating into the core franchises of the five big independent investment banks: Merrill Lynch, Goldman Sachs, Morgan Stanley, Lehman Brothers, and Bear Stearns. Generally, the investment banks, which were not subject to regulation by the Federal Reserve and did not have to adhere to as strict capital requirements, remained the major investment banking financial institutions. However, the financial crisis changed the landscape dramatically. In March 2008, the Federal Reserve helped J.P. Morgan acquire Bear Stearns as the investment bank faced bankruptcy. This was seen as a controversial decision and cost the Federal Reserve $30 billion. However, the Fed defended the move as essential. In September 2008, Lehman Brothers was allowed to fail and Merrill Lynch was purchased by Bank of America. Of the five major independent investment banks that existed a year earlier, only two─Goldman Sachs and Morgan Stanley─remained. Even Goldman Sachs and Morgan Stanley were facing a severe liquidity crisis during the weekend of September 20-21, 2008. To address the crisis, one week after the closure of Lehman Brothers and the sale of Merrill Lynch to Bank of America, the Federal Reserve granted a request by the last two major investment banks to change their status to bank holding companies. By becoming bank holding companies, the firms agreed to significantly tighter regulations and much closer supervision by bank examiners from several government agencies rather than only the Securities and Exchange Commission. With the conversion, the investment banks would look

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e more like commercial banks, with more disclosure, higher capital reserves and less risk-taking. In exchange for subjecting themselves to more regulation, the companies would have access to the full array of the Federal Reserve’s lending facilities. For example, as bank holding companies, Morgan and Goldman will have greater access to the discount window of the Federal Reserve, which banks can use to borrow money from the central bank. While they were allowed to draw on temporary Fed lending facilities in recent months, they could not borrow against the same wide array of collateral that commercial banks could. Further, they had enhanced potential access to TARP money. These events on Wall Street—the failure or sale of three of the five largest independent investment banks and the conversion of the two remaining firms from investment banks to commercial banks—effectively turned back the clock to the 1920s, when investment banks and commercial banks functioned under the same corporate umbrella. As part of the increased authority given to the Federal Reserve in the 2010 Wall Street Reform and Consumer Protection Act, the Fed proposed in late 2011 that net credit exposures between any two of the nation's six largest financial firms would be limited to 10 percent of the company's regulatory capital. Other financial firms would be subject to a 25 percent limit which was required by the 2010 Act. The proposed Fed rule aims to reduce the interconnectedness of financial institutions in the U.S. financial system and reduce the ability of any single financial firm to damage the financial system and the broader economy—as happened when Lehman Brothers was allowed to fail. The result of the new rules is that big U.S. banks could be forced to return to a more traditional banking model that revolves around deposit taking and making loans. This could result in smaller capital markets and less securities lending. 3. a. Yes, the bank is in compliance with the laws. The Financial Services Modernization Bill of 1999 allows commercial banks and investment banks to own each other with no limits on income. b. Yes, the bank is in compliance with the laws. The bank would not have been in compliance prior to the Financial Services Modernization Bill of 1999 because its revenues exceed the 25% of total revenues earned from allowable investment banking activities in the Glass-Steagall Act. 4. The Financial Services Modernization Act of 1999 completely changed the landscape for insurance activities as it allowed bank holding companies to open insurance underwriting affiliates and insurance companies to open commercial bank as well as securities firm affiliates through the creation of a financial service holding company. With the passage of this Act banks no longer have to fight legal battles to overcome restrictions on their ability to sell insurance in these states. The insurance industry also applauded the Act as it forced banks that underwrite and sell insurance to operate under the same set of state regulations (pertaining to their insurance lines) as insurance companies operating in that state. Under the new Act, a financial services holding company that engages in commercial banking, investment banking, and insurance activities will be functionally regulated. This means that the holding company=s banking activities will be regulated by bank regulators (such as the Federal Reserve, FDIC, OCC), its securities activities will be regulated by the SEC, and its insurance activities will be regulated by up to 50 state insurance regulators. Further, in July 2010, the Wall Street Reform and Consumer Protection Act (see below) established a new office at Treasury (the Office of National Insurance) that monitors the insurance industry and helps decide if an insurer is big enough to warrant tighter oversight. The Act established a Financial Stability Oversight Council that has authority to review both banks and nonbank companies, including insurance companies to see if they could threaten the overall financial system. 5. Shadow banking is the performance of banking services by nonfinancial service firms. New participants in the shadow banking system include structured investment vehicles (SIVs), special purpose vehicles (SPVs), assetbacked paper vehicles, asset-backed commercial paper (ABCP) conduits, limited-purpose finance companies, and credit hedge funds. A January 2020 report from the U.S. Financial Stability Board (FSB) put assets of shadow banks worldwide at $114 trillion at the end of 2018. Based on the FSB data, total assets of these nonbank financial intermediaries amount to approximately 133 percent of global GDP and approximately 30 percent of global financial assets. The Euro area has the highest share of shadow banking assets (32 percent), the United States has the second highest (26 percent), China has the third highest (10 percent), the UK has fourth highest (9 percent), and the Cayman Islands has the fifth highest share (6 percent). In several jurisdictions, shadow banking sectors are very large compared to their GDP. For example, shadow banking assets were 1,485 times GDP in the Cayman Islands and, within the euro area, 236 times GDP in Luxembourg, 13 times GDP in Ireland, and seven times GDP in the Netherlands. In the shadow banking system, savers place their funds with money market mutual and similar funds, which invest these funds in the liabilities of shadow banks. Borrowers get loans and leases from shadow banks such as finance companies rather than from banks. Like the traditional banking system, the shadow banking system

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e intermediates the flow of funds between net savers and net borrowers. However, instead of the bank serving as the middleman, it is the nonbank financial service firm, or shadow bank, that intermediates. Further, unlike the traditional banking system, where the complete credit intermediation is performed by a single bank, in the shadow banking system it is performed through a series of steps involving many nonbank financial service firms. For example, the lending process might involve (1) loan originations performed by a finance company, (2) the purchase and warehousing of these loans conducted by single and multiple SIVs funded through asset-backed commercial paper (ABCP), and (3) the purchase of ABCP by money market mutual funds. Thus, the shadow banking system decomposes the traditional process of deposit-funded, hold-to maturity lending conducted by banks into a more complex, wholesale-funded, securitization based lending process that involves multiple shadow banks which are not regulated by a specific regulatory body. As of 2019, these shadow banks continue to be unregulated by the federal government. However, the 2010 Wall Street Reform and Consumer Protection Act calls for regulators to be given broad authority to monitor and regulate nonbank financial firms that pose risks to the financial system. On April 11, 2012, the Financial Stability Oversight Council (FSOC) issued a Final Rule and Interpretive Guidance regarding the manner in which the Council makes designations (to determine which nonbank financial companies should be subject to supervision by the Federal Reserve and prudential standards) under section 113 of the Dodd-Frank Act. On November 17, 2017, the Department of the Treasury issued a report to the President in response to a Presidential Memorandum directing the Secretary of the Treasury to conduct a thorough review of the determination and designation processes of the Council. In response, the Council proposed an interpretive guidance in March 2019 to revise and update the 2012 Interpretive Guidance. The Council intends to seek to identify, assess, and address potential risks and emerging threats on a system-wide basis by taking an activities-based approach to its work. 6. The main feature of the Riegle-Neal Act of 1994 is the removal of barriers to interstate banking. As of September 1995, bank holding companies are allowed to acquire banks in other states. As of 1997, banks are allowed to convert out-of-state subsidiaries into branches of a single interstate bank. The act resulted in significant consolidations and acquisitions and the emergence of very large banks with branches all over the country, as currently practiced in the rest of the world. 7. Under the Federal Deposit Insurance Reform Act of 2005, beginning in January 2007, the FDIC began calculating deposit insurance premiums based on a more aggressively risk-based system. Further, under the act, if the reserve ratio drops below 1.15 percent—or the FDIC expects it to do so within six months—the FDIC must, within 90 days, establish and implement a plan to restore the DIF to 1.15 percent within five years. Such was the case in March 2008 when the FDIC reserve ratio dropped to 1.19 percent. At this point the FDIC was certain that the reserve ratio would drop below 1.15 by the end of the next quarter. Accordingly, the FDIC developed and implemented (on April 1, 2009) a restoration plan for the DIF which would restore the DIF reserve ratio to 1.15 percent. 8. Holding relatively small amounts of liquid assets exposes a CB to increased illiquidity and insolvency risk. Excessive illiquidity can result in a CB’s inability to meet required payments on liability claims (such as deposit withdrawals) and, at the extreme, its insolvency. Moreover, it can even lead to contagious effects that negatively impact other CBs. Consequently, regulators impose minimum liquid asset reserve requirements on CBs. In general, these requirements differ in nature and scope for various CBs. The requirements depend on the illiquidity risk exposure perceived for the CB’s type and other regulatory objectives that relate to minimum liquid asset requirements. Currently, in accordance with Federal Reserve Regulation D, banks in the United States are required to hold the following “target” minimum reserves against net transaction accounts (transaction accounts minus demand deposit balances due from U.S. commercial banks and cash items in process of collection). 9. The Basel Agreement identifies the risk-based capital ratios, explicitly incorporated the different credit risks of assets (both on and off the balance sheet), into capital adequacy measures. The new capital ratios were agreed upon by the member countries of the Bank for International Settlements. The ratios are to be implemented for all commercial banks under their jurisdiction. Further, most countries in the world now have accepted the guidelines of this agreement for measuring capital adequacy. 10. The major feature of the Basel Agreement is that the capital ratios of banks must be calculated by using riskweighted assets as denominator. In a very rough fashion, these capital ratios mark to market a DI’s on and offbalance-sheet positions to reflect its credit risk.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 11. The FDIC Improvement Act (FDICIA) of 1991 required that banks and thrifts adopt risk-based capital requirements. Consistent with this act, U.S. DI regulators formally agreed with other member countries of the Bank for International Settlements (BIS) to implement new risk-based capital ratios for all depository institutions under their jurisdiction. The BIS phased in and fully implemented these risk-based capital ratios on January 1, 1993, under what has become known as the Basel (or Basle) Agreement (now called Basel I). The 1993 Basel Agreement explicitly incorporated the different credit risks of assets (both on and off the balance sheet) into capital adequacy measures. In 2001, the BIS issued a Consultative Document, “The New Basel Capital Accord,” that proposed the incorporation of operational risk into capital requirements and updated the credit risk assessments in the 1993 agreement. The new Basel Accord or Agreement (called Basel II) allowed for a range of options for addressing both credit and operational risk. Two options were for the measurement of credit risk. The first is the Standardized Approach and the second is an Internal Ratings–Based (IRB) Approach. The Standardized Approach was similar to that of the 1993 agreement, but was more risk sensitive. Under the IRB Approach, DIs were allowed to use their internal estimates of borrower creditworthiness to assess credit risk in their portfolios (using their own internal rating systems and credit scoring models) subject to strict methodological and disclosure standards, as well as explicit approval by the DI’s supervising regulator. Basel III was passed in 2010 (fully effective in 2019). The goal of Basel III is to raise the quality, consistency, and transparency of the capital base of banks to withstand credit risk and to strengthen the risk coverage of the capital framework. Advanced (IRB) approaches may be used by institutions with consolidated assets of $250 billion or more or with consolidated on-balance-sheet foreign exposures of $10 billion or more (approximately 20 of the largest U.S. banking organizations). All other depository institutions use the Standardized Approach for calculating capital adequacy. 12. Since December 18, 1992, under the FDICIA legislation, regulators must take specific actions−prompt corrective action (PCA)−when a DI falls outside the zone 1, or well capitalized, category. Table 13-4 summarizes these regulatory actions. Importantly, the prompt corrective action provision requires regulators to appoint a receiver for the DI when the tangible equity to total assets ratio falls to 2 percent or less. Thus, even though the DI is not technically insolvent in terms of book value of equity, the institution can be placed into receivership. The idea behind the mandatory and discretionary set of actions to be taken by regulators for each of the five capital adequacy zones is to enforce minimum capital requirements and limit the ability of regulators to show forbearance to the worst capitalized DIs. 13. Under Basel III, depository institutions must calculate and monitor four capital ratios: common equity Tier I (CET1) risk-based capital ratio, Tier I risk-based capital ratio, total risk-based capital ratio, and Tier I leverage ratio. i) Common equity Tier I risk-based capital ratio = Common equity Tier I capital/Risk-weighted assets ii) Tier I risk-based capital ratio = Tier I capital (Common equity Tier I capital + additional Tier I capital)/Riskweighted assets iii) Total risk-based capital ratio = Total capital (Tier I + Tier II)/Risk-weighted assets, and iv) Tier I leverage ratio = tier I capital / total exposure. 14. Under the Standardized Approach, the Basel III leverage ratio is defined as the ratio of Tier 1 capital to onbalance-sheet assets. Under the Advanced Approach, Basel III leverage ratio is defined as the ratio of Tier I core capital divided by the book value of total exposure. Total exposure is equal to the DI’s total assets plus off-balancesheet exposure. For derivative securities, off-balance-sheet exposure is current exposure plus potential exposure as described above. For off-balance-sheet credit (loan) commitments a conversion factor of 100 percent is applied unless the commitments are immediately cancelable. In this case, a conversion factor of 10 percent is used. Once Basel III is fully phased in, to be to be adequately capitalized, a DI must hold a minimum leverage ratio of 4.5 percent. 15. The five zones of capital adequacy are:

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Zone 1: Well capitalized. The CET1 ratio exceeds 6.5 percent, Tier I risk-based ratio exceeds 8 percent, total riskbased capital ratio (RBC) ratio exceeds 10 percent, and Tier I leverage ratio exceeds 5 percent. No regulatory action is required. Zone 2: Adequately capitalized. The CET1 ratio exceeds 4.5 percent, but is less than 6.5 percent, Tier I risk-based ratio exceeds 6 percent, but is less than 8 percent, total risk-based capital ratio (RBC) ratio exceeds 8 percent, but is less than 10 percent, and Tier I leverage ratio exceeds 4 percent, but is less than 5 percent. Institutions may not use brokered deposits except with the permission of the FDIC. Zone 3: Undercapitalized. The CET1 ratio is below 4.5 percent, Tier I risk-based ratio is below 6 percent, total riskbased capital ratio (RBC) ratio is below 8 percent, and Tier I leverage ratio is below 4 percent. Requires a capital restoration plan, restricts asset growth, requires approval for acquisitions, branching, and new activities, disallows the use of brokered deposits, and suspends dividends and management fees. Zone 4: Significantly undercapitalized. The CET1 ratio is below 3 percent, Tier I risk-based ratio is below 4 percent, total risk-based capital ratio (RBC) ratio is below 6 percent, and Tier I leverage ratio is below 3 percent. Same as zone 3 plus recapitalization is mandatory, places restrictions on deposit interest rates, interaffiliate transactions, and the pay level of officers. Zone 5: Critically undercapitalized. The tangible equity to total asset ratio is less than or equal to 2 percent. Places the bank in receivership within 90 days, suspends payment on subordinated debt, and restricts other activities at the discretion of the regulator. The mandatory provisions for each of the zones described above include the penalties for any of the zones prior to the specific zone. 16. CET1 is primary or core capital of the DI. CET1 capital is closely linked to a DI’s book value of equity, reflecting the concept of the core capital contribution of a DI’s owners. CET1 capital consists of the equity funds available to absorb losses. Basically, it includes the book value of common equity plus minority equity interests held by the DI in subsidiaries minus goodwill. Goodwill is an accounting item that reflects the amount a DI pays above market value when it purchases or acquires other DIs or subsidiaries. Tier I capital is the primary capital of the DI plus additional capital elements. Tier I capital is the sum of CET1 capital and additional Tier I capital. Included in additional Tier I capital are other options available to absorb losses of the bank beyond common equity. These consist of instruments with no maturity dates or incentives to redeem, e.g., noncumulative perpetual preferred stock. These instruments may be callable by the issuer after 5 years only if they are replaced with “better” capital. Tier II capital is supplementary capital. Tier II capital is a broad array of secondary “equity like” capital resources. It includes a DI’s loan loss reserves assets plus various convertible and subordinated debt instruments with maximum caps. 17. The two components are risk-weighted on-balance-sheet assets and risk-weighted off-balance-sheet assets. 18. Prior to 1978, foreign branches and agencies entering the United States were primarily licensed at the state level. As such, their entry, regulation, and oversight were almost totally confined to the state level. Beginning in 1978 with the passage of the International Banking Act (IBA) and the 1991 passage of the Foreign Bank Supervision Enhancement Act (FBSEA), federal regulators have exerted increasing control over foreign banks operating in the United States. Foreign banking activities have been hampered by both pieces of legislation. Since U.S. banking legislation is, in many instances, stricter than regulations abroad, this reduces the attractiveness of opening full scale branches of foreign banks in the U.S. Foreign banks will have to justify continued activity in the U.S. market on the grounds of return to the entry. 19. The Foreign Bank Supervision Enhancement Act’s five main features have significantly enhanced the powers of federal bank regulators over foreign banks in the United States:

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 1. Entry - under FBSEA, a foreign banking organization must now have the Fed’s approval to establish a subsidiary, branch, agency, or representative office in the United States. The approval applies to both a new entry and an entry by acquisition. To secure Fed approval, the organization must meet a number of standards, two of which are mandatory. First, the foreign bank must be subject to comprehensive supervision on a consolidated basis by a home country regulator. Second, that regulator must furnish all the information that the Federal Reserve requires to evaluate the application. Both standards attempt to avoid the lack of disclosure and lack of centralized supervision associated with BCCI’s failure. 2. Closure - FBSEA also gives the Federal Reserve authority to close a foreign bank if its home country supervision is inadequate, if it violates U.S. laws, or if it engages in unsound and unsafe banking practices. 3. Examination - the Federal Reserve has the power to examine each office of a foreign bank, including its representative offices. Further, each branch or agency must be examined at least once a year. 4. Deposit Taking - only foreign subsidiaries with access to FDIC insurance can take retail deposits under $100,000. This effectively rolls back the provision of the IBA that gave foreign branches and agencies access to FDIC insurance. 5. Activity Powers - beginning December 19, 1992, state-licensed branches and agencies of foreign banks were not allowed to engage in any activity that was not permitted to a federal branch. 20. The Federal Deposit Insurance Reform Act of 2005 instituted a deposit insurance premium scheme, effective January 1, 2007 that combined examination ratings, financial ratios, and for large banks (with total assets greater than $10 billion) long term debt issuer ratings. The new rules consolidate the existing nine risk categories into four, named Risk Categories I through IV. Risk Category I contains all well-capitalized institutions in Supervisory Group A (generally those with CAMELS composite ratings of 1 or 2). Risk Category II contains all institutions in Supervisory Groups A and B (generally those with CAMELS composite ratings of 1, 2 or 3), except those in Risk Category I and undercapitalized institutions. Risk Category III contains all undercapitalized institutions in Supervisory Groups A and B, and institutions in Supervisory Group C (generally those with CAMELS composite ratings of 4 or 5) that are not undercapitalized. Risk Category IV contains all undercapitalized institutions in Supervisory Group C. 21. Within Risk Category I, the final rule combines CAMELS component ratings with financial ratios to determine an institution’s assessment rate. For Risk Category I institutions, each of six financial ratios component ratings will be multiplied by a corresponding pricing multiplier, as listed in Table 13–13. The six financial ratios are: Tier I leverage ratio; loans past due 30-89 days/gross assets; nonperforming assets/gross assets; net loan charge-offs/gross assets; net income before taxes/risk-weighted assets; and the weighted-average CAMELS component rating. The products are then summed and added to a uniform amount, 1.954. Table 13-14 gives initial base assessment rates for three institutions with varying characteristics, assuming the pricing multipliers given above, using the base assessment rates for institutions in Risk Category I (which range between a minimum of 2 basis points to a maximum of 4 basis points). The assessment rate for an institution in the table is calculated by multiplying the pricing multipliers by the risk measure values to produce each measure’s contribution to the assessment rate. The sum of the products plus the uniform amount yields the total assessment rate. For Institution 1 in the table, this sum actually equals 1.56, but the table reflects the assumed minimum assessment rate of 2 basis points. For Institution 3 in the table, the sum actually equals 4.25, but the table reflects the assumed maximum assessment rate of 4 basis points. Weights for the CAMELS components to calculate the weighted average CAMELS rating are 25 percent, 20 percent, 25 percent, 10 percent, 10 percent and 10 percent for C, A, M, E, L and S component, respectively. 22. With these CAMELS rating and capital ratios, Webb Bank falls into the Category II risk category and has a deposit insurance assessment rate of 10 basis points per $1 of assessment base (total assets minus tangible equity). 23. Residential 1-4 family mortgages would be separated into two risk categories (“category 1 residential mortgage exposures” and “category 2 residential mortgage exposures”). Category 1 residential mortgages include traditional, first-lien, prudently underwritten mortgage loans. Category 2 residential mortgages include junior liens and nontraditional mortgage products. Category 1 mortgages have a risk weight of 50 percent; and category 2 mortgages have a risk weight of 100 percent.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e

24. Risk weights for sovereign exposures are determined using OECD Country Risk Classifications (CRCs). A sovereign is a central government (including the U.S. government) or an agency, department, ministry, or central bank of a central government. The OECD’s CRCs assess a country’s credit risk using two basic components: the country risk assessment model (CRAM)− an econometric model that produces a quantitative assessment of country credit risk−and the qualitative assessment of the CRAM results−which integrates political risk and other risk factors not fully captured by the CRAM. The two components are combined and classified into one of eight risk categories (0-7). Countries assigned to categories 0-1 have the lowest possible risk assessment and are assigned a risk weight of 0 percent, while countries assigned to category 7 having the highest possible risk assessment and are assigned a risk weight of 150 percent. The OECD provides CRCs for more than 201 countries. Assessments are publicly available on the OECD website. Countries with no CRC assessments are assigned a credit risk weight of 100 percent. A 150 percent risk weight is assigned to sovereign exposures immediately upon determining that an event of sovereign default has occurred or if a sovereign default has occurred during the previous five years. 25. Basel III introduced a capital conservation buffer designed to ensure that DIs build up a capital surplus, or buffer, outside periods of financial stress which can be drawn down as losses are incurred during periods of financial stress. The buffer requirements provide incentives for DIs to build up a capital surplus (e.g., by reducing discretionary distributions of earnings (reduced dividends, share buy-backs and staff bonuses)) to reduce the risk that their capital levels would fall below the minimum requirements during periods of stress. The capital conservation buffer must be composed of CET1 capital and are held separately from the minimum risk-based capital requirements. Under Basel III, a DI would need to hold a capital conservation buffer of greater than 2.5 percent of total risk-weighted assets to avoid being subject to limitations on capital distributions and discretionary bonus payments to executive officers. To have no limitations on the bank’s payout ratio, the CET1 ratio must be > 7%, the Tier I ratio must be > 8.5%, and the total capital ratio must be > 10.5%. Basel III also introduced a countercyclical capital buffer which may be declared by any country which is experiencing excess aggregate credit growth. The countercyclical buffer can vary between 0 percent and 2.5 percent of risk-weighted assets. This buffer must be met with CET1 capital and DIs are given 12 months to adjust to the buffer level. Like the capital conservation buffer, if a DI’s capital levels fall below the set countercyclical capital buffer, restrictions on earnings payouts are applied. The countercyclical capital buffer aims to protect the banking system and reduce systemic exposures to economic downturns. Losses can be particularly large when a downturn is preceded by a period of excess credit growth. The accumulation of a capital buffer during an expansionary phase would increase the ability of the banking system to remain healthy during periods of declining asset prices and losses from weakening credit conditions. By assessing a countercyclical buffer when credit markets are overheated, accumulated capital buffers can absorb any abnormal losses that a DI might experience when the credit cycle turns. Consequently, even after these losses are realized, DIs would remain healthy and able to access funding, meet obligations, and continue to serve as credit intermediaries. 26. The reserve maintenance period would extend from June 17 through June 30. It starts 30 days later than the start of the reserve computation period. This makes it easier for bank managers to calculate and meet their reserve requirements and increases the accuracy of information on aggregate required reserve balances. Problems: 1. To determine the deposit insurance assessment for each institution, we set up the following tables: CAMELS Components: C A M E L S Weighted Average CAMELS Component

1 × 0.25 = 0.25 2 × 0.20 = 0.40 1 × 0.25 = 0.25 2 × 0.10 = 0.20 1 × 0.10 = 0.10 2 × 0.10 = 0.20 1.40

1 × 0.25 = 0.25 2 × 0.20 = 0.40 2 × 0.25 = 0.50 3 × 0.10 = 0.30 1 × 0.10 = 0.10 1 × 0.10 = 0.10 . 1.65

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Loans Mix Index: (1)

(2) Weighted charge-off rate percent

Construction & Development 4.50 Commercial & Industrial 1.60 Leases 1.50 Other Consumer 1.46 Loans to Foreign Government 1.34 Real Estate Loans Residual 1.02

(3) (4) (5) (6) Institution A Institution B Loan Product Loan Product category of two category of two as a percent columns as a percent columns of total assets of total assets 0.40 1.800 0.30 1.350 11.35 18.160 15.66 25.056 0.45 0.675 1.05 1.575 16.50 24.090 16.80 24.528 0.00 0.000 0.60 0.804 0.00 0.000 0.00 0.000

Multifamily Residential Nonfarm Nonresidential 1–4 Family Residential Loans to Depository Banks

0.88 0.73 0.70 0.58

0.50 0.00 38.85

Agricultural Real Estate Agricultural

0.24 0.24

4.55 7.40

0.440 0.000 27.195 0.00

1.25 0.00 40.15 0.000

1.092 1.776

SUM (Loan Mix Index)

0.00 0.00

1.100 0.000 28.105 2.80 0.000 0.000

75.23

84.14

Uniform Amount

Base Assessment Rates for Two Institutions (2) (3) (4) (5) (6) Institution A Institution B Contribution Contribution Risk to Risk to Pricing Measure Assessment Measure Assessment Multiplier Value Rate Value Rate 7.352 7.352

Tier I leverage ratio (%)

(1.264)

8.25

(10.428)

7.58

(9.581)

Nonperforming loans and leases/gross assets (%)

0.942

0.25

0.236

4.55

4.286

Other real estate owned /gross assets (%)

0.533

0.54

0.288

0.75

0.400

Net income before taxes/risk-weighted assets (%)

(0.720)

2.15

(1.548)

1.85

(1.332)

Brokered deposits/total assets (%)

0.264

84.56

22.324

79.68

21.036

One year asset growth (%)

0.061

5.66

0.345

7.75

0.472

Loan mix index

0.081

75.23

6.094

84.14

6.815

(1)

1.624

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e

Weighted average CAMELS component ratings Sum of contributions Initial assessment rate

1.519

1.40

2.127 26.79 26.79

1.65

2.506 31.95 30.00

2. To determine the deposit insurance assessment for each institution, we set up the following tables: CAMELS Components: C A M E L S Weighted Average CAMELS Component Loans Mix Index: (1) (6)

Institution A 1 × 0.25 = 0.25 1 × 0.20 = 0.20 1 × 0.25 = 0.25 2 × 0.10 = 0.20 1 × 0.10 = 0.10 2 × 0.10 = 0.20

Institution B 2 × 0.25 = 0.50 1 × 0.20 = 0.20 1 × 0.25 = 0.25 1 × 0.10 = 0.10 3 × 0.10 = 0.30 3 × 0.10 = 0.30 . 1.65

1.20

(2)

(3)

(4)

(5)

Institution A Weighted charge-off rate percent Construction & Development 4.50 Commercial & Industrial 1.60 Leases 1.50 Other Consumer 1.46 Loans to Foreign Government 1.34 0.804 Real Estate Loans Residual 1.02 0.000 Multifamily Residential 0.88 Nonfarm Nonresidential 1–4 Family Residential

0.73 0.70

Loan Product category of two as a percent columns of total assets 0.00 0.000 10.56 16.896 0.65 0.975 17.55 25.623 0.00 0.00

Institution B Loan

0.000

Product category of two as a percent columns of total assets 0.00 0.000 18.68 29.888 2.15 3.225 18.95 27.667 0.60

0.000

0.00

0.000

1.10

0.968

0.00 41.10

0.000 28.770

0.00 37.41

0.000 26.187

Loans to Depository Banks 0.290 Agricultural Real Estate

0.58

0.00

0.24

1.10

0.264

0.35

0.084

Agricultural

0.24

0.40

0.096

0.40

0.096

SUM (Loan Mix Index)

0.000

0.50

72.62

89.21

(1)

Base Assessment Rates for Two Institutions (2) (3) (4) (5) (6) Institution A Institution B

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e

Pricing Multiplier

Risk Measure Value

Contribution to Assessment Rate 7.352

Risk Measure Value

Contribution to Assessment Rate 7.352

Tier I leverage ratio (%)

(1.264)

8.55

(10.807)

8.25

(10.428)

Nonperforming loans and leases/gross assets (%)

0.942

0.35

0.329

5.12

4.823

Other real estate owned /gross assets (%)

0.533

0.42

0.224

0.75

0.400

Net income before taxes/risk-weighted assets (%)

(0.720)

2.00

(1.440)

1.65

(2.370)

Brokered deposits/total assets (%)

0.264

82.20

21.701

76.50

20.196

One year asset growth (%)

0.061

4.35

0.265

6.80

0.415

Loan mix index

0.081

72.62

5.882

89.21

7.226

Weighted average CAMELS component ratings Sum of contributions Initial assessment rate

1.519

1.20

1.823 25.33 25.33

1.65

2.506 31.30 30.00

Uniform Amount

3. a. Reserve requirements = (0 × $15.2m) + ($110.2m - $15.2m)(0.03) + ($225m - $110.2m) (0.10) = 0 + $2.850m + $11.480m = $14.330 million After subtracting the average daily balance of vault cash of $5 million, the bank needs to maintain a daily average of $9.330 million ($14.330 million - $5 million) during the maintenance period. b. The average daily balance over the maintenance period was $8 million. Therefore, average reserves held were short $1.330 million. c. For the 14-day period, the cumulative sum of its daily average net transaction accounts is = $225m × 14 = $3,150m. If $35 million is transferred on Friday, the total reduction is $210 million over two weekends ($35m × 3 days × 2 weekends), and the total 14-day balance is $2,940m. The average daily deposits will be $210 million. Reserve requirements = (0 × $15.2m) + ($110.2m - $15.2m)(0.03) + ($210m - $110.2m) (0.10) = 0 + $2.850m + $9.980m = $12.830 million. City Bank needs to maintain average reserves of $7.830 million ($12.830 million - $5 million) during the maintenance period. Since it had $8 million of reserves, a surplus of $0.17m per day would now exist. 4. a. Reserve requirements = ((0 × $15.2m) + ($110.2m - $15.2m)(0.03) + ($325m - $110.2m) (0.10) = 0 + $2.850m + $21.480m = $24.330 million

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e After subtracting the average daily balance of vault cash of $4.3 million, the bank needs to maintain a target daily average of $20.030 million ($24.330 million - $4.3 million) during the maintenance period. b. Yes. The bank has average reserves of $24.60 million. This amount exceeds the required amount by $4.570 million. 5. a. Average daily net transaction accounts = (300m + 250m + 280m + 260m + 260m + 260m + 280m + 300m + 270m + 260m + 250m + 250m + 250m + 240m)/14 = 3,710m/14 = 265m Reserve requirement = (0 × $15.2m) + ($110.2m - $15.2m)(0.03) + ($265m - $110.2m) (0.10) = 2.850m + 15.480m = $18.330m b. Average vault cash and reserves maintained = $22.7m + $2m = $24.7m Excess over required reserves = $24.7m - $18.330m = $6.370m The bank is in compliance with required reserves. 6. a.

Risk-weighted assets = $20x0.0 + $40x0.0 + $600x0.5 + $430x1.0 = $730. The CET1 risk-based ratio is ($45 + $40)/$730 = 0.11644 or 11.644 percent.

b. Tier I capital ratio = ($45 + $40)/$730 = 0.11644 or 11.644 percent. c. The total risk-based capital ratio = ($45 + $40 + $25)/$730 = 0.15068 or 15.068 percent. d. The leverage ratio is ($45 + $40)/$1,090 = 0.07798 or 7.798 percent. e. The bank would be place in the well-capitalized category. 7. Basel III introduced a capital conservation buffer designed to ensure that DIs build up a capital surplus, or buffer, outside periods of financial stress which can be drawn down as losses are incurred during periods of financial stress. The buffer requirements provide incentives for DIs to build up a capital surplus (e.g., by reducing discretionary distributions of earnings (reduced dividends, share buy-backs and staff bonuses)) to reduce the risk that their capital levels would fall below the minimum requirements during periods of stress. The capital conservation buffer must be composed of CET1 capital and are held separately from the minimum risk-based capital requirements. Under Basel III, a DI would need to hold a capital conservation buffer of greater than 2.5 percent of total risk-weighted assets to avoid being subject to limitations on capital distributions and discretionary bonus payments to executive officers. To have no limitations on the bank’s payout ratio, the CET1 ratio must be > 7%, the Tier I ratio must be > 8.5%, and the total capital ratio must be > 10.5%. In problem 6, all three of these conditions are met. So, the bank has no limitations on its payout ratio. 8. a. CET1 capital decreases to $400,000, Tier I capital decreases to $450,000 and total capital decreases to $850,000. Cash has a 0 risk weight so risk-weighted assets do not change. Thus, the CET1 ratio decreases to 4 percent, the Tier I ratio decreases to 4.5 percent and the total capital ratio decreases to 8.5 percent. b. The risk weight for category 1 mortgages with a loan-to-value ratio of 80 percent is 50 percent. Thus, riskweighted assets increase to $10 million + $2 million (0.5) = $11 million. The CET1 ratio decreases to $500,000/$11 million = 4.54 percent, the Tier I ratio decreases to $550,000/$11 million = 5 percent and the total capital ratio decreases to $950,000/$11 million = 8.64 percent. c. T-bills have a 0 risk weight so risk-weighted assets remain unchanged. Thus, all three ratios remain unchanged. d. CET1 equity increases to $1.3 million, Tier I equity increases to $1.35 million, and total capital increases to $1.75 million. The business loan’s risk weight is 100 percent. Thus, risk-weighted assets increase to $10 million + $800,000 (1) = $10.8 million. The CET1 ratio, increases to $1.3m/$10.8m = 12.03 percent, the Tier I ratio increases to $1.35m/$10.8m = 12.50 percent, and the total capital ratio increases to 16.20 percent.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e e. CET1 and Tier I capital are unchanged. Total capital increases to $1.95 million. General obligation municipal bonds fall into the 20 percent risk category. So, risk-weighted assets increase to $10 million + $1 million (0.2) = $10.2 million. Thus, the CET1 ratio decreases to $500,000/$10.2 million = 4.90 percent, the Tier I ratio decreases to $550,000/$10.2 million = 5.39 percent, and the total capital ratio increases to 19.12 percent. f. The category 1 mortgage loans with loan-to-value ratios of 40 percent have a risk weight of 35 percent. The ATMs are 100 percent risk weighted. Thus, risk-weighted assets increase to $10 million - $4 million (0.35) + $4 million (1.0) = $12.6 million. The CET1 capital ratio decreases to $500,000/$12.6m = 3.97 percent, the Tier I capital ratio decreases to $550,000/$12.6m = 4.37 percent, and the total capital ratio decreases to $950,000/$12.6m = 7.54 percent. 9. a.

Risk-weighted assets: Cash OECD interbank deposits Mortgage loans Consumer loans Total risk-weighted assets

0 × 21 0.20 × 25 0.50 × 70 1.00 × 70

= = = = =

$0 $5 $35 $70 $110

= $110

Standby LCs: Foreign exchange contracts: Potential exposure Current exposure Interest rate swaps: Potential exposure Current exposure

$30 × 0.50 × 1.0

$15

= $15

$40 × 0.05 in the money

= =

$2 $0

$300 × 0.015 Out-of-the money

= = =

$4.5 $2 $8.5

1.0

CET1 capital required

= $8.5 = $133.50 × 0.045 $6.0075

Tier I capital required

× 0.06 $8.01

Total capital required

× 0.08 = $10.68

Total risk-weighted on- and off-balance-sheet assets

c. No, the bank does not have sufficient total capital to meet the Basel requirements. It needs CET1 capital of $6.0075 million, Tier I capital of $8.01 million, and total capital of $10.68 million. The bank has $5 million of CET1 capital, $7 million of Tier I capital ($5 million CET1 capital and $2 million of additional Tier I capital), and $10 million of total capital ($3 million ($2 million in subordinate debt and $1 million in reserve for loan losses) of Tier II capital). If the bank issues $1.0075 million in CET1 capital, it will need $0.0025 million in additional Tier I capital, and no Tier II capital. With these additions the bank will have $6.0075 million of CET1 capital, $8.01 million of Tier I capital, and $11.01million of total capital. A new balance sheet after the issuance of the new required equity is shown below. You will note that the total capital exceeds the minimum of $10.68 million. New balance sheet: Cash OECD interbank deposits Mortgage loans Consumer loans Reserve for loan losses Total

$22.01 25 70 70 (1) $186.01

Deposits Subordinated debt (over 5 years) Cumulative preferred stock Equity

$176 2 2.0025 6.0075 $186.01

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e

Total risk-weighted on- and off-balance-sheet assets CET1 capital required including capital conservation buffer

= $133.50 × 0.070 $9.345

Tier I capital required including capital conservation buffer

× 0.085 $11.3475 × 0.105 = $14.0175

Total capital required

No, the bank does not have sufficient total capital to meet the Basel requirements. It needs CET1 capital of $9.345 million, Tier I capital of $11.3475 million, and total capital of $14.0175 million. The bank has $5 million of CET1 capital, $7 million of Tier I capital, and $10 million of total capital. If the bank issues $4.345 million in CET1 capital, it will need $0.0025 million in additional Tier I capital, and no Tier II capital. With these additions the banks will have $9.345 million of CET1 capital, $11.345 million of Tier I capital, and $14.345 million of total capital. A new balance sheet after the issuance of the new required equity is shown below. You will note that the total capital exceeds the minimum of $14.0175 million. New balance sheet: Cash OECD interbank deposits Mortgage loans Consumer loans Reserve for loan losses Total

$25.3475 25 70 70 (1) $189.3475

10. a. Risk-weighted on-balance-sheet assets:

Standby LCs: Foreign exchange contracts: Potential exposure Current exposure

Deposits Subordinated debt (over 5 years) Cumulative preferred stock Equity

$176 2 2.0025 9.345 $189.3475

$21 × 0 = $50 × 0.50 = $70 × 1.00 Total

$0 25 =

70 =

$20 × 1.0

$20 × 1.0 = $20

$40 × 0.075 in the money

= = =

CET1 capital required

$3 $0 $3 × 1.0 = $ 3 = $118 × 0.045 $5.31

Tier I capital required

× 0.06 $7.08

Total capital required

× 0.08 = $9.44

Total risk-weighted on- and off-balance-sheet assets

$95

c. No, the bank does not have sufficient total capital to meet the Basel requirements. It needs CET1 capital of $5.31 million, Tier I capital of $7.08 million, and total capital of $9.44 million. The bank has $6 million of CET1 capital and Tier I capital, and $8 million of total capital. Thus, the bank has sufficient CET1 capital, but insufficient additional Tier I and Tier II capital. If the bank issues $1.08 million in CET1 (or additional Tier I) capital, it will need $0.36 million in additional Tier II capital. With these additions the bank will have $7.08 million of CET1 capital, $7.08 million of Tier I capital, and

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e $9.44 million of total capital. A new balance sheet after the issuance of the new required equity is shown below. Assets Cash (0%) Mortgage loans (50%) Consumer loans (100%) Reserve for loan losses Total assets d.

Liabilities and Equity Deposits Subordinated debt (> 5 years) Equity

$22.44 50 70 (1) $141.44

Total Liabilities and equity

Total risk-weighted on- and off-balance-sheet assets

$133 1.36 7.08 $141.44

CET1 capital required including capital conservation buffer

= $118 × 0.070 $8.26

Tier I capital required including capital conservation buffer

× 0.085 $10.03

Total capital required

× 0.105 = $12.39

No, the bank does not have sufficient total capital to meet the Basel requirements. It needs CET1 capital of $8.26 million, Tier I capital of $10.03 million, and total capital of $12.39 million. The bank has $6 million of CET1 capital and Tier I capital, and $8 million of total capital. Capital conservation buffer must be met with CET1 capital. Thus, if the bank issues $4.03 million in CET1 capital, it will need $0.36 million in Tier II capital. With these additions the bank will have $10.03 million of CET1 and Tier I capital, and $12.39 million of total capital. A new balance sheet after the issuance of the new required equity is shown below. Assets Cash (0%) Mortgage loans (50%) Consumer loans (100%) Reserve for loan losses Total assets

$25.39 50 70 (1) $144.39

11. a. b. c.

d. e.

f. g.

h. i.

Liabilities and Equity Deposits Subordinated debt (> 5 years) Equity

$133 1.36 10.03

Total Liabilities and equity

$144.39

Risk weight 0% 0

$10 million cash reserves. $50 million 91-day U.S. Treasury bills $25 million cash items in the process of collection. $5 million U.K. government bonds, OECD CRC rated 1 $5 million French short-term government bonds, OECD CRC rated 2 $1 million general obligation municipal bonds $40 million repurchase agreements (against U.S. Treasuries) $2 million loan to foreign bank, OECD rated 3 $500 million 1-4 family home mortgages,

$0 $0

$5 million

$1 million

$200,000

$8 million

50 50

$1 million $250 million

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e category 1, loan-to-value ratio 80% $10 million 1-4 family home mortgages, category 2, loan-to-value ratio 95% k. $5 million 1-4 family home mortgages, 100 days past due l. $500 million commercial and industrial loans, AAA rated m. $500 million commercial and industrial loans, B- rated j.

200

$20 million

150

$7.5 million

100

$500 million

100

$500 million

100

$50,000

$10,000

$280,000

100

$1,600,000

100

$8.5 million

100

$3.4 million

100

$30 million

credit equivalent amount n. o. p. q. r. s. t. u.

$100,000 performance-related standby letters of credit to a AAA rated corporation $100,000 performance-related standby letters of credit to a municipality issuing general obligation bonds $7 million commercial letter of credit to a foreign bank, OECD CRC rated 2 $3 million five-year loan commitment to a foreign government, OECD CRC rated 1 $8 million bankers’ acceptance conveyed to a U.S., AA rated corporation $17 million three-year loan commitment to a private agent $17 million three-month loan commitment to a private agent $30 million standby letter of credit to back an A rated corporate issue of commercial paper

100

$4 million five-year interest rate swap with no current exposure w. $6 million two-year currency swap with $500,000 current exposure

potential exposure

current exposure

100

$20,000

500,000

100

$800,000

Face Value $121,600 5,400 414,400 9,800 159,000 937,900 1,640,000 170,000 26,500 112,900

Weight 0% 0% 0% 0% 20% 20% 20% 20% 20% 50%

Value $0 $0 $0 $0 $31,800 $187,580 $328,000 $34,000 $5,300 $56,450

5,000,000 4,667,669 11,600 455,000

50% 100% 50% 100%

$2,500,000 $4,667,669 $5,800 $455,000

Face

Credit-Equivalent

12. On Balance Sheet Items Cash Short-term government securities (<92 days.) Long-term government securities (>92 days) Federal Reserve stock Repos secured by federal agencies Claims on U.S. depository institutions Loans to foreign banks, OECD CRC rated 2 General obligations municipals. Claims on or guaranteed by federal agencies Municipal revenue bonds Residential mortgages, category 1, loan-to-value ratio 75% Commercial loans Loans to sovereigns, OECD CRC rated 3. Premises and equipment Conversion

Risk-

Weighted

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Off Balance Sheet Items: Value U.S. Government Counterparty Loan commitments: < 1 year 1-5 year Standby letters of credit: Performance-related Direct-credit substitute U.S. Depository Institutions Counterparty Loan commitments: < 1 year. > 1 year Standby letters of credit: Performance-related Direct-credit substitute Commercial letters of credit: State and Local Government Counterparty (revenue municipals) Loan commitments: >1 year Standby letters of credit: Performance-related

Factor

Value

Amount

Asset

20% 50%

$300 1,140

$60 570

$0 0

50% 100%

200 100

100 100

0 0

20% 50%

100 3,000

20 1,500

4 300

50% 100% 20%

200 56,400 400

100 56,400 80

20 11,280 16

50%

100

50%

135,400

67,700

33,850

Corporate Customer Counterparty Loan commitments: < 1 year >1 year Standby letters of credit: Performance-related Direct-credit substitute Commercial letters of credit:

20% 50%

3,212,400 3,046,278

642,480 1,523,139

50% 100% 20%

101,543 490,900 78,978

50,772 490,900 15,796

50,772 490,9000 15,796

Sovereign Counterparty Loan commitments, OECD CRC rated 1: < 1 year >1 year

20% 50%

110,500 1,225,400

22,100 612,700

0 0

Sovereign Counterparty Loan commitments, OECD CRC rated 2: < 1 year >1 year

20% 50%

85,000 115,500

17,000 57,750

3,400 11,500

Sovereign Counterparty Loan commitments, OECD CRC rated 7: >1 year.

50%

30,000

15,000

22,500

Interest rate market contracts: (current exposure assumed to be zero.) < 1 year (notional amount) > 1-5 year (notional amount)

0% 0.5%

2,000 5,000

0 25

The risk-weighted asset base under Basel III is:

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e

On-balance-sheet risk-weighted asset base Off-balance-sheet risk-weighted asset base Total risk-weighted asset base

$8,271,599 $2,806,007 $11,077,606

13. Under Basel III: CET1 = 4.5% capital requirement × $11,077,606 = 498,492 Tier I = 6% capital requirement × $11,077,606 = $664,656 Tier II = 8% capital requirement × $11,077,606 = $886,208 Total Risk Based Capital = Tier I + Tier II = $664,656 + $886,208 = $1,550,864 14. The bank has $13,731,769 in total on-balance-sheet assets, $8,693,839 in off-balance sheet lending commitments, and $25 in credit equivalent amounts of derivative securities. The minimum regulatory Tier I capital at 4% is $897,025. 15. CET1 capital = $225,000 + $200,000 + $565,545 = $990,545; Tier I capital = $990,545 + $50,000 = 1,040,545; and total capital = 1,040,545 + $50,000 + $85,000 = $1,175,545. Yes, the bank meets the Basel III standards for adequate capital because CET1 capital is above 4.5% ($990,545/$11,077,606 = 8.94%), Tier I capital is above 6% ($1,040,545/$11,077,606 = 9.39%), and total capital is above 8% ($1,175,545/$11,077,606 = 10.61%). The bank also complies with the well-capitalized: the CET1 capital is above 6.5%, Tier I capital is above 8%, and total capital is above 10%. 16. The bank does have sufficient capital to meet the capital conservation buffer: the CET1 capital is above 7.0%, Tier I capital is above 8.5%, and total capital is above 10.5%.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 14 Questions: 1. A comparison of Table 11-1 with Table 14-1 reveals that unlike banks, savings institutions hold the vast majority of their assets in the form of mortgages and mortgage backed securities. Like banks, the liabilities of savings institutions consist primarily of demand and time deposits. The assets of commercial banks are more diversified than those of savings institutions. Although there is a wide dispersion of sizes for commercial banks, we can see from Figure 11-6 that in 2019 there were 5,177 banks with assets of $18,645.3 billion, giving us an average size of $3,601.6 million. From Tables 14-1 and 14-2, we see there were 659 savings institutions with assets totaling $1,153.8 billion giving us an average of $1,750.9 million. 2. In the mid-1980s, real estate and land prices in Texas and the Southwest collapsed. This was followed by economic downturns in the Northeast and Western states of the United States. Many borrowers with mortgage loans issued by savings institutions in these areas defaulted. In other words, the risks incurred by many of these institutions did not pay off. This risk-taking behavior was accentuated by the policies of the federal insurer of savings associations’ deposits, the FSLIC. It chose not to close capital-depleted, economically insolvent savings institutions (a policy of regulatory forbearance) and to maintain deposit insurance premium assessments independent of the risk taken by the institution. As a result, an alarming number (1,248) of savings institution failures occurred in the 1982–1992 period (peaking at 316 in 1989), alongside a rapid decline in asset growth of the industry. 3. In the 1980s, the large number of savings institution failures depleted the resources of the Federal Savings and Loan Insurance Corporation (FSLIC) to such an extent that by 1989 it was massively insolvent. For example, between 1980 and 1988, 514 savings institutions failed, at an estimated cost of $42.3 billion. Moreover, between 1989 and 1992 an additional 734 savings institutions failed, at a cost of $78 billion. As a result, Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989. This legislation abolished the FSLIC and created a new savings association insurance fund (SAIF) under the management of the FDIC (with the help of a $100 billion infusion of funds by the U.S. government). FIRREA also replaced the Federal Home Loan Bank Board with the Office of Thrift Supervision (OTS) as the main regulator of federally chartered savings institutions. In addition, the act created the Resolution Trust Corporation (RTC) to close and liquidate the most insolvent savings institutions. The FIRREA also strengthened the capital requirements of savings institutions and constrained their non-mortgage-related asset investment powers under a revised qualified thrift lender test, or QTL test. Following FIRREA, Congress further enacted the Federal Deposit Insurance Corporation Improvement Act (FDICIA). The FDICIA of 1991 introduced risk-based deposit insurance premiums (starting in 1993) in an attempt to limit excessive risk taking by savings institution managers. It also introduced a prompt corrective action (PCA) policy, enabling regulators to close thrifts and banks faster.

4. Table 14-1 shows the balance sheet of savings institutions in 2019. On this balance sheet, loans secured by real estate and securities represent 71.9 percent of total assets. In 2019, savings institutions’ loans to individuals totaled 12.3 percent of total assets. Commercial and industrial loans amounted to just 3.8 percent of assets. Small time and savings deposits are still the predominant source of funds, with total deposits accounting for 79.8 percent of total liabilities and net worth. Other borrowed funds include repurchase agreements and direct federal fund borrowings. Finally, net worth is the book value of the equity holders’ capital contribution; it amounted to 10.8 percent in 2019. 5. Savings institutions are regulated by the Office of the Comptroller of the Currency, the FDIC, and state agencies (for state chartered savings institutions). The FDIC-DIF oversees the deposit insurance fund for savings institutions. 6. Mutual organizations are savings institutions in which the depositors are also legally the owners of the institution. 7. Like the commercial banking industry, savings institutions experienced record profits in the mid- to late 1990s as interest rates (and thus the cost of funds to savings institutions) remained low and the U.S. economy (and thus the demand for loans) prospered. The result was an increase in the spread between interest income and interest expense for savings institutions and consequently an increase in net income. In 1999, savings institutions reported $10.7 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e billion in net income and an annualized ROA of 1.00 percent. Only the $10.8 billion of net income reported in 1998 exceeded these results. Asset quality improvements were widespread during 1999, providing the most favorable net operating income that the industry had ever reported. However, the downturn in the U.S. economy resulted in a decline in savings institutions’ profitability in 2000. Specifically, their ROA and ROE ratios fell slightly in 2000 to 0.92 percent and 11.14 percent, respectively, from their 1999 levels. Despite an economic recession, this downturn was short-lived. Both ROA and ROE increased to record levels each year from 2001 through 2003. One reason for this trend was that in the early 2000s, the industry’s net interest margins rose; the cost of funding earning assets declined by 2.70 percent, while the yield on earning assets declined by only 2.35 percent. A flat (and at times even downward sloping) yield curve increased funding costs and contributed to decreased margins in the mid-2000s. In the late 2000s, as the U.S. economy experienced its strongest recession since the Great Depression, savings institutions’ performance deteriorated. For all of 2007, net income was $6.0 billion, down $11.1 billion from 2006. The average ROA for the year was 0.13 percent, the lowest yearly average since 1989. In 2008, net income was $8.6 billion. This was the first negative earnings year since 1991. The ROA for the year was -0.72 percent. However, only 5 savings institutions failed or were assisted during the year. In this group was Washington Mutual the largest savings institution, with over $300 billion in assets. Like commercial banks, as the economy improved in the second half of 2009 through 2013, so did savings institution performance. Savings institutions earned $1.4 billion in net income in the third quarter of 2009, up from -$18.3 million in the second quarter. This trend continued into 2010 as savings institutions earned $8.3 billion for the year, ROA for the industry was 0.65 percent and ROE 5.76 percent up from 0.14 percent and 1.31 percent respectively in 2009. By 2019, the industry ROA was 1.36 percent and ROE was 12.41 percent. Further, only one savings institution failed in 2019. Table 14–2 presents several performance ratios for the industry from 1989 through 2019. 8. Historically, savings institutions have concentrated primarily on residential mortgages. Credit unions have historically focused on consumer loans funded with member deposits. 9. Credit unions (CUs) are nonprofit depository institutions mutually organized and owned by their members (depositors). They were established in the United States in the early 1900s as self-help organizations. The first credit unions were organized in the Northeast, initially in Massachusetts. Members paid an entrance fee and put up funds to purchase at least one deposit share. Members were expected to deposit their savings in the CU, and these funds were lent only to other members. This limit in the customer base of CUs continues today as, unlike commercial banks and savings institutions, CUs are prohibited from serving the general public. Rather, in organizing a credit union, members are required to have a common bond of occupation (e.g., police CUs), association (e.g., universityaffiliated CUs), or cover a well-defined neighborhood, community, or rural district. CUs may, however, have multiple groups with more than one type of membership. Each credit union decides the common bond requirements (i.e., which groups it will serve) with the approval of the appropriate regulator. To join a credit union an individual must then be a member of the approved group(s). The primary objective of credit unions is to satisfy the depository and borrowing needs of their members. CU member deposits (called shares, representing ownership stakes in the CU) are used to provide loans to other members in need of funds. Earnings from these loans are used to pay interest on member deposits. Because credit unions are nonprofit organizations, their earnings are not taxed. This tax-exempt status allows CUs to offer higher rates on deposits and charge lower rates on some types of loans compared to banks and savings institutions, whose earnings are taxable. 10. Credit unions did not suffer the same fate as the savings institutions because their portfolios were much more conservative than those of savings associations and savings banks; they specialize in making short-term consumer loans and tend to hold more government securities and less long-term residential mortgages. Traditionally more than 40 percent of their assets have been in small consumer loans, often for amounts less than $10,000, which are funded mainly by member deposits. This combination of relatively matched credit risk and maturity in the asset and liability portfolios left credit unions less exposed to credit and interest rate risk than commercial banks and savings institutions. CUs’ lending activities are funded mainly by deposits contributed by their over 120.4 million members. Their members usually belong to the credit union because of their association with work or geography, which results in more loyalty and a lower inclination to move to other institutions. Thus, the factors that led to the thrift crisis, higher interest rates and riskier investments, were not experienced by credit unions. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 11. The nation’s credit union system consists of three distinct tiers: the top tier at the national level (U.S. Central Credit Union); the middle tier at the state or regional level (corporate credit unions); and the bottom tier at the local level (credit unions). Corporate credit unions are financial institutions that are cooperatively owned by their member credit unions. As of June 2019, there were 11 corporate credit unions with assets of $23 billion. These 11 corporate credit unions serve their members primarily by investing and lending excess funds (unloaned deposits) that member credit unions place with them. Additional services provided by corporate credit unions include automated settlement, securities safekeeping, data processing, accounting, and payment services. As of June 2019, the share of CUs with corporate credit union capital is over 80 percent. The U.S. Central Credit Union serves as a “corporate’s corporate”—providing investment and liquidity services to corporate credit unions. The Central Credit Union acts as the main provider of liquidity for corporate credit unions. It invests their surplus funds and provides financial services and operational support. 12. As of 2019, 5,236 credit unions had assets of $1.57 trillion. This compares to $192.8 billion in assets in 1988. Individually, credit unions tend to be very small, with an average asset size of $299 million in 2019, compared to $3,601.6 million for banks. The total assets of all credit unions are smaller than the largest U.S. banking organization(s). For example, in 2019, JPMorgan Chase had $2.34 trillion in total assets, Bank of America had $1.85 trillion, Wells Fargo had $1.71 trillion, and Citigroup had $1.45 trillion. The largest U.S. credit union as of 2019 was Navy Federal Credit Union (with total assets of $111.9 billion and over 8.9 million members), followed by State Employees Credit Union (with total assets of $41.3 billion and 2.4 million members) and PenFed Federal Credit Union (with total assets of $24.7 billion and 1.9 million members). 13. CUs concentrate mainly on servicing the financial needs of its members -mainly individual consumers. Given their emphasis on retail or consumer lending, as discussed earlier, 28.5 percent of CU assets are in the form of small consumer loans (compared to 12.3 percent at savings institutions and 9.9 percent at commercial banks) and another 30.7 percent are in the form of 1–4 family home mortgages (compared to 21.9 percent at savings institutions and 13.1 percent at commercial banks). Together, these member loans comprise 59.2 percent of total assets. Because of the common bond requirement on credit union customers, few business or commercial loans are issued by CUs. Credit unions also invest in investment securities (16.8 percent of total assets in 2019 compared to 33.4 percent at savings institutions and 21.4 percent at commercial banks). Table 14–4 shows that 30.3 percent of the investment portfolio has maturity of less than 1 year, and 34.9 percent has maturity of 1 to 3 years. Their investment portfolio composition, along with cash holdings and equivalents (8.5 percent of total assets), allows credit unions ample liquidity to meet their daily cash needs —such as share (deposit) withdrawals. Credit union funding comes mainly from member deposits ((84.2 percent of total funding in 2019 compared to 79.8 percent for savings institutions and 78.0 percent for commercial banks). Figure 14–3 presents the distribution of these deposits in 2019. Regular share accounts (similar to passbook savings accounts at other depository institutions, but so named to designate the deposit holders’ ownership status) accounted for 33.7 percent of all CU deposits, followed by money market deposit accounts (20.8 percent of deposits), certificates of deposit (21.8 percent), and share draft transaction accounts (similar to NOW accounts at other depository institutions—see Chapter 11) (15.8 percent of deposits). Credit unions hold lower levels of equity than other depository institutions. Since CUs are not Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e stockholder owned, this equity is basically the accumulation of past earnings from CU activities that is “owned” collectively by member depositors. As will be discussed in Chapters 20 and 23, this equity protects a CU against losses on its loan portfolio as well as other financial and operating risks. In 2019, CUs' capital-to-assets ratio was 11.4 percent compared to 10.8 percent for savings institutions and 11.3 percent for commercial banks. 14. Like savings institutions, credit unions can be federally or state chartered. As of 2019, 63.7 percent of the 5,236 CUs were federally chartered and subject to National Credit Union Administration (NCUA) regulation, accounting for 51.5 percent of the total membership and 49.9 percent of total assets. The NCUA is an independent federal agency that charters, supervises, examines, and insures the nation’s credit unions. In addition, through its insurance fund (the National Credit Union Share Insurance Fund, or NCUSIF), the NCUA provides deposit insurance guarantees of up to $250,000 for insured state and federal credit unions. Currently, the NCUSIF covers 98 percent of all credit union deposits. The fund’s reserves come entirely from premiums paid by member credit unions. 15. As CUs have expanded in number, size, and services, bankers claim that CUs unfairly compete with small banks that have historically been the major lender in small towns. In 1997, the banking industry filed two lawsuits in its push to narrow the widening membership rules governing credit unions. The first lawsuit challenged an occupationbased credit unions ability to accept members from companies unrelated to the firm that originally sponsored the credit union. In the second lawsuit, the American Bankers Association asked the courts to bar the federal government from allowing occupation-based credit unions to convert to community-based charters. Bankers argued in both lawsuits that such actions, broadening the membership of credit unions along other than occupation-based guidelines, would further exploit an unfair advantage allowed through the credit union tax-exempt status. In February 1998, the Supreme Court sided with banks in its decision that credit unions could no longer accept members that were not a part of the common bond of membership. In April 1998, however, the U.S. House of Representatives overwhelmingly passed a bill that allowed all existing members to keep their credit union accounts. The bill was passed by the Senate in July 1998 and signed into law in August 1998. The final legislation not only allowed CUs to keep their existing members but it allowed CUs to accept new groups of members=including small businesses and low income communities that had been locked out by the Supreme Court ruling. Credit unions provide a public service by offering loans to those who might not otherwise have access to credit through commercial banks and savings institutions: low- and moderate-income individuals within a specific group— the credit union’s common bond. Further, credit union profits are distributed back to members in the form of better rates on deposits and loans as well as lower and fewer fees on services. It is these services that have justified credit unions’ tax exempt status. However, throughout the 2000s, many credit unions pursued regional charters and expanded their fields of membership. The result has been a blurring of credit unions’ common bond membership. Consequently, credit unions have become more like banks, but with tax exempt status. As credit unions have grown in size some are again questioning their protected status. Indeed, a recent report from the President's Economic Recovery Advisory Board included ending the credit union tax exemption on a list of recommendations addressing the nation's budget deficit. Yet, despite the renewed discussion, credit unions continue to operate as nonprofit, tax exempt depository institutions. 16. In another hit to commercial banks, credit unions saw record increases in membership in late 2011 and early 2012, most of the increase coming from commercial bank customers. For the year ending June 30, 2012 credit union membership increased by nearly 2.2 million new members: almost twice the 1.2 million average annual growth experienced in similar 12-month periods over the previous 10 years and four times greater than the 550,000 new members over that same period the prior year. Much of the growth in membership occurred as a part nationwide campaigns, such as Bank Transfer Day on November 5, 2011, that encouraged consumers to leave their “big” banks for credit unions and community banks, which tend to incur fewer fees. Among the catalysts for these campaigns was Bank of America's plan to impose a monthly fee for debit card use. The plan was scrapped after seeing the strong negative reactions from consumers. 17. Like other depository institutions, local credit unions have grown in asset size in the 1990s and 2000s. Asset growth from 1999 to 2016 was more than 5.4 percent. In addition, CU membership increased from 77.5 million to 107.6 million over the 1999-2016 period. Asset growth was especially pronounced among the largest CUs (with assets of over $100 million) as their assets increased by almost 20 percent annually from 1999 through 2016. Figure 14-8 shows the trend in ROA for CUs from 1993 through 2016. ROA for the industry was 0.75 in the first six Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e months of 2016. Larger CUs generally outperform small CUs. For example, the largest credit unions experienced an ROA of 0.88 percent in 2016, while ROA for the smallest CUs was 0.09 percent. Smaller CUs generally have a smaller and less diversified customer base and have higher overhead expenses per dollar of assets. Thus, their ROAs have been hurt. Given the mutual-ownership status of this industry, however, growth in ROA (or profits) is not necessarily the primary goal of CUs. Rather, as long as capital or equity levels are sufficient to protect a CU against unexpected losses on its credit portfolio as well as other financial and operational risks, this not-for-profit industry has a primary goal of serving the deposit and lending needs of its members. This contrasts with the emphasis placed on profitability by stockholder-owned commercial banks and savings institutions. 18. While local credit unions as a whole survived the financial crisis more profitably than commercial banks and savings institutions, corporate credit unions did not. As mentioned earlier, corporate credit unions serve their members by investing and lending excess funds that member credit unions place with them. Like commercial banks, in the early and mid-2000s, corporate credit unions faced increasingly tough business conditions that strained their financial position. To generate earnings, some corporate credit unions invested in riskier investments, such as mortgage-related and asset-backed securities. The National Credit Union Administration (NCUA) allowed corporate credit unions to invest in these higher risk securities. As the financial crisis hit, corporate credit unions that invested in higher risk securities started experiencing large losses on them. These corporate credit unions reported $18 billion in unrealized losses on securities, as of November 2008. As information about the financial conditions of these corporate credit unions became public, local credit unions reduced their exposure to the corporates. Between March 31, 2008 and September 30, 2008, local credit unions deposits in corporate credit unions fell by nearly 49 percent from $44.7 billion to $22.9 billion. In addition to the resulting demand for funds this withdrawal of deposits produced, these corporate credit unions had accumulated $50 billion in toxic mortgage-backed securities. The corporate credit union system started to collapse. Without action, losses on these problem assets would have caused the entire credit union industry to breakdown. To start resolving the crisis, in March 2009 the NCUA placed two corporates, U.S. Central and WesCorp, into conservatorship. Further, the NCUA purchased many of the toxic assets of the corporates. As of the third quarter 2010, the NCUA held roughly 70 percent of the assets of the corporate credit union system, which included $50 billion in toxic assets. The NCUA also took several actions to address long term issues surrounding corporate credit unions. Capital standards were increased and minimum retained earnings levels were established. Further, prompt corrective action requirements were increased. Investments in private label residential mortgage backed securities and subordinated securities were prohibited and concentration limits were set on investments. Ultimately, five of the largest corporate credit unions (Constitution Corporate, Members of United Corporate, Western Corporate, Southwest Corporate, and U.S. Central Corporate) in the United States were declared insolvent. 19. The three types of finance companies are (1) sales finance institutions, (2) personal credit institutions, and (3) business credit institutions. Finance companies differ from commercial banks in that they rely on short- and longterm borrowings, such as commercial paper and bonds, instead of deposits. Their assets consist mainly of business and consumer loans, usually short term. They are less regulated and as a result also tend to hold more equity to assets to signal their solvency because they are heavy borrowers in the credit markets. 20. A comparison of Table 14-5 with Table 11-1 shows that finance companies hold relatively more equity, 17.1 percent for finance companies and 11.3 percent for commercial banks. The difference is most likely attributable to the debt of commercial banks being insured, usually by the FDIC. This insurance makes the debt safer from the depositors' and stockholders' perspective. This allows the commercial bank to take on more debt than the uninsured finance company. Since finance companies are heavy borrowers in the capital markets and do not enjoy the same regulatory “safety net” as banks, they need to signal their safety and solvency to investors. Such signals are usually sent by holding much higher equity or capital-to-assets ratios—and therefore, lower leverage ratios—than banks. 21. Business and consumer loans (called accounts receivable) are major assets held by finance companies; in 2019 they represented 79.2 percent of total assets. In 2019 consumer loans constituted 59.3 percent of all finance company loans, mortgages represented 9.5 percent, and business loans comprised 31.2 percent. On the liability side Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e of the balance sheet, in 2019, bank loans amounted to $153.6 billion (10.2 percent of total assets), commercial paper was $62.8 billion (4.2 percent of total assets), and other debt (due to parents and notes, bonds, and debentures) totaled $1,030.1 billion (68.5 percent of total assets). Total capital comprised $257.0 billion (17.1 percent of total assets). 22. According to Table 14-7, consumer finance areas, especially motor vehicle loans, have been the fastest growing areas of business for finance companies. 23. Finance companies generally charge higher rates for consumer loans because they generally attract riskier customers than commercial banks. In fact, customers that seek individual loans from finance companies are often those who have been refused loans at banks or thrifts. Because new car sales by U.S. firms in 1997 through 1999 were lower than normal, finance companies owned by the major auto manufacturers slashed the interest rates charged on new car loans (some as low as 0.9 percent) over this period. Moreover, after the terrorist attacks in September 2001 the major auto manufacturers lowered new car rates to 0.0 percent in an attempt to boost sales. Some of these 0.0 percent rates continued to be offered into 2005 as the general level of interest rates remained low. The 2008–2009 financial crisis saw a resurrection of 0.0 percent car loan rates as auto manufacturers tried to boost slumping car sales. Notice that the difference between new car loans at commercial banks and finance companies continued to widen throughout the early 2000s. By 2003 finance companies were charging more than 3.53 percent less on new car loans than commercial banks, mainly due to the zero interest rates offered by the major auto manufacturers’ captive finance company loans to new car buyers. It was not until 2013 that the historical trend returned as finance companies charged an average rate on new car loans that was 0.24 percent higher than commercial banks. 24. Finance companies have several advantages over commercial banks in offering loan services to small-business customers. First, finance companies are not subject to regulations that restrict the types of products and services they can offer. Second, because finance companies do not accept deposits, they have no regulators monitoring their behavior. Third, since they are often subsidiaries of industrial companies, they are likely to have substantial industry and product expertise. Fourth, they are more willing to take on risky customers. Finally, finance companies have lower overhead than banks. 25. Because finance companies do not accept deposits, they are not subject to extensive oversight by federal and state regulators, as are banks or thrifts—even though they offer services that compete directly with those of depository institutions (e.g., consumer installment loans and mortgages). The lack of regulatory oversight for these companies enables them to offer a wide scope of “bank-like” services and yet avoid the expense of regulatory compliance and the same “net regulatory burden” imposed on banks and thrifts. 26. Residential and commercial mortgages have become a major component in finance companies’ asset portfolios, although they did not generally offer mortgages prior to 1979. Finance companies, which are not subject to as extensive a set of regulations as are banks, are often willing to issue mortgages to riskier borrowers than commercial banks. They compensate for the additional risk by charging higher interest rates. Mortgages include all loans secured by liens on any type of real estate. The mortgages in the loan portfolio can be first mortgages or second mortgages in the form of home equity loans. Home equity loans allow customers to borrow on a line of credit secured with a second mortgage on their home. Home equity loans have become very profitable for finance companies since the Tax Reform Act of 1986 was passed, disallowing the tax deductibility of consumers’ interest payments other than those made on home mortgages. Also, the bad debt expense and administrative costs of home equity loans are lower than on other finance company loans, and as a result they have become a very attractive product to finance companies. 27. Wholesale loans are loan agreements between parties other than the companies’ consumers. For example, Ford Motor Credit Company (FMCC) provides wholesale financing to Ford Motor Company dealers for inventory floor plans in which FMCC pays for Ford dealers’ auto inventories received from Ford. FMCC puts a lien on each car on the showroom floor. While the dealer pays periodic interest on the floor plan loan, it is not until the car is sold that the dealer pays for the car. A wholesale loan is a loan to a company used to finance business with its suppliers as opposed to a retail loan that finances a transaction between a company and a consumer.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 28. Since finance companies are heavy borrowers in the capital markets and do not enjoy the same regulatory “safety net” as banks, they need to signal their safety and solvency to investors. Such signals are usually sent by holding much higher equity or capital-to-assets ratios—and therefore, lower debt-to-asset ratios—than banks. For example, the 2013 aggregate balance sheet for finance companies shows a capital-assets ratio of 13.7 percent. This compares to the capital-to-assets ratio of 11.3 percent for commercial banks. A low debt-to-assets ratio for a finance company would likely be interpreted as a signal of safety and ability to borrow more money if needed. As such it is a positive signal.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 15 Questions: 1. The primary function of a life insurance company is to protect policyholders from adverse events. Insurance companies accept premium payments in exchange for compensation in the event that certain pre-specified, but undesirable, events occur. The primary function of depository institutions is to provide financial intermediation for individual and corporate savers. By accepting deposits and making loans, depository institutions allow savers with predominantly small, short-term financial assets to benefit from investments in larger, longer-term assets. These long-term assets typically yield a higher rate of return than short-term assets. 2. Adverse selection is the problem that customers who apply for insurance policies are more likely to be those most in need of insurance (i.e., someone with chronic health problems is more likely to purchase a life insurance policy than someone in perfect health). Thus, in calculating the probability of having to pay out on an insurance contract and, in turn, determining the insurance premium to charge, insurance companies’ use of health (and other) statistics representing the overall population may not be appropriate (since the insurance company’s pool of customers is likely to be more prone to health problems than the overall population). Insurance companies deal with the adverse selection problem by establishing different pools of the population based on health and related characteristics (such as income). By altering the pool used to determine the probability of losses to a particular customer’s health characteristics, the insurance company can more accurately determine the probability of having to pay out on a policy and can adjust the insurance premium accordingly. 3. Life insurance companies have long-term liabilities because of the life insurance products that they sell. As a result, the asset side of the balance sheet predominantly includes long-term government and corporate bonds, corporate equities, and a declining amount of mortgage products. The asset side of a depository institution’s balance sheet is comprised primarily of short- and medium-term loans to corporations and individuals and some liquid investment securities (e.g., Treasury securities). A major similarity between depository institutions and insurance firms is the high degree of financial leverage incurred by both groups of firms. Both groups solicit funds (from policyholders or depositors) and use them to finance an asset portfolio predominately consisting of debt securities. A major difference between them is their composition of the liabilities, which is fixed for depository institutions but stochastic for insurance firms. While the face value of bank deposits is fixed, the insurance company's net policy reserves depend on expected future required payouts which can be highly uncertain. The other difference is that insurance companies are allowed to invest in equity instruments, which currently are prohibited for depository institutions. 4. We can see in Table 15-2 that since the 1920s and 30s, life insurance companies have increased their holdings of bonds and stocks and decreased their holdings of mortgage loans and policy loans. Government securities comprise the next largest component and have recently increased back to their earlier levels after reaching very low levels in the 60s and 70s. The need for a more certain stream of cash flows to pay off policies is a major reason for the investment in bonds. The bull market of the 1990s is a major reason for the large percentage of assets invested in equities. The large drop in equity prices during the 2008–2009 financial crisis explains the reduction in the percentage of stocks held by insurance companies in the late 2000s. However, as the U.S. economy strengthened after the crisis, the percentage of stocks held rose closer to precrisis levels. 5. The four basic lines of life insurance products are: (1) ordinary life, (2) group life, (3) credit life, and (4) other activities. Ordinary life is sold on an individual basis and represents the largest segment (53.6% in 2018) of the life insurance market. The insurance policy can be structured as pure life insurance (term life) or may contain a savings component (whole life or universal life). Group policies (45.6%) are similar to ordinary life insurance policies except that they are centrally administered, providing cost economies in evaluating, screening, selling, and servicing the policies. Credit life (<1%) typically is term life sold in conjunction with some debt contract. Their cost per unit of coverage is usually much higher than other methods of covering these liabilities in the event of unexpected death. Thus, they are a rarely used type of life insurance. Other major activities of life insurance companies are the sale of annuities, private pension plans, and accident and health insurance. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 6. Annuities represent the reverse of life insurance principles. While life insurance involves different contractual methods to build up a fund and the eventual payout of a lump sum to the beneficiary, annuities involve different methods of liquidating a fund over a long period of time, such as paying out a fund’s proceeds to the beneficiary. The contract may be initiated by investing a lump sum or by making periodic payments before the annuity payments begin. 7. Life insurance and annuity products can be used to create a steady stream of cash disbursements and payments to avoid paying or receiving a single-lump sum cash amount. That is, a life insurance policy (whole life or universal life) requires regular premium payments that entitle the beneficiary to the receipt of a single lump sum payment. Upon receipt of such a lump sum, a single annuity could be obtained which would generate regular cash payments until the value of the insurance policy is depleted. 8. The primary change in the balance sheet of a life insurance company would be an increase in the liability accounts that reflect these pension plans. Guaranteed investment contracts (GICs) and separate account categories likely would increase, depending on the type of pension plans provided to the customers. The premiums and contributions would be invested in the normal asset categories of the insurance company, except in cases where the pension fund requires aggressive investment strategies. In this case, the funds may be invested in specific equity mutual funds. 9. An important piece of legislation affecting the regulation of life insurance companies is the McCarran–Ferguson Act of 1945, which confirms the primacy of state over federal regulation of insurance companies. Thus, unlike the depository institutions, which can be chartered at either the federal or state levels, a life insurer is chartered entirely at the state level. In addition to chartering, state insurance commissions supervise and examine insurance companies using a coordinated examination system developed by the National Association of Insurance Commissioners (NAIC). Regulations cover areas such as insurance premiums, insurer licensing, sales practices, commission charges, and the types of assets in which insurers may invest. While both banks and insurance companies receive regulatory scrutiny as to the quality of their assets and liabilities, bank regulations also dictate minimum reserve and capital requirements. Banks have more geographic restrictions. In 2009, the U.S. Congress considered establishing an optional federal insurance charter. The move behind such a charter picked up steam following the failure of the existing state by state regulatory system to act in preventing the problems at insurance giant AIG from becoming a systemic risk to the national economy. Those in favor of an optional federal insurance charter noted that under the current state by state system, insurers face obstacles such as inconsistent regulations, barriers to innovation, conflicting agent licensing, and education requirements. The Wall Street Reform and Consumer Protection Act of 2010 established the Federal Insurance Office (FIO), an entity that reports to Congress and the President on the insurance industry. While the industry continues to be regulated by the states, the FIO has the authority to monitor the insurance industry, identify regulatory gaps or systemic risk, deal with international insurance matters and monitor the extent to which underserved communities have access to affordable insurance products. The Wall Street Reform and Consumer Protection Act also called for the establishment of the Financial Stability Oversight Council (FSOC), which is charged with designating any financial institution (including insurance companies) that presents a systemic risk to the economy and subjecting them to greater regulation. Also the result of the Wall Street Reform and Consumer Protection Act, the Federal Reserve has become a major supervisor of insurance firms. The Fed extended much of its authority over the insurance industry through the designation of three of the largest insurers (American International Group, Prudential Financial, and MetLife) as “systemically important financial institutions.” However, with the closure of the Office of Thrift Supervision in 2011, the Fed also supervises 14 insurance companies that own savings institutions. In total, the Fed supervises about one-third of U.S. insurance industry assets. This increased oversight by the Fed has incited concern among insurance companies and state regulators that the Fed will enact onerous capital rules and supervise insurance firms like banks. Promoting the concerns are cases like that of MetLife that failed the Fed’s “stress tests” in 2012 despite the firm’s protests the Fed misunderstood its business model. In 2015, MetLife sued the U.S. to overturn its designation as a non-bank systemically important financial institution. The insurer argued that its failure would not pose a risk to the financial system. MetLife further argued that, because it is harder for a customer to pull money from an insurance contract than it is for a depositor to withdraw money from a bank deposit account during a crisis, Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e the insurance industry is safer than banking. Not counting on the courts to agree, in 2016 MetLife announced that it would divest a large piece of its life insurance unit: a unit that had been the core of the company’s business for decades. However, shortly after this, a federal judge ruled that MetLife did not deserve to be labeled too big to fail and as such was allowed to shed its designation as a systemically important financial institution and the increased regulatory oversight that went along with that designation. 10. Unlike banks and thrifts, life insurers have no access to a federal guarantee fund (although, as mentioned above, during the financial crisis the federal government took the unprecedented step of bailing out several major insurance companies). These state guarantee funds differ in a number of important ways from deposit insurance. First, although these programs are sponsored by state insurance regulators, they are actually run and administered by the private insurance companies themselves. Second, unlike the Depositors Insurance Fund (DIF), in which the FDIC has established a permanent reserve fund by requiring banks to pay annual premiums in excess of payouts to resolve failures, no such permanent guarantee fund exists for the insurance industry—with the sole exception of the property–casualty and life guarantee funds in the state of New York. This means that contributions are paid into the guarantee fund by surviving firms in a state only after an insurance company has actually failed. Third, the size of the required contributions that surviving insurers make to protect policyholders in failed insurance companies differs widely from state to state. In those states that have guarantee funds, each surviving insurer is normally levied a pro rata amount, according to the size of its statewide premium income. This amount either helps pay off small policyholders after the assets of the failed insurer have been liquidated or acts as a cash injection to make the acquisition of a failed insurer attractive. The definition of small policyholders varies among states, ranging from $100,000 to $500,000. Finally, because no permanent fund exists and the annual pro rata payments to meet payouts to failed insurer policyholders are often legally capped, a delay usually occurs before small policyholders receive the cash surrender values of their policies or other payment obligations from the guarantee fund. This contrasts with deposit insurance, which normally provides insured depositors immediate coverage of their claims up to $250,000. 11. Insurance companies earn profits by taking in more premium income than they pay out in policy payments. Firms can increase their spread between premium income and policy payouts in two ways. The first way is to decrease future required payouts for any given level of premium payments. This can be accomplished by reducing the risk of the insured pool (provided the policyholders do not demand premium rebates that fully reflect lower expected future payouts). The second way is to increase the profitability of interest income on net policy reserves. Since insurance liabilities typically are long term, the insurance company has long periods of time to invest premium payments in interest earning asset portfolios. The higher is the yield on the insurance company's investments, the greater is the difference between the premium income stream and the policy payouts (except in the case of variable life insurance) and the greater is the insurance company's profitability. 12. The two major lines of property-casualty insurance are property insurance (insurance coverage related to the loss of real and personal property) and casualty—or perhaps more accurately, liability (insurance coverage that offers protection against legal liability exposures). In many cases, property and liability insurances are sold together, such as personal or commercial multiple peril and auto insurance. Fire and allied lines usually are sold as property insurance only. Liability insurance is sold separately for coverages such as malpractice or product liability hazards. In addition, reinsurance provides a means for primary insurers to pool their risk by transferring some of the risk and premium to a reinsurer. 13. Product lines based on net premiums typically are included in the property-casualty insurance arena. The largest decreases have been in the fire and allied categories, while the multiple peril (or umbrella) and liability policies have shown the largest increases. The changes are related in that much of the decreased coverage has been subsumed into the multiple peril policies. 14. The three sources of underwriting risk in the PC industry are: (a) unexpected increases in loss rates, (b) unexpected increases in expenses, and (c) unexpected decreases in investment yields. Loss rates are influenced by whether the product lines are property or liability (with the latter being less predictable), whether they are lowseverity high- frequency lines or high-severity low-frequency lines (with the latter being more difficult to estimate), and whether they are long-tail or short-tail lines (with the former being more difficult to estimate). Loss rates also are affected by product inflation and social inflation. Unexpected increases in expenses are a result of increases in commission costs to brokers, general expenses, taxes and other expenses related to acquisitions. Finally, investment Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e yields depend on the stock and bond markets as well as on the asset allocations of the portfolios. 15. The four characteristics or features of the perils insured against by property-casualty insurance, ranked by the features in terms of actuarial predictability and total loss potential are:  Property versus liability: In general, maximum levels of losses are more predictable for property lines than for liability lines.  Severity versus frequency: In general, loss rates are more predictable on low-severity, high-frequency lines than they are on high-severity, low-frequency lines.  Long Tail versus Short Tail: Some liability lines suffer from a long-tail risk exposure phenomenon that makes estimation of expected losses difficult. This long-tail loss arises in policies for which the insured event occurs during a coverage period but a claim is not filed or made until many years later. The delay in the filing of a claim is in accordance with the terms of the insurance contract and often occurs because the detrimental consequences of the event are not known for a period of time after the event actually occurs.  Product Inflation versus Social Inflation: Loss rates on all P&C property policies are adversely affected by unexpected increases in inflation. The inflation risk of property lines is likely to reflect the underlying inflation of the economy, while the inflation risk of liability lines may be subject to the changing values or social risk of the society. Liability lines, however, may be subject to social inflation, as reflected by juries’ willingness to award punitive and other damages at rates far above the underlying rate of inflation. Such social inflation has been particularly prevalent in commercial liability and medical malpractice insurance and has been directly attributed by some analysts to faults in the U.S. civil litigation system. 16. Loss rates on all P&C property policies are adversely affected by unexpected increases in inflation. Inflation generally has an adverse effect on the cost of providing benefits that have been purchased by the insured, particularly if the policy is written in terms of the replacement cost of the asset and the premiums are not adjusted for inflation. In addition, the investment value of bonds and other fixed-rate assets of insurers from which claims proceeds are derived may decrease in value from unexpected inflation. Such increases were triggered, for example, by the oil price shocks of 1973, 1978, and 2008. However, in addition to a systematic unexpected inflation risk in each line, line-specific inflation risks may also exist. The inflation risk of property lines is likely to reflect the approximate underlying inflation risk of the economy. 17. a. In general, loss rates are more predictable on low severity, high-frequency lines than on high-severity, lowfrequency lines. For example, losses in fire, auto, and homeowners peril lines tend to be expected to occur with high frequency and to be independently distributed across any pool of insured customers. Thus, only a limited number of customers are affected by any single event. Furthermore, the dollar loss of each event in the insured pool tends to be relatively small. Applying the law of large numbers, the expected loss potential of such lines—the frequency of loss times the extent of the damage (severity of loss)—may be estimable within quite small probability bounds. Other lines, such as earthquake, hurricane, and financial guarantee insurance, tend to insure very low-probability (frequency) events. Here, many policyholders in the insured pool are affected by any single event (i.e., their risks are correlated) and the severity of the loss could be potentially enormous. This means that estimating expected loss rates (frequency times severity) is extremely difficult in these coverage areas. As a result, premiums for high-severity low-frequency lines will be charged higher premiums than low-severity high-frequency lines. b. Some liability lines suffer from a long-tail risk exposure phenomenon that makes estimation of expected losses difficult. This long-tail loss arises in policies for which the insured event occurs during a coverage period but a claim is not filed or made until many years later. The delay in the filing of a claim is in accordance with the terms of the insurance contract and often occurs because the detrimental consequences of the event are not known for a period of time after the event actually occurs. Losses incurred but not reported have caused insurers significant problems in lines such as medical malpractice and other liability insurance where product damage suits. Because long-tail lines of businesses are harder to predict than short-tail lines because, premiums in this category of business will be higher. 18. The balance sheet of a P&C company is similar to that of a life insurance company. Long-term financial assets such as bonds, common equities, and preferred stock comprise the majority of the assets, while loss reserves, loss adjustment expenses, and unearned premiums dominate the liabilities. In contrast, short- and medium-term financial assets dominate the asset side of the balance sheets of most banks and borrowed funds in the form of deposits are the primary liability for commercial banks. Whereas banks provide time and size intermediation for depositors, PC Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e insurance companies use premium payments to provide assurance against certain types of risk for customers. For a bank the deposits represent borrowed funds, while the premiums to an insurance company represent the actual price for the risk coverage. 19. The loss ratio measures the actual losses incurred on a line of insurance relative to the premiums earned on the line. A ratio greater than 100 implies that the premiums earned did not cover the losses on the product line. The loss ratio has increased from the 60 percent range in the early 1950s to the 70 and 80 percent range in the 1990s into the early 2010s. A turnaround started in 2013, as the loss ratio dropped to 67.4 and values stayed below 70 through 2015 when the loss ratio was 69.8. In 2017 and 2018, the loss ratio was 76.2 and 71.4, respectively. 20. The expense ratio measures the expenses incurred relative to premiums written. The two major sources of expense risk to P&C insurers are (1) loss adjustment expenses (LAE) and (2) commissions and other expenses. LAE relate to the costs surrounding the loss settlement process. For example, many P&C insurers employ adjusters who determine the liability of an insurer and the size of an adjustment or settlement to make. The other major area of expense involves the commission costs paid to insurance brokers and sales agents and other operating expenses related to the acquisition of business. The expense ratio includes the commission and other expenses for P&C. In contrast to the increasing trend in the loss ratio, the expense ratio decreased over recent years. Despite this trend, expenses continued to account for a significant portion of the overall costs of operations. In 2018, for example, commission and other expenses amounted to 27.2 percent of premiums written. Clearly, sharp rises in commissions and other operating costs can rapidly render an insurance line unprofitable. 21. The combined ratio is equal to the loss ratio plus the expense ratio. It is a measure of the overall underwriting profitability of a line, which includes the loss, loss adjustment expenses, and expense ratios, is the combined ratio. Technically, the combined ratio is equal to the loss ratio plus the ratios of LAE to premiums written and commissions and other expenses to premiums written. The combined ratio after dividends adds dividends paid to policyholders as a portion of premiums earned to the combined ratio. If the combined ratio is less than 100 percent, premiums alone are sufficient to cover both losses and expenses related to the line. 22. In cases where the combined ratio is greater than 100, overall profitability can be ensured only by a sufficient investment return on premiums earned. That is, P&C firms invest premiums in assets between the time they receive the premiums and the time they make payments to meet claims. Since the 1980s, the combined ratio consistently has been greater than 100. For example, in 2016, net investment income to premiums earned (or the P&C insurers’ investment yield) was 8.5 percent. As a result, the overall average profitability (or operating ratio = combined ratio after dividends minus investment yield) of P&C insurers was 91.5 percent. It was equal to the combined ratio after dividends (100.0) minus the investment yield (8.5). Since the operating ratio was less than 100 percent, P&C insurers were profitable overall in 2016. Net returns on investments can have a big impact on industry profitability. For example, in 2012 P&C insurers’ investment yield was 10.5 percent. As a result, the operating ratio of P&C insurers was 92.7 (the combined ratio after dividends (103.2) minus the investment yield (10.5)). While the combined ratio after dividends corresponds to net losses, the high investment yield resulted in an operating ratio that was less than 100. That is, P&C insurers were profitable in 2012. However, lower net returns on investments (e.g., 2.8 percent rather than 10.5 percent) would have meant that underwriting P&C insurance was marginally unprofitable (i.e., the operating ratio of insurers in this case would have been 100.4).

Problems: 1. a. The required payment is the present value of $200,000 per year for 20 years at 10 percent. 200,000{[1 - (1/(1 + 0.10)20)]/0.10} = $1,702,712.74 or using a financial calculator, N = 20, I = 10, PMT = 200,000, then compute PV = $1,702,712.74 b. The annual cash flows are given by X: $1,000,000= X{[1 - (1/(1 + 0.10)20)]/0.10} => X = $1,000,000/(8.51356372) = $117,459.62 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Solving for X, annual cash flows X = $117,459.62. or using a financial calculator, N = 20, I = 10, FV = 1,000,000, then compute PMT = $117,459.62 c. In this case, the first annuity is to be received five years from today. The initial sum today will have to be compounded by five periods to estimate the annuities: $1,000,000(1 + 0.10)5 = X{[1 - (1/(1 + 0.10)20)]/0.10} Solving for X, annual cash flows, X = $189,169.90 or using a financial calculator, N = 20, I = 10, PV = 1,000,000(1 + 0.10)5, then compute PMT = $189,169.90 2. a. The required payment is the present value of $240,000 per year for 20 years at 7 percent. 240,000{[1 - (1/(1 + 0.07)20)]/0.07} = $2,542,563.42 or using a financial calculator, N = 20, I = 7, PMT = 240,000, then compute PV = $2,542,563.42 b. The annual cash flows are given by X: $2,500,000= X{[1 - (1/(1 + 0.07)20)]/0.07} => X = $2,500,000/(10.59401425) = $235,982.31 Solving for X, annual cash flows X = $235,982.31. or using a financial calculator, N = 20, I = 7, FV = 2,500,000, then compute PMT = $235,982.31 c. In this case, the first annuity is to be received six years from today. The initial sum today will have to be compounded by five periods to estimate the annuities: $2,500,000(1 + 0.07)6 = X{[1 - (1/(1 + 0.07)20)]/0.07} Solving for X, annual cash flows, X = $354,145.82 or using a financial calculator, N = 20, I = 7, PV = 2,500,000(1 + 0.07)6, then compute PMT = $354,145.82 3. The value of $10,000 deposited annually in a fund will amount to the following in ten years: FV = 10,000{[(1 + 0.08)10 -1]/0.08} = $144,865.62 or using a financial calculator, N = 10, I = 8, PMT = 10,000, then compute FV = $144,865.62 The annuities per year over the next twenty years at 8% will be: $144,865.62 = X{[1 - (1/(1 + 0.08)20)]/0.08} Solving for X, annual cash flows, X = $14,754.88 or using a financial calculator, N = 20, I = 8, PV = 144,865.62, then compute PMT = $14,754.88 4. a. FV = $10,000{[(1 + 0.08)10 -1]/0.08}(1 + 0.08) = $10,000 (14.48656247)(1 + 0.06) = $156,454.87 or using a financial calculator, N = 10, I = 8, PMT = 10,000, BEG mode, then compute FV = $156,454.87

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e b. In this case, the first annuity is to be received ten years from today. The amount of retirement funds at the end of year ten (the answer to part (a) of $156,454.87) will be paid out over twenty years with the first payment to be $156,454.87 = X{[1 - (1/(1 + 0.08)20)]/0.08}(1.08) => X = $14,754.88 or using a financial calculator, N = 20, I = 8, PV = $156,454.87, BEG mode, then compute PMT = $14,754,88 c.

Deposit Period 7 percent

Value at 10 Years $147,835.99

Distribution Period 7 percent 9 percent

Annual Payment $13,041.75 $14,857.72

9 percent

$165,602.93

7 percent 9 percent

$14,609.11 $16,643.32

5. a. FV = $12,000{[(1 + 0.07)30 -1]/0.07}(1 + 0.07) = $1,212,876.50 or using a financial calculator, N = 30, I = 7, PMT = 12,000, BEG mode, then compute FV = $1,212,876.50 b. In this case, the first annuity is to be received 30 years from today. The amount of retirement funds at the end of year ten (the answer to part (a) of $1,212,876.50) will be paid out over twenty years with the first payment to be $1,212,876.50 = X{[1 - (1/(1 + 0.07)20)]/0.07}(1.07) => X = $106,997.16 or using a financial calculator, N = 20, I = 7, PV = $1,212,876.50, BEG mode, then compute PMT = $106,997.16 c.

Deposit Period 6 percent

Value at 30 Years $1,005,620.13

Distribution Period 6 percent 8 percent

Annual Payment $82,711.84 $94,837.62

8 percent

$1,468,150.42

6 percent 8 percent

$120,754.76 $138,457.74

6. a. 20,000{[1 - (1/(1 + 0.06)15)]/0.06} = $194,244.98 or using a financial calculator, N = 15, I = 6, PMT = 20,000, then compute PV = $194,244.98 b. 20,000{[1 - (1/(1 + 0.06)20)]/0.06} = $229,398.42 or using a financial calculator, N = 20, I = 6, PMT = 20,000, then compute PV = $229,398.42 c. For 15 years, the lump sum is $194,244.98 × (1.06) = $205,899.68. For 20 years, the lump sum is $229,398.42 × (1.06) = $243,162.33. 7. a. 15,000{[1 - (1/(1 + 0.05)20)]/0.05} = $186,933.16 or using a financial calculator, N = 20, I = 5, PMT = 15,000, then compute PV = $186,933.16 b. 15,000{[1 - (1/(1 + 0.05)30)]/0.05} = $230,586.77 or using a financial calculator, N = 30, I = 5, PMT = 15,000, then compute PV = $230,586.77 c. For 20 years, the lump sum is $186,933.16 × (1.05) = $196,279.81. For 30 years, the lump sum is $230,586.77 × (1.05) = $242,116.10. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 8. a. No, because the combined ratio is 73% + 12.5% + 18% = 103.5%. b. Yes, because the combined ratio adjusted for investment yield is 103.5% - 8% = 95.5%. 9. Combined ratio = 77.5% + 23.9% + 5.0% = 106.40%. In order to be profitable, the yields on investments have to be greater than 6.4%. 10. Combined ratio = 64.8% + 25.6% + 6.0% = 96.4%. The combined ratio is less than 100%. Thus, the operating ratio will be positive as long at the investment ratio is greater than negative 3.6%. 11. Pure loss = $3.6 million - $1.96 million = $1.64 million Expenses = 0.066 × $3,600,000 = $237,600 Dividends = 0.012 × $3,600,000 = $43,200 Investment returns = $170,000 Net profits = $1,640,000 - $237,600 - $43,200 + $170,000 = $1,529,200 12. Pure loss = $12.75 million - $9.18 million = $3,570,000 Expenses = 0.201 × $12,750,000 = $2,562,750 Dividends = 0.05 × $12,750,000 = $637,500 Investment returns = $1,420,000 Net profits = $3,570,000 – $2,562,750 - $637,500 + $1,420,000 = $1,789,750 13. Loss ratio = $4,343,750/$6,250,000 = 69.5% Expense ratio = $1,593,750/$6,250,000 = 25.5% Dividend ratio = $156,250/$6,250,000 = 2.5% Combined ratio = 69.5% + 25.5% + 2.5% = 97.5% Investment ratio = $218,750/$6,250,000 = 3.5% Operating ratio = 97.5% - 3.5% = 94.0% Overall profitability = 100.0% - 94.0% = 6.0% 14. Loss ratio = $3,962,700/$5,550,000 = 71.4% Expense ratio = $1,526,250/$5,550,000 = 27.5% Dividend ratio = $333,000/$5,550,000 = 6.0% Combined ratio = 71.4% + 27.5% + 6.0% = 104.9% Investment ratio = $349,650/$5,550,000 = 6.3% Operating ratio = 104.9% - 6.3% = 98.6% Overall profitability = 100.0% - 98.6% = 1.4%

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 16 Questions: 1. As with all intermediaries, these firms bring together those who may need extra money with those who wish to invest their money. This may take the form of an investment banker underwriting an IPO for a growing company or a brokerage firm finding good investment for a client. 2. Beginning in 1980 and until the stock market crash of October 19, 1987, the number of firms in the industry expanded dramatically from 5,248 in 1980 to 9,515 in 1987. The aftermath of the crash included a major shakeout, with the number of firms declining to 6,016 by 2006. Concentration of business among the largest firms over this period increased dramatically. Some of the significant growth in size came through M&A by the top-ranked firms. Indeed, most of the mergers in the industry. Many recent M&As are inter-industry mergers (e.g., among insurance companies and investment banks). The financial crisis resulted in a second major change in the structure of the industry. The five largest investment banks in existence at the beginning of 2008 (Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley) were all gone as investment banks by the end of the year. Lehman Brothers failed at the start of the financial crisis, Bear Stearns and Merrill Lynch were acquired by financial services holding companies (JPMorgan Chase and Bank of America, respectively), and Goldman Sachs and Morgan Stanley requested and were granted commercial bank charters. 3. Firms in the industry can be divided along a number of dimensions. The largest firms, the so-called national fullline firms, service both retail customers (especially in acting as broker–dealers, thus assisting in the trading of existing securities) and corporate customers (such as underwriting, thus assisting in the issue of new securities). With the changes in the past few years, national full-line firms now fall into three subgroups. First are the commercial bank holding companies that are the largest of the full service investment banks. They have extensive domestic and international operations and offer advice, underwriting, brokerage, trading, and asset management services. The largest of these firms include Bank of America (through their acquisition of Merrill Lynch), Morgan Stanley, and JPMorgan Chase (through its many acquisitions, including that of Bear Stearns, for $240 million in 2008). Second are the national full-line firms that specialize more in corporate business with customers and are highly active in trading securities. Examples are Goldman Sachs and Salomon Brothers/Smith Barney, the investment banking arm of Citigroup (created from the merger of Travelers and Citicorp in 1998). Third are the large investment banks. These firms maintain more limited branch networks concentrated in major cities operating with predominantly institutional client bases. These firms include Lazard Ltd. and Greenhill & Co. The rest of the industry is comprised of firms that perform a mix of primary and secondary market services for a particular segment of the financial markets: 1. Regional securities firms that are often subdivided into large, medium, and small categories and concentrate on servicing customers in a particular region, e.g., New York or California (such as Raymond James Financial). 2. Specialized discount brokers that effect trades for customers on- or offline without offering investment advice or tips (such as Charles Schwab). 3. Specialized electronic trading securities firms (such as E*trade) that provide a platform for customers to trade without the use of a broker. Rather, trades are enacted on a computer via the Internet. 4. Venture capital firms that pool money from individual investors and other FIs (e.g., hedge funds, pension funds, and insurance companies) to fund relatively small and new businesses (e.g., in biotechnology). 5. Other firms in this industry include research boutiques, companies with large clearing operations, and other firms that do not fit into one of the preceding categories. This would include firms such as GTS, Virtu Financial and Citadel Securities (also known as designated market makers). 4. A major similarity between securities firms and all other types of FIs is a high degree of financial leverage. They all solicit funds that are used to finance an asset portfolio consisting of financial securities. The difference is that securities firms' liabilities tend to be extremely short term (see the balance sheet in Table 16-7). Typically payables incurred in the transaction process. In contrast, unlike other types of FIs, securities firms and investment banks do not transform the securities issued by the net users of funds into claims that may be “more” attractive to the net Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e suppliers of funds (e.g., banks and their creation of bank deposits). Rather, they serve as brokers intermediating between fund suppliers and users. 5. The key activity areas of security firms are: a)

Investment Banking: Investment banks specialize in underwriting and distributing both debt and equity issues in the corporate market. New issues can be placed either privately or publicly and can represent either a first issued (IPO) or a secondary issue. Secondary issues of seasoned firms typically will generate lower fees than an IPO. In a private offering the investment bank receives a fee for acting as the agent in the transaction. In best-efforts public offerings, the firm acts as the agent and receives a fee based on the success of the offering. The firm serves as a principal by actually takes ownership of the securities in a firm commitment underwriting. Thus, the risk of loss is higher. Finally, the firm may perform similar functions in the government markets and the asset-backed derivative markets. In all cases, the investment bank receives fees related to the difficulty and risk in placing the issue.

b) Venture Capital: A difficulty for new and small firms in obtaining debt financing from commercial banks is that CBs are generally not willing or able to make loans to new companies with no assets and business history. In this case, new and small firms often turn to investment banks (and other firms) that make venture capital investments to get capital financing as well as advice. Venture capital is a professionally managed pool of money used to finance new and often high-risk firms. Venture capital is generally provided to back an untried company and its managers in return for an equity investment in the firm. Venture capital firms do not make outright loans. Rather, they purchase an equity interest in the firm that gives them the same rights and privileges associated with an equity investment made by the firm’s other owners. c)

Market Making: Security firms assist in the market-making function by acting as brokers to assist customers in the purchase or sale of an asset. In this capacity the firms are providing agency transactions for a fee. Security firms also take inventory positions in assets in an effort to profit on the price movements of the securities. These principal positions can be profitable if prices increase, but they can also create downside risk in volatile markets.

d) Trading: Trading activities can be conducted on behalf of a customer or the firm. The activities usually involve position trading, pure arbitrage, risk arbitrage, and program trading. Position trading involves the purchase of large blocks of stock to facilitate the smooth functioning of the market. Pure arbitrage involves the purchase and simultaneous sale of an asset in different markets because of different prices in the two markets. Risk arbitrage involves establishing positions prior to some anticipated information release or event. Program trading involves positioning with the aid of computers and futures contracts to benefit from small market movements. In each case, the potential risk involves the movements of the asset prices, and the benefits are aided by the lack of most transaction costs and the immediate information that is available to investment banks. e)

Investing: Securities firms act as agents for individuals with funds to invest by establishing and managing mutual funds and by managing pension funds. The securities firms generate fees that directly affect the revenue stream of the companies.

Cash Management: Cash management accounts are checking accounts that earn interest and may be covered by FDIC insurance. The accounts have been beneficial in providing full-service financial products to customers, especially at the retail level.

g) Mergers and Acquisitions: Most investment banks provide advice to corporate clients who are involved in mergers and acquisitions. For example, they assist in finding merger partners, underwrite any new securities to be issued by the merged firms, assess the value of target firms, recommend terms of the merger agreement, and even assist target firms in preventing a merger (for example, writing restrictive provisions into a potential target firm’s securities contracts).

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e h) Back-Office and Other Service Functions: Security firms offer clearing and settlement services, research and information services, and other brokerage services on a fee basis. 6. Investing involves managing pools of assets such as closed- and open-end mutual funds and in competition with life insurance companies and pension funds. Securities firms can manage such funds either as agents for other investors or as principals for themselves and their stockholders. The objective in funds management is to choose asset allocations to beat some return-risk performance benchmark. Investment banking refers to activities related to underwriting and distributing new issues of debt and equity securities. New issues can be either first-time issues of companies’ debt or equity securities or the new (or seasoned) issues of firms whose debt or equity is already trading. 7. Securities underwriting can be undertaken through either public or private offerings. A public offering represents the sale of a security to the public at large. In a private offering, an investment bank acts as a private placement agent for a fee, placing the securities with one or a few large institutional investors such as life insurance companies. Issuers of privately placed securities are not required to register with the SEC since the placements (sales of securities) are made only to large, sophisticated investors. 8. With a best efforts underwriting, the investment banker acts as an agent of the company and receives a fee based on the number of securities sold. With firm commitment underwriting, the investment banker purchases the securities from the companies and then sells them to the investing public at what it hopes will be a higher price. All things being equal, the issuing company would prefer the firm commitment basis since this assures from the company’s perspective that all of the shares are sold. However, the investment banker may agree to buy the shares at a rather low price compared to what the company thinks it could get by working with the investment banker on a best efforts basis. 9. Venture capital is a professionally managed pool of money used to finance new and often high-risk firms. Venture capital is generally provided by investment institutions or private individuals willing to back an untried company and its managers in return for an equity investment in the firm. Venture capital firms do not make outright loans. Rather, they purchase an equity interest in the firm that gives them the same rights and privileges associated with an equity investment made by the firm’s other owners. As equity holders, venture capital firms are not generally passive investors. Rather, they provide valuable expertise to the firm’s managers and sometimes even help in recruiting senior managers for the firm. They also generally expect to be fully informed about the firm’s operations, any problems, and whether the joint goals of all of the firm’s owners are being met. 10. Institutional venture capital firms are business entities whose sole purpose is to find and fund the most promising new firms. Private-sector institutional venture capital firms include venture capital limited partnerships (that are established by professional venture capital firms, acting as general partners in the firm: organizing and managing the firm and eventually liquidating their equity investment), financial venture capital firms (subsidiaries of investment or commercial banks), and corporate venture capital firms (subsidiaries of nonfinancial corporations which generally specialize in making start-up investments in high-tech firms). Limited partner venture capital firms dominate the industry. In addition to these private sector institutional venture capital firms, the federal government, through the SBA, operates Small Business Investment Companies (SBICs). SBICs are privately organized venture capital firms licensed by the SBA that make equity investments (as well as loans) to entrepreneurs for start-up activities and expansions. As federally sponsored entities, SBICs have relied on their unique opportunity to obtain investment funds from the U.S. Treasury at very low rates relative to private-sector institutional venture capital firms. In contrast to institutional venture capital firms angel venture capitalists (or angels) are wealthy individuals who make equity investments. Angel venture capitalists have invested much more in new and small firms than institutional venture capital firms. 11. A difficulty for new and small firms in obtaining debt financing from banks is that banks are generally not willing or able to make loans to new companies with no assets and business history. In this case, new and small firms often turn to venture capital firms to get capital financing as well as advice. As equity holders, venture capital firms are not generally passive investors. Rather, they provide valuable expertise to the firm’s managers and sometimes even help in recruiting senior managers for the firm. They also generally expect to be fully informed Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e about the firm’s operations, any problems, and whether the joint goals of all of the firm’s owners are being met. Venture capital firms look for two things in making their decisions to invest in a firm. The first is a high return. Venture capital firms are willing to invest in high-risk new and small firms. However, they require high levels of returns (sometimes as high as 700 percent within five to seven years) to take on these risks. The second is an easy exit. Venture capital firms realize a profit on their investments by eventually selling their interests in the firm. They want a quick and easy exit opportunity when it comes time to sell. Basically, venture capital firms provide equity funds to new, unproven, and young firms. This separates venture capital firms from commercial banks and investment firms, which prefer to invest in existing, financially secure businesses. 12. Pure arbitrage entails buying an asset in one market at one price and selling it immediately in another market at a higher price. Pure arbitrageurs often attempt to profit from price discrepancies that may exist between the spot, or cash, price of a security and its corresponding futures price. Risk arbitrage involves buying securities in anticipation of some information release—such as a merger or takeover announcement or a Federal Reserve interest rate announcement. It is termed risk arbitrage because if the event does not actually occur—for example, if a merger does not take place or the Federal Reserve does not change interest rates—the trader stands to lose money. If an investor observes two similar assets trading at different prices in different exchanges, he/she should short sell the more expensive stock and use the proceeds to purchase the cheaper stock to lock in a given spread. This would be an example of a pure arbitrage rather than risk arbitrage. We are assuming that transactions costs are negligible. 13. Agency transactions are two-way transactions made on behalf of customers —for example, acting as a stockbroker or dealer for a fee or commission. Agency transactions are done on behalf of a customer. In this case the investment banker is acting as a stockbroker. In a principal transaction, the market maker seeks to profit on the price movements of securities and takes either long or short inventory positions for its own account. In this case, the profit is made from the differences in the prices that the company pays for the security and the price at which they are sold. In the first case, the company bears no risk. In the second case, the company is risking its own capital. 14. One reason for the decline is the stock market crash of 1987. A major effect of the 1987 stock market crash was a sharp decline in stock market trading volume and, thus, in the brokerage commissions earned by securities firms over the 1987–1991 period. Also affecting the profitability of the investment banking industry was the decline in bond and equity underwriting during the 1987–1990 period. This was partly a result of the stock market crash, partly a result of a decline in M&As, and partly a reflection of investor concerns about junk bonds. More recently, trading on-line by individual investors has resulted in fewer commissions. Finally, the subprime mortgage market collapse and the eventual full market crash in 2006 through 2008 pushed stock market values down and, as a result, commission income in the securities industry down. 15. Profits for securities firms increased between 1991-2000 because of: i. the resurgence of stock markets and trading volume, ii. increases in the profits of fixed-income trading, and iii. increased growth in the underwriting of new issues. Indeed, despite a downturn in the U.S. economy toward the end of 2000, pretax profits in the securities industry soared to an all-time high of $31.6 billion in 2000. 16. The continued slowdown of the U.S. economy in 2001, an accompanying drop in stock market values, and terrorist attacks on the World Trade Center (which housed offices of many securities firms and investment banks) in September 2001 brought an end to record profits in the securities industry. Industry pretax profits for 2001 fell 24 percent to $16.0 billion. Bank of New York alone estimated costs associated with the terrorist attacks were $125 million. Citigroup estimated it cost $100-$250 million in business from branches that were closed and because of the four days in which the stock market did not trade. Morgan Stanley, the largest commercial tenant in the World Trade Center, said the cost of property damage and relocating its employees was $150 million. Also impacting profit, the securities industry was rocked by several allegations of securities law violations as well as a loss of investor confidence in Wall Street and corporate America as a result of a number of corporate governance failures and accounting scandals including Enron, Merck, WorldCom, and other major U.S. corporations. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e With the recovery of the U.S. economy in the mid-2000s, the U.S. securities industry again earned record profits as revenue growth strengthened and became more broadly based. Domestic underwriting surged to $3,338.3 billion in 2006, from $1,623.9 billion in 2001. Further, the industry maintained its profitability mainly through deep cuts in expenses. Total expenses fell 10.4 percent from 2002 levels, largely due to lower interest expenses. Interest expense fell from $48.4 billion in 2002 to $37.5 billion in 2003 and $44.2 billion in 2004. The results for 2003 were a surge in pre-tax profits to $24.1 billion and for 2004 of $20.7 billion. Interest rate increases in 2005 caused interest expense incurred by the securities industry to increase. The result was that, while gross revenues remained high, the increased interest expense caused pretax profits to fall to $17.6 billion in 2005. A surge in revenues from trading gains and corporate advisory services caused pretax profits to bounce back to a record level of $33.1 billion in 2006. 17. Signs of the impending financial crisis arose in 2007. The industry began 2007 on a strong note, but hit by the subprime mortgage market meltdown that began in the summer of 2007, ended the year with pretax profits of just $0.78 billion. Many revenue lines showed solid growth in 2007 and total revenues reached a record high of $474.2 billion in 2007. However, trading and investment account loses were large; totaling a loss of $6 billion in 2007 compared to a gain of $43 billion in 2006. The worst of the financial crisis hit in 2008 as the industry reported a record loss for the year of $34.1 billion. Revenues were $290.5 billion, down 38.7 percent from 2007. Nearly all revenue lines decreased from 2007 levels, with trading and investment account losses being the largest (-$65.0 billion in 2008). Total expenses also declined, to $324.7 billion, a drop of 31.4 percent from 2007. As quickly as industry profits plunged during the financial crisis, they recovered in 2009. Pretax profits were a record $61.4 billion. Revenues totaled $288.1 billion for the year. Commission and fee income was $49.0 billion of the total, reflecting improved trading volume. Trading revenues, which had been negative for six consecutive quarters, grew to $45.3 billion. Industry expenses for 2009 were $212.4 billion, 33.7 percent below 2008 levels. Of this, interest expenses fell to just $21.9 billion, 82.2 percent below 2008 levels. While still in a fragile state, the industry seemed to be recovering along with the economy. The U.S. and world economies grew very slowly after the financial crisis. While interest rates remained at historic lows, concerns about the health of Eurozone economies and the U.S. fiscal cliff kept economic growth at a standstill. Memories of the financial crisis were still fresh in the minds of investors. Events such as the May 2010 “flash crash,” the October 2011 collapse of MF Global Holdings, and the August 2012 trading glitch at Knight Capital, caused individual and institutional investors to limit capital market activity. Industry pretax profits fell to $34.8 billion, $14.2 billion, and $32.1 billion in 2010, 2011, and 2012, respectively. By the mid-2010s, while the industry had put most problems from the financial crisis behind it, the industry was affected by post-crisis consequences, with increased regulation on risk taking and capital requirements. Since 2013, many companies undertook strategic initiatives to respond to new regulations and to de-risk their firms. This has led to balance sheet reductions as well as to downsizing or disposition of select businesses, trading products, and investments. In addition, corporate strategies increasingly focus on client services and away from making large bets through principal investments like hedge funds or risky trading activity for using the firm’s capital. As regulation became stricter following the 2008 crisis, many large banks across the globe have sold assets or are selling, and/or discontinuing, lines of operations, and are focusing more on their core competencies. A result of the new regulations is that profitability is down: pre-tax profits in 2013, 2014, and 2015 fell to $26.3 billion, $27.0 billion, and $23.8 billion, respectively. In 2016 through 2018, the pretax profits rose because revenues grew faster than expenses. Revenues grew 34 percent from $273.3 billion in 2015 to $366.9 billion in 2018, while expenses grew 29 percent from $249.4 billion in 2015 to $322.2 billion in 2018. As a result, industry profits reached $44.7 billion in 2018, the highest level since 2010. 18. Receivables from other broker-dealers accounted for 29.3 percent of assets; reverse repurchase agreements— securities purchased under agreements to resell (i.e., the broker gives a short-term loan to the repurchase agreement seller)—accounted for 29.1 percent of assets; and long positions in securities and commodities were 22.6 percent of assets. With respect to liabilities, repurchase agreements-securities sold under agreement to repurchase-were the major source of funds. Repurchase agreements amounted to 34.3 percent of total liabilities and equity.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 19. An investor would try to buy gold in London at $1,018 and sell it in New York for $1,025 yielding a riskless profit of $7 per ounce. This is an example of pure arbitrage. The success of the transaction may be undermined by transactions costs, the bid-ask spread, and how quickly the investor can execute the transaction before others try the same actions and move the two prices together before a profit can be made. 20. The investment bank fears that interests will rise, thus lowering the value of the bonds. 21. According to Table 16-6, debt issues are greater than equity issues by a ratio of sometimes as much as ten to one or higher. Debt is less risky than equity, so there is less risk of an adverse price movement with debt compared to equity. Further, debt is more likely to be bought in larger blocks by fewer investors, a transaction characteristic that makes the selling process less costly. 22. The National Securities Markets Improvement Act (NSMIA) of 1996 reaffirmed the significance of the SEC as the primary regulator of securities firms. According to the NSMIA, states are not allowed to require federally registered securities firms to be registered in a state as well. States are also prohibited from requiring registrations of securities firms’ transactions and from imposing substantive requirements on private placements. Prior to NSMIA, most securities firms were subject to regulation from the SEC and each state in which they operated. NSMIA provides that states may still require securities firms to pay fees and file documents submitted to the SEC, but most of the regulatory burden imposed by states has been removed. States are also now prohibited from requiring registration of securities firms’ transactions and from imposing substantive requirements on private placements. Thus, NSMIA effectively gives the SEC the exclusive regulatory jurisdiction over securities firms. 23. The primary regulator of the securities industry is the Securities and Exchange Commission (SEC), established in 1934 largely in response to abuses by securities firms that many at the time felt were partly responsible for the economic problems in the United States. The primary role of the SEC includes administration of securities laws, review and evaluation of registrations of new securities offerings (ensuring that all relevant information is revealed to potential investors), review and evaluation of annual and semiannual reports summarizing the financial status of all publicly held corporations, and the prohibition of any form of security market manipulation. The National Securities Markets Improvement Act (NSMIA) of 1996 reaffirmed the significance of the SEC as the primary regulator of securities firms. According to the NSMIA, states are no longer allowed to require federally registered securities firms to be registered in a state as well. States are also now prohibited from requiring registration of securities firms’ transactions and from imposing substantive requirements on private placements. Prior to the NSMIA, most securities firms were subject to regulation from the SEC and from each state in which they operated. While the NSMIA provides that states may still require securities firms to pay fees and file documents to be submitted to the SEC, most of the regulatory burden imposed by states has been removed. Thus, the NSMIA effectively gives the SEC the exclusive regulatory jurisdiction over securities firms. While the SEC sets the overall regulatory standards for the industry, the Financial Industry Regulatory Authority (FINRA) monitors trading abuses and the capital solvency of securities firms. The SEC provides governance in the area of underwriting and trading activities of securities firms, and the Securities Investor Protection Corporation protects investors against losses up to $500,000 when those losses have been caused by the failure of securities firms. Also overseeing this industry at the federal level is the U.S. Congress. For example, The U.S. Senate Permanent Subcommittee on Investigations was created with the broad mandate to determine whether any changes are required in U.S. law to better protect the public. In the spring of 2010, a subcommittee hearing focused on the role of investment banks in contributing to the financial crisis. Investment banks such as Goldman Sachs bundled toxic mortgages into complex financial instruments, many of which were rated AAA by credit rating agencies, and sold them to investors. Goldman Sachs, in an attempt to manage its own risk on these securities, shorted the mortgage market, setting itself up for gains that would offset losses on the mortgage securities. The subcommittee brought up evidence and internal Goldman documents that showed Goldman knew the housing market was on the brink of collapse but continued to sell mortgage-backed securities to investors. All the while, Goldman allegedly bet against the securities it built and sold with the knowledge that the housing market’s collapse would bring the firm a sizeable payday.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e The financial crisis reshaped much of the securities firms and investment banking industry. In response, regulators were charged with reshaping regulations to prevent events similar to those that led to the market collapse and the near collapse of this industry. The 2010 Wall Street Reform and Consumer Protection Act set forth many changes in the way securities firms and investment banks are regulated. The bill’s Financial Services Oversight Council of financial regulators was given oversight of the industry in its charge to identify emerging systemic risks. The bill also gave new authority for the Federal Reserve to supervise all firms that could pose a threat to financial stability and called for stronger capital and other prudential standards for all financial firms, and even higher standards for large, interconnected firms. The bill gave authority to the government to resolve nonbank financial institutions whose failure could have serious systemic effects and revised the Federal Reserve’s emergency lending authority to improve accountability. Investment banks also saw stricter oversight as the bill called for the regulation of securitization markets, stronger regulation of credit rating agencies, a requirement that issuers and originators retain a financial interest in securitized loans, comprehensive regulation of all over-the-counter derivatives, and new authority for the Federal Reserve to oversee payment, clearing, and settlement systems. The Act mandated that over-the-counter (OTC) derivatives trading be moved to listed futures markets and cleared through a registered derivatives clearing organization (DCO) or exchange. The process was implemented in three stages during 2013. The first stage, for Category 1 entities (which included mostly swap dealers and major swap participants), was implemented on March 11, 2013. Category 2 implementation (including a much larger group of more than 100 firms was implemented on June 11 and the Category 3 group (including all others involved in swap transactions) was implemented on September 11. Under the new regulations, investment banks and brokerage firms may face an increase in their information technology capital and operating costs, as well as an increase in compliance and legal costs. Further, under the new rules these FIs could face potential risks to principal investing and capital levels for market-making. 24. As domestic securities trading and underwriting have grown in the 1990s and 2000s so has foreign securities trading and underwriting. Figures 16-4 and 16-5 show the foreign transactions in U.S. securities and U.S. transactions in foreign securities from 2003-2018. For example, foreign investors’ transactions involving U.S. stocks increased from $6,173.7 billion in 2003 to $24,031.1 billion in 2008 before falling to $13,155.2 in 2009, during the financial crisis. As of 2018, stock transactions had increased to an all-time high of $36,293.0 billion. Similarly, U.S. investors’ transactions involving stocks listed on foreign exchanges grew from $2,697.7 billion in 2003 to $10,866.3 billion in 2008 before falling to $6,398.4 in 2009 and recovering to $11,906.5 billion in 2018. Table 16-8 reports the total dollar value and number of international security offerings from 1995-2018. Over this period, total international offerings increased from $443.3 billion in 1995 to $3,781.7 billion in 2007, and then decreased in 2008 during the financial crisis to $3,349.7 billion. As the economy recovered in 2009, so did international securities offerings, increasing to $3,877.2 billion in 2009. But the recovery was short lived as new issues decreased to $2,840.0 billion in 2011 and stood at just $3,067.1 billion in 2018. Of the amounts in 2018, U.S. security issuers offered $564.2 billion in international markets, up from $72.9 billion in 1995.

Problems: 1. a. If the investment bank sells the stock for $13.25 per share, Looney Landscaping Corp. receives $12.50 × 15,000,000 shares = $187,500,000. The profit to the investment bank is ($13.25 - $12.50) × 15,000,000 shares = $11,250,000. The stock price of Looney Landscaping Corp. is $13.25 since that is what the public agrees to pay. From the perspective of Looney Landscaping Corp., the $11.25 million represents the commission that it must pay to issue the stock. If the investment bank sells the stock for $11.95 per share, Looney Landscaping Corp. still receives $12.50 × 15,000,000 shares = $187,500,000. The profit to the investment bank is ($11.95 - $12.50) × 15,000,000 shares = $8,250,000. The stock price of Looney Landscaping Corp. is $11.95 since that is what the public agrees to pay. From the perspective of the investment bank, the -$8.25 million represents a loss for the firm commitment it made to Looney Landscaping Corp. to issue the stock. b. If the investment bank sells the stock for $12.50 per share, Looney Landscaping Corp. receives ($12.50 - $0.275) × 13,600,000 shares = $166,260,000, the investment bank’s profit is $0.275 × 13,600,000 shares = $3,740,000, and Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e the stock price is $12.50 per share since that is what the public pays. If the investment bank sells the stock for $11.95 per share, Looney Landscaping Corp. receives ($11.95 - $0.275) × 13,600,000 shares = $158,780,000, the investment bank’s profit is still $0.275 - 13,600,000 shares = $3,740,000, and the stock price is $11.95 per share since that is what the public pays. 2. An increase in interest rates will cause the value of the bonds to fall. If rates increase 5 basis points over night, the bonds will lose $1,695,036.30 in value. The investment bank will absorb the decrease in market value since the issuing firm has already received its payment for the bonds. If market rates decrease by 5 basis points, the investment bank will benefit by the $1,702,557.67 increase in market value of the bonds. These two changes in price can be found with the following two equations respectively: Vb = 20,000,000 {[1 - (1/(1 + 0.04025)20)]/0.04025} + 500,000,000/(1 + 0.04025)20 - 500,000,000 = -$1,695,036.30 On a financial calculator: N = 20, I = 4.025, PMT = 20,000,000, FV = 500,000,000 => PV = $498,304,963.70 => $498,304,963.70 - 500,000,000 = -1,695,036.30 Vb = 20,000,000 {[1 - (1/(1 + 0.03975)20)]/0.03975} + 500,000,000/(1 + 0.03975)20 - 500,000,000 = $1,702,557.67 On a financial calculator: N = 20, I = 3,975, PMT = 20,000,000, FV = 500,000,000 => PV = $501,702,557.67 => $501,702,557.67 - $500,000,000 = $1,702,557.67 3. The investment banker pays $70,500,000 ($23.50 × 3,000,000) to KDO for the shares and receives $75,000,000 ($25 × 3,000,000) on the sale. The investment bank’s profit is $4,500,000, and the stock price is $25 since that is what the public pays. From the perspective of KDO, the $4,500,000 represents the commission that it must pay to issue the stock. 4. GM receives $33.50 × 4,000,000 shares = $134,000,000. The profit/loss to the investment bank is ($32.00 $33.50) × 4,000,000 shares = -$6,000,000. The stock price of GM is $32.00 since that is what the public must pay. From the perspective of the investment bank, the $6,000,000 represents the loss that it must incur on the firm commitment offering. 5. MEP receives $221,550,000 = (($54 - $1.25) × 4,200,000), the investment bank’s profit is $1.25 per share × 4,200,000 shares = $5,250,000, and the stock price is $54 per share since that is what the public pays. 6. XYZ receives $226,800,000, the investment bank’s profit is $0.675 per share × 8,400,000 = $5,670,000, and the stock price is $27 per share since that is what the public pays. The net proceeds after commission to XYZ is $221,130,000.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 17 Questions: 1. A mutual fund represents a pool of financial resources obtained from individuals and invested in the money and capital markets. It represents another way for those with extra funds to channel those funds to those in need of extra funds. 2. Investing in mutual funds allows an investor to achieve a greater level of diversification than could likely be achieved by investing in individual stock on one's own account. A single share of a mutual fund could represent ownership in over a thousand different companies. Whereas the investment in the mutual fund might cost one hundred dollars, buying over a thousand individual shares of stock could cost over one hundred thousand dollars. Further, since mutual funds can buy and sell securities in large blocks, its trading cost are much lower than those of the individual investor buying a few shares at a time. 3. Long-term mutual funds primarily invest in assets that have maturities of more than one year. Long-term funds comprise equity funds (composed of common and preferred stock securities), bond funds (composed of fixedincome securities with a maturity of over one year), and hybrid funds (composed of both stock and bond securities). Some money market assets are included for liquidity purposes. Short-term funds comprise taxable money market mutual funds (MMMFs) and tax-exempt money market mutual funds (containing various mixes of those money market securities with an original maturity of less than one year). Long-term equity funds typically are well diversified, and the risk is more systematic or market based. Bond funds have extensive interest rate risk because of their long-term, fixed-rate nature. Sector, or industry-specific, funds have systematic (market) and unsystematic risk, regardless of whether they are equity or bond funds. The principal type of risk for short-term funds is interest rate risk, because of the predominance of fixed-income securities. Because of the shortness of maturity of the assets, which often is less than 60 days, this risk is mitigated to a large extent. Short-term funds generally have virtually no liquidity or default risk because of the types of assets held. The growth in long term funds in the 1990s and early 2000s reflected the dramatic increase in equity returns, as well as the reduction in transaction costs, and the recognition of diversification benefits achievable through mutual funds. The financial crisis and the collapse in stock and other security prices produced a sharp drop in long-term mutual fund activity. At the end of 2008, total assets fell to $5,435.3 billion. Investor demand for certain types of mutual funds plummeted, driven in large part by deteriorating financial market conditions. Stock market funds suffered substantial outflows, while inflow to U.S. government money market funds reached record highs. As the economy recovered starting in 2009, so did assets invested in mutual funds, growing to $7,873.0 billion by the end of 2010. By 2016, total assets in long-term funds were $13,208.8 billion, far surpassing pre-crisis levels. 4. Money market mutual funds provide an alternative investment opportunity to interest bearing deposits at commercial banks, which may explain the increase in MMMFs in the 1980s and early 2000s when the spread earned on MMMFs investments relative to deposits was mostly positive. Figure 17–2 illustrates the net new cash flows invested in money market mutual funds and long-term funds (equity funds, bond funds, etc.). The net gain in switching to MMMFs from interest bearing deposits is a higher return in exchange for the loss of FDIC deposit insurance coverage. Many investors appeared willing to give up FDIC insurance coverage to obtain additional returns in the late 1980s and late 1990s through 2001. However, additional returns also come from long-term funds such as equity mutual funds and bond funds. Net new cash flows to equity mutual funds have tended to rise and fall with returns on stocks. Bond mutual fund net new cash flows typically are correlated with the performance of US bonds, which, in turn, is largely driven by the US interest rate environment. While the 2008–2009 financial crisis and the collapse in stock and other security prices produced a sharp drop in mutual fund activity, MMMFs saw smaller drops as investors moved out of long-term, equity funds and into the safer MMMFs. As the economy recovered after 2009, bonds funds experienced large inflows in 2009 and 2010. In contrast, MMMFs experienced substantial outflows in 2009 and 2010 reflecting the search by investors for higher yields in an environment of low short-term interest rates accompanied by a steep yield curve and a continued unwinding of the flight to safety in response to the financial crisis.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 5. In 2019, 82.9 percent of all mutual fund assets were in long term funds; the remaining funds, or 17.1 percent, were in money market mutual funds. From Table 17-2, the percentage invested in long term versus short term funds can, and has, varied considerably over time. For example, the share of money market funds was 49.2 percent in 1985, 46.8 percent in 1990, and 26.50 percent in 2000. The decline in the growth rate of short term funds and increase in the growth rate of long term funds reflects the increase in equity returns during the period 1980-1999 and the generally low level of short term interest rates over the period. In the early 2000s, as interest rates rose and equity returns fell, growth in money market funds outpaced the growth in long-term funds. However, in the early 2000s, as interest rates rose, the U.S. economy weakened, and stock returns fell, the growth of money market funds increased relative to the growth of long-term funds. In the mid-2000s, the U.S. economy grew and stock values increased. As a result, the share of long-term funds grew (to 74.3 percent of all funds in 2007), while money market funds decreased (to 25.7 percent in 2007). The financial crisis and the collapse in stock prices produced a sharp drop in long-term mutual fund activity. Equity funds suffered substantial outflows, while inflow to U.S. government money market funds reached record highs. At the end of 2008, the share of long-term equity and bond funds plunged to 60.2 percent of all funds, while money market funds increased to 39.8 percent. As discussed below, part of the move to money market funds was the fact that during the worst of the financial crisis, the U.S. Treasury extended government insurance to all money market mutual fund accounts on a temporary basis. In 2009, as the economy and the stock market recovered, the share of long-term equity and bond funds increased back to 70.2 percent of all funds, while money market funds fell to 29.8 percent. By 2010, the share of long-term equity and bond funds was 76.3 percent of all funds, while money market funds was 23.7 percent. As a result of a long bull market, the share of long-term funds increased to an all-time high of 82.9 percent in 2019, and the share of money market funds fell to 17.1 percent. 6. The principal type of risk for short-term funds is interest rate risk, because of the predominance of fixed-income securities. Because of the shortness of maturity of the assets, this risk is mitigated to a large extent. Short-term funds generally have virtually no liquidity or default risk because of the types of assets held. An exception occurred during the financial crisis of 2008-2009. In September 2008, Primary Reserve Fund, a large and reputedly conservative money market fund had holdings of $785 million in commercial paper issued by Lehman. As a result of Lehman’s failure, shares in Primary Reserve Fund ‘broke the buck’ (i.e., fell below $1), meaning that its investors lost principal. This was the first incidence of a share price dip below a dollar for any money market mutual fund open to the general public. This fund had built a reputation for safe investment. Hence its exposure to Lehman scared investors, leading to a broad run on money market mutual funds. Within a few days more than $200 billion had flowed out of these funds. The U.S. Treasury stopped the run by extending government insurance to all money market mutual fund accounts held in participating money market funds as of the close of business on September 19, 2008. The insurance coverage lasted for one year (through September 18, 2009). Long-term equity funds typically are well diversified, and the risk is more systematic or market based. Bond funds have extensive interest rate risk because of their long-term, fixed-rate nature. Sector, or industry-specific, funds have systematic (market) and unsystematic risk, regardless of whether they are equity or bond funds. 7. One major economic reason for the existence of mutual funds is the ability to achieve diversification through risk pooling for small investors. By pooling investments from a large number of small investors, portfolio managers are able to hold well-diversified stocks. In addition, they also can obtain cheaper transactions costs and engage in information, research, and monitoring activities at lower costs. Many small investors are able to gain benefits of the money and capital markets by using mutual funds. Once an account is opened in a fund, a small amount of money can be invested on a periodic basis. In many cases, the amount of the investment would be insufficient for direct access to the money and capital markets. On the other hand, corporations are more likely to be able to diversify by holding a large bundle of individual securities and assets, and money and capital markets are easily accessible by direct investment. Further, an argument can be made that the goal of corporations should be to maximize shareholder wealth, not to be diversified. 8. Table 17-4 lists some characteristics of household mutual fund owners. As of 2016, 55.9 million (44.4 percent of) U.S. households owned mutual funds. This was down from 56.3 million (52.0 percent) in 2001. Most are long-term owners, with 56 percent making their first purchases before 1990. While mutual fund investors come from all age groups, ownership is concentrated among individuals in their prime saving and investing years. Sixty-three percent Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e of households owning mutual funds in 2016 were headed by individuals between the ages of 35 and 64. Interestingly, the number of families headed by a person with less than a college degree investing in mutual funds is 50 percent. In 72 percent of married households owning mutual funds, the spouse also worked full- or part-time. The bull markets of the 1990s, the low transaction costs of purchasing mutual fund shares, as well as the diversification benefits achievable through mutual fund investments are again the likely reasons for these trends. The typical fundowning household has $94,300 invested in a median number of four mutual funds. Compared to 1995, 2016 has seen a slight increase in the median age of mutual fund holders (from 44 to 51 years) and a large increase in median household financial assets owned (from $50,000 to $200,000). Finally, saving for retirement was one of the financial goals for 92 percent of mutual fund–owning households and 74 percent indicated that retirement saving was the household’s primary financial goal. 9. Mutual funds are open end in that the number of shares outstanding fluctuates daily with the amount of share redemptions and new purchases. Shares are redeemable (meaning that investors buy and sell shares from and to the mutual fund company at their approximate net asset value (NAV, see below) that is set once a day, after markets close). Thus, the demand for shares determines the number of shares outstanding. Open-end mutual funds can be compared with regular corporations traded on stock exchanges and to closed-end investment companies, both of which have a fixed number of shares outstanding at any given time. Closed-end funds generally do not continuously offer their shares for sale. Rather, they sell a fixed number of shares at one time (in an initial public offering), after which the shares typically trade on a secondary market. For example, real estate investment trusts (REITs) are closed-end investment companies that specialize in investing in real estate company shares and/or in buying mortgages. For most closed-end company funds, investors generally buy and sell the company’s shares that trade continuously during the day on a stock exchange as they do for corporate stocks. Since the number of shares available for purchase, at any moment in time, is fixed, the NAV of the fund’s shares is determined by the value of the underlying shares as well as by the demand for the investment company’s shares themselves. When demand for the investment company’s shares is high (as was the case in the mid- and late 1990s when stock markets boomed), because the supply of shares in the fund is fixed the shares can trade for more than the NAV of the securities held in the fund’s asset portfolio. In this case, the fund is said to be trading at a premium (i.e., more than the fair market value of the securities held). When demand for the shares is low (as was the case in 2001 and 2008–2009 when stock market values fell), the value of the closed-end fund’s shares can fall to less than the NAV of its assets. In this case, its shares are said to be trading at a discount (i.e., less than the fair market value of the securities held). In 2016, $266 billion was invested in 545 closed-end funds, compared to $16,350 billion invested in 8,105 open-end mutual funds. Unit investment trusts (UITs) have characteristics of both mutual funds and closed-end funds. Like mutual funds, UITs issue redeemable shares (so-called units). Like closed-end funds, UITs typically issue only a fixed number of shares. Unlike mutual funds and closed-end funds however, UITs have a termination date that is set when the UIT is established and differs according to the investments held in the portfolio. UITs are generally fixed portfolios of securities (up to twenty specific stocks or bonds) that see little or no change over the life of the UIT. Thus, investors know what they are investing in for the period of their investment. Upon termination of the UIT, proceeds from the sale of the securities are either paid to UIT holders or reinvested in another UIT. In 2016, $4.25 billion was invested in 5,188 UITs. 10. Exchange traded funds (ETFs) are long-term mutual funds that are also designed to replicate a particular stock market index. (In February 2008 the SEC gave approval for the first actively managed ETF and a growing number of them are now actively managed.) However, unlike closed-end funds where the price per share (or net asset value, NAV) is determined only once a day after markets have closed, ETFs trade intraday on a stock exchange at prices that are determined by the market. While legally classified as open-end mutual funds, ETFs are similar to closed-end funds in that a fixed number of shares are outstanding at any point in time. Like a mutual fund, an ETF offers investors a proportionate share in a pool of stocks, bonds, and other assets. ETFs may be bought or sold through a broker or in a brokerage account, like trading shares of any publicly traded company. While ETFs are registered with the SEC as investment companies, they differ from traditional mutual funds both in how their shares are issued and redeemed and in how their shares or units are traded. Specifically, ETF shares are created by an institutional investor’s depositing of a specified block of securities with the ETF. In return for this deposit, the institutional investor receives a fixed amount of ETF shares, some or all of which may then be sold on a stock exchange. The institutional investor may obtain its deposited securities by redeeming the same number of ETF shares it received Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e from the ETF. Individual investors can buy and sell the ETF shares only when they are listed on an exchange. Unlike an institutional investor, a retail investor cannot purchase or redeem shares directly from the ETF, as with a traditional mutual fund. ETFs include funds such as SPDRs and Vanguard’s Large-Cap VIPERS funds. 4 Like index funds, the share price of an ETF changes over time in response to a change in the stock prices underlying a stock index. Further, since both ETFs and index funds are intended to track a specific index, management of the funds is relatively simple and management fees are lower than those for actively managed mutual funds. Unlike index funds, however, ETFs can be traded during the day, they can be purchased on margin, and they can be sold short by an investor who expects a drop in the underlying index value. Because ETFs behave like stocks, investors are subject to capital gains taxes only when they sell their shares. Thus, ETF investors can defer capital gains for as long as they hold the ETF. These features of ETFs (intraday tradability, transparency, tax efficiency, and access to specific markets or asset classes) have contributed to the growing popularity of ETFs. ETFs also have gained favor due to the rising popularity of passive investments (discussed below), increasing use of asset allocation models, and a move toward external feebased models of compensation. As a result, assets invested in the 1,687 ETFs in existence in 2016 totaled $2.39 trillion, up from $66 billion invested in a total of 80 funds in 2000. Most ETFs are registered as investment companies under the Investment Company Act of 1940 and are regulated by the SEC. Thus, they are subject to the same regulatory requirements as other mutual funds. Generally, the price at which an ETF trades closely tracks the market value of the securities held in the portfolio. One reason for this fairly close relationship is the ability for authorized participants (APs) to create or redeem ETF shares at net asset value at the end of each trading day. An AP is typically a large financial institution that enters into a legal contract with an ETF distributor to create and redeem shares of the fund. APs are the only investors allowed to interact directly with the fund. Thus, they play a key role in the primary market for ETF shares. APs receive no compensation from the ETF distributor and have no legal obligation to create or redeem the ETF’s shares. Rather, APs derive their compensation by acting as dealers in ETF shares. That is, APs stand ready to create and redeem shares in the primary market when doing so is a more effective way of managing their firms’ aggregate exposure than trading in the secondary market. Creations and redemptions are processed through the National Securities Clearing Corporation (NSCC) and have the same guarantee as a domestic stock trade. Most ETFs do not create or redeem shares on many trading days. Rather than the creation and redemption of shares through an AP, investors trade shares in secondary markets. On average, daily aggregate ETF creations and redemptions are a fraction (10 percent) of their total primary market activity and secondary market trading, and account for less than 0.5 percent of the funds’ total net assets. 11. In March 2009, the SEC adopted amendments to the form used by mutual funds to register under the Investment Company Act of 1940 and to offer their securities under the Securities Act of 1933 in order to enhance the disclosures that are provided to mutual fund investors. The amendments (first proposed in November 2007) required key information to appear in plain English in a standardized order at the front of the mutual fund statutory prospectus. The new amendment also included a new option for satisfying prospectus delivery obligations with respect to mutual fund securities under the Securities Act. Under the option, key information is sent or given to investors in the form of a summary prospectus and the statutory prospectus is provided on an Internet Web site. The improved disclosure framework was intended to provide investors with information that is easier to use and more readily accessible, while retaining the comprehensive quality of the information that was previously available. 12. The investor receives the income and dividends paid by the companies, capital gains from the sale of securities by the mutual fund at more than their purchase price, and the sale of additional mutual fund shares and the profitable investment made with the funds from these shares can produce a capital appreciation that adds to the value of all shares in the mutual fund. 13. Net asset value (NAV) is the average market value of the mutual fund. The total market value of the fund is determined by summing the total value of each asset in the fund. The value of each asset can be found by multiplying the number of shares of the asset by the corresponding price of the asset. Dividing this total fund value by the number of shares in the mutual fund will give the NAV for the fund. The NAV is calculated at the end of each daily trading session, and thus reflects any adjustments in value cased by (a) changes in value of the underlying assets, (b) dividend distributions of the companies held, or (c) changes in ownership of the fund. This process of Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e daily recalculation of the NAV is called marking-to-market. 14. It is quite likely that for people in the early years of investing, 20 and 30 year old, they would prefer a fairly aggressive high growth type of fund. As these people mature into their forties and fifties and retirement becomes a bit more imminent, they may switch to a fund with more of a balance between income and growth. In their later years, investors may try to protect their saving by switching to higher yield stock and bond funds. 15. A load fund charges an up-front fee that often is called a sales charge and is used as a commission payment for sales representatives. These fees can be as high as 5.75 percent. A no-load fund does not charge a sales fee, although a small annual fee can be charged to cover certain administrative expenses. This small fee, which is called a 12b-1 fee, usually ranges between 0.25 and 1.00 percent of assets. Load funds have adjusted returns that are decreased after the fee is removed. In each case the relative performance ranking of the fund decreases after the load is subtracted. The argument in favor of load funds is that they provide the investor with more personal attention and advice on fund selection than no-load funds. However, the cost of increased personal attention may not be worthwhile. High fees do not guarantee good performance. For example, Table 17–6 lists initial fees for the largest U.S. stock funds in 2016. Notice that only American Funds assesses a load fee on mutual fund share purchases. After adjusting for this fee, the 12-month returns on the 7 American Funds mutual funds fall from 10.95 percent to 4.62 percent to 8.39 percent to 0.67 percent. 16. No-load funds generally require a small percentage (or fee) of investable funds to meet fund level marketing and distribution costs. Such annual fees are known as 12b-1 fees after the SEC rule covering such charges. The SEC does not limit the size of 12b-1 fees that funds may charge. However, under Financial Industry Regulatory Authority (FINRA) rules, 12b-1 fees that are used to pay marketing and distribution expenses (as opposed to shareholder service expenses) cannot exceed 0.75 percent of a fund’s average net assets per year. FINRA imposes an annual cap of 0.25 percent on shareholder service fees. Because these fees, charged to cover fund operating expenses, are paid out of the funds assets, investors indirectly bear these expenses. Because the sales load is a one-time charge, it must be converted to an annualized payment incurred by the shareholder over the life of his or her investment. With this conversion, the total shareholder cost of investing in a fund is the sum of the annualized sales load plus any annual fees. Generally, the longer your holding period, the more you would prefer the load fund since a longer holding period would allow you to spread the cost of the load across more years. Eventually, the annualized cost of the load would be less than the annual 12b-1 fee. 17. The primary reason for the increased proportion of funds in equities during the 1990s was the strength of the equity market that was driven by the underlying strength of the economy during this period. Contrarily, the economy experienced its worst recession since the Great Depression in the late 2000s, causing investors to retreat from equities as preferred investments. Underscoring the attractiveness of equities in 2007 was the fact that equity funds represented 71.9 percent of total long-term mutual fund assets in 2007, while hybrid and bonds funds represented 28.1 percent. In contrast, consider the distribution of assets in 2008 when the equity markets were plummeting and the economy was in recession. Equity funds made up 63.1 percent of long-term mutual fund assets, and hybrid and bond funds made up 36.8 percent. Note too that total long-term financial assets fell from $8,913.9 billion in 2007 (before the start of the financial crisis) to just $5,788.0 billion in 2008 (at the height of the crisis), a drop of 35.1 percent. As the economy and financial markets recovered, financial assets held by long-term mutual funds increased to $7,795.3 billion in 2009, of which 62.5 percent were corporate equities. By 2019, while total assets had far surpassed pre-crisis levels, only 64.4 percent of this was invested in corporate equities. Thus, even 11 years after the start of the financial crisis long-term funds had not switched their holdings of corporate equities back to their pre-crisis levels. 18. The Securities and Exchange Commission (SEC) is the primary regulator of the mutual fund industry. The SEC is not concerned with the administration of sound economic monetary policy, but rather is primarily concerned with the protection of investors from possible abuses by managers of mutual funds. Several pieces of legislation have been enacted to clarify and assist this regulatory process. Under the Securities Act of 1933, mutual funds must file a registration statement with the SEC and abide by the rules established under the act for the distribution of Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e prospectuses to investors. The Securities Exchange Act of 1934 establishes antifraud provisions aimed at the accurate transmission of information to prospective investors. The 1934 act also appointed the National Association of Securities Dealers to supervise the distribution of mutual fund shares. The Investment Advisors Act of 1940 regulates the activities of mutual fund advisors, and the Investment Company Act establishes rules involving fees and charges. The Insider Trading and Securities Fraud Enforcement Act of 1988 addresses issues of insider trading, and the Market Reform Act of 1990 provides for the establishment of circuit breakers to halt trading in case of severe market downturns. Finally, the National Securities Market Improvement Act of 1996 exempts mutual funds from the regulatory burden of state securities regulators. 19. The abusive activities fell into four general categories: market timing, late trading, directed brokerage, and improper assessment of fees to investors. Market timing involves short term trading of mutual funds that seeks to take advantage of short term discrepancies between the price of a mutual fund’s shares and out-of-date values on the securities in the fund’s portfolio. It is especially common in international funds as traders can exploit differences in time zones. Late trading allegations involved cases in which some investors were able to buy or sell mutual fund shares long after the price had been set at 4:00pm Eastern time each day (i.e., after the close of the NYSE and NASDAQ). Directed brokerage involves arrangements between mutual fund companies and brokerage houses and whether those agreements improperly influenced which funds brokers recommended to investors. The investigation examined whether some mutual fund companies agreed to direct orders for stock and bond purchases and sales to brokerage houses that agreed to promote sales of the mutual fund company’s products. Finally, regulators claimed that the disclosure of 12b-1 fees allowed some brokers to trick investors into believing they were buying no-load funds. Before 12b-1 fees all funds sold through brokers carried front-end load fees. As discussed above, with 12b-1 fees, fund companies introduced share classes, some of which carried back-end loads that declined over time and others that charged annual fees of up to 1 percent of asset values. Funds classes that charged annual 12b-1 fees would see performance decrease by that amount and thus not perform as well as an identical fund that carried a lower 12b-1 fee. The shareholder, however, only saw the fund’s raw return (before annual fees) and not the dollar amount of the fee paid. The result of these illegal and abusive activities were new rules and regulations imposed (in 2004) on mutual fund companies. The rules were intended to give investors more information about conflicts of interest, improve fund governance, and close legal loopholes that some fund managers had abused. The SEC also took steps to close a loophole that allowed improper trading to go unnoticed at some mutual funds. Prior to the new rules, the SEC required that funds report trading by senior employees in individual stocks but not in shares of mutual funds they manage. The SEC now requires portfolio managers to report trading in funds they manage. To address the problem of market timing, the SEC now requires funds to provide expanded disclosure of the risks of frequent trading in fund shares and of their policies and procedures regarding such activities. Mutual funds also now have to be more open about their use of fair value pricing (a practice of estimating the value of rarely traded securities or updating the values of non-U.S. securities that last traded many hours before U.S. funds calculate their share prices each day) to guard against stale share prices that could produce profits for market timers. The SEC has also proposed that mutual funds or their agents receive all trading orders by 4:00pm Eastern time, when the fund’s daily price is calculated. This “hard closing,” which would require fund orders to be in the hands of the mutual fund companies by 4:00pm, is intended to halt late trading abuses. To ensure that the required rule changes took place, starting October 5, 2004, the SEC required that mutual funds hire chief compliance officers to monitor whether the mutual fund company follows the rules. The chief compliance officer will report directly to mutual fund directors, and not to executives of the fund management company. To further insulate the chief compliance officer from being bullied into keeping quiet about improper behavior, only the fund board can fire the compliance officer. Duties of the compliance officer include policing personal trading by fund managers, ensuring accuracy of information provided to regulators and investors, reviewing fund business practices such as allocating trading commissions, and reporting any wrongdoing directly to fund directors. New SEC rules also called for shareholder reports to include the fees shareholders paid during any period covered, as well as management’s discussion of the fund’s performance over that period. As of September 1, 2004, mutual fund companies must provide clear information to investors on brokerage commissions and discounts, including improved disclosure on upfront sales charges for broker-sold mutual funds. Investors now get a document showing Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e the amount they paid for a fund, the amount their broker was paid, and how the fund compares with industry averages based on fees, sales loads, and brokerage commissions. As of December 2004, mutual funds must provide to investors summary information in a fund prospectus on eligibility for breakpoint discounts and explain what records investors may need to show brokers to demonstrate they qualify for discounts. After the financial crisis, in a February 2013 letter sent to the Financial Stability Oversight Council (FSOC) (set up as a result of the Wall Street Reform and Consumer Protection Act to oversee the financial system), the leaders of all 12 regional Federal Reserve banks called for a significant overhaul of the money market industry. The letter stated that, even four years after the financial crisis, without reform money market mutual fund activities could spread the risk of significant credit problems from the funds to banks to the broader financial system. New York Fed President, William Dudley, stated that the risk of a run on money market funds was potentially higher in 2013 than before the crisis because banks increasingly used these funds as a source of financing and because Congress blocked the Fed and Treasury from using certain emergency tools that could stabilize the funds during a market panic. As a result of the calls for reform, in 2014, the SEC adopted amendments to the rules that govern money market mutual funds. The amendments make structural and operational reforms to address risks of investor runs in money market funds, while preserving the benefits of the funds. The new rules require a floating net asset value (NAV) for institutional prime money market funds. Floating NAV allows the daily share prices of these funds to fluctuate along with changes in the market value of fund assets. Further, liquidity fees and redemption gates were instituted, giving money market fund boards the ability to impose fees and gates during periods of stress. The final rules also include enhanced diversification, disclosure and stress testing requirements, as well as updated reporting by money market funds and private funds that operate like money market funds. Also, in 2015 the SEC proposed rules and amendments to modernize and enhance the reporting and disclosure of information by investment companies and investment advisers. The new rules would enhance the quality of information available to investors and would allow the Commission to more effectively collect and use data provided by investment companies and investment advisers. The SEC also proposed a comprehensive package of rule reforms designed to enhance effective liquidity risk management by open-end funds, including mutual funds and exchange-traded funds (ETFs). Under the proposed reforms, mutual funds and ETFs would be required to implement liquidity risk management programs and enhance disclosure regarding fund liquidity and redemption practices. The proposal is designed to better ensure investors can redeem their shares and receive their assets in a timely manner. A fund’s liquidity risk management program would be required to contain multiple elements, including: classification of the liquidity of fund portfolio assets based on the amount of time an asset would be able to be converted to cash without a market impact; assessment, periodic review and management of a fund’s liquidity risk; establishment of a fund’s three-day liquid asset minimum; and board approval and review. 20. Mutual funds have been the fastest-growing sector in the U.S. financial institutions industry throughout the 1990s and into the 2000s. Only the worldwide financial crisis and the worst worldwide recession since the Great Depression curtailed the growth in this industry. Worldwide investment in mutual funds is shown in Table 17–10. Combined assets invested in non–U.S. mutual funds are approximately equal to that invested in U.S. mutual funds alone. However, recent growth in non–U.S. funds has exceeded that in U.S. funds. Worldwide (other than in the United States) investments in mutual funds have increased over 187 percent, from $4.916 trillion in 1999 to $14.130 trillion in 2007. This compares to growth of 75 percent in U.S. funds. Likewise, non–U.S. mutual funds experienced bigger losses in total assets during the financial crisis. Worldwide funds fell to $9.316 trillion (34.1 percent) in 2008, while U.S. funds fell to $9.603 trillion (20.0 percent). By 2016, as worldwide economies improved worldwide investments in mutual funds increased to $21.16 trillion (an increase of 127 percent from 2008), while U.S. investments increased to $18.13 trillion (an increase of 88.8 percent). In addition, as this industry developed in countries throughout the world, the number of mutual funds worldwide (other than in the United States) increased by 126 percent, from 43,537 in 2000 to 98,255 in 2016. Much more established in the United States, the number of mutual funds increased by 7.0 percent over this period. As may be expected, the worldwide mutual fund market is most active in those countries with the most sophisticated securities markets (e.g., Japan, France, Germany, Australia, and the United Kingdom). Note that the large value of mutual funds in Luxembourg is a result of the country’s introduction of legislation in 1988 that gave fund managers maximum freedom in their fund’s management. The legislation let managers make virtually any investments they wanted to [including investments in options, futures, and venture capital] as long as they were clear enough about Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e their intentions with investors. In addition, Luxembourg had an infrastructure of lawyers, accountants, banks, and computer technicians that made it an easy place to operate mutual funds. 21. Hedge funds are investment pools that invest funds for (wealthy) individuals and other investors (e.g., commercial banks). They are similar to mutual funds in that they are pooled investment vehicles that accept investors’ money and generally invest it on a collective basis. Hedge funds, however, are not subject to the numerous regulations that apply to mutual funds for the protection of individuals, such as regulations requiring a certain degree of liquidity, regulations requiring that mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest, regulations to ensure fairness in the pricing of funds shares, disclosure regulations, and regulations limiting the use of leverage. Further, hedge funds do not have to disclose their activities to third parties. Thus, they offer a high degree of privacy for their investors. Until 2010, hedge funds were not required to register with the SEC. Thus, they were subject to virtually no regulatory oversight (e.g., by the SEC under the Securities Act and Investment Advisers Act) and generally took significant risk. Even after 2010, hedge funds offered in the United States avoid regulations by limiting the asset size of the fund. Historically, hedge funds avoided regulations by limiting the number of investors to less than 100 individuals (below that required for SEC registration), who must be deemed “accredited investors.” To be accredited, an investor must have a net worth of over $1 million or have an annual income of at least $200,000 ($300,000 if married). Institutional investors can be qualified as accredited investors if total assets exceed $5 million. These stiff financial requirements allowed hedge funds to avoid regulation under the theory that individuals with such wealth should be able to evaluate the risk and return on their investments. According to the SEC, these types of investors should be expected to make more informed decisions and take on higher levels of risk. Because hedge funds have been exempt from many of the rules and regulations governing mutual funds, they can use aggressive strategies that are unavailable to mutual funds, including short selling, leveraging, program trading, arbitrage, and derivatives trading. Further, since hedge funds that do not exceed $100 million in assets under management do not register with the SEC, their actual data cannot be independently tracked. Therefore, much hedge fund data are self-reported. It is estimated that in 2016 there were over 10,000 hedge funds in the world, with managed assets estimated at $2.98 trillion. 22. Most hedge funds are highly specialized, relying on the specific expertise of the fund manager(s) to produce a profit. Hedge fund managers follow a variety of investment strategies, some of which use leverage and derivatives, others use more conservative strategies and involve little or no leverage. Generally, hedge funds are set up with specific parameters so investors can forecast a risk-return profile. “More risky” funds are the most aggressive and may produce profits in many types of market environments. Funds in this group are classified by objectives such as: aggressive growth, emerging markets, macro, market timing, and short selling. Aggressive growth funds invest in equities expected to experience acceleration in growth of earnings per share. Generally, high price-to-earnings ratios, low or no dividend companies are included. These funds hedge by shorting equities where earnings disappointment is expected or by shorting stock indexes. Emerging market funds invest in equity or debt securities of emerging markets which tend to have higher inflation and volatile growth. Macro funds aim to profit from changes in global economies, typically brought about by shifts in government policy which impact interest rates. These funds include investments in equities, bonds, currencies and commodities. They use leverage and derivatives to accentuate the impact of market moves. Market timing funds allocate asset among different asset classes depending on the manager’s view of the economic or market outlook. Thus, portfolio emphasis may swing widely between assets classes. Unpredictability of market movements and the difficulty of timing entry and exit from markets adds significant risk to this strategy. Short selling funds sell securities in anticipation of being able to buy them back in the future at a lower price based on the manager’s assessment of the overvaluation of the securities or in anticipation of earnings disappointments. “Moderate risk” funds are more traditional funds, similar to mutual funds, with only a portion of the portfolio being hedged. Funds in this group are classified by objectives such as: distressed securities, fund of funds, opportunistic, multi strategy, and special situations. Distressed securities funds buy equity, debt or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Profits opportunities come from the market’s lack of understanding of the true value of these deep discount securities and from the fact that the majority of institutional investor cannot own below investment grade securities. Fund of funds mix hedge funds and other pooled investment Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e vehicles. This blending of different strategies and asset classes aims to provide a more stable long term investment return than any of the individual funds. Returns and risk can be controlled by the mix of underlying strategies and funds. Capital preservation is generally an important consideration for these funds. Opportunistic funds change their investment strategy as opportunities arise to profit from events such as IPOs, sudden price changes resulting from a disappointing earnings announcement, and hostile takeover bids. These funds may utilize several investing styles at any point in time and are not restricted to any particular investment approach or asset class. Multi strategy funds take a diversified investment approach by implementing various strategies simultaneously to realize short and long term gains. This style of investment allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Special situation funds invest in event driven situations such as mergers, hostile takeovers, reorganizations, or leveraged buyouts. These funds may undertake simultaneous purchases of stock in companies being acquired, and the sale of stock in its bidder, hoping to profit from the spread between the current market price and the final purchase price of the company. “Risk avoidance” funds are also more traditional funds, similar to mutual funds, with only a portion of the portfolio being hedged. Funds in this group are classified by objectives such as: income, market neutral – arbitrage, market neutral - securities hedging, and value. Income funds invest with the primary focus on yield or current income rather than solely on capital gains. These funds use leverage to buy bonds and some fixed income derivatives, profiting from principal appreciation and interest income. Market neutral – arbitrage funds attempt to hedge market risk by taking offsetting positions, often in different securities of the same issuer, e.g., long convertible bonds and short the firm’s equity. Their focus is on obtaining returns with low or no correlation to both the equity and bond markets. Market neutral - securities hedging funds invest equally in long and short equity portfolios in particular market sectors. Market risk is reduced but effective stock analysis is critical to obtaining a profit. These funds use leverage to magnify their returns. They also sometimes use market index futures to hedge systematic risk. Value funds invest in securities perceived to be selling at deep discounts relative to their intrinsic values. Securities include those that may be out of favor or underfollowed by analysts. 23. Hedge fund managers generally charge two type of fees: management fees and performance fees. As with mutual funds, the management fee is computed as a percentage of the total assets under management and typically run between 1.5 to 2.0 percent. Performance fees are unique to hedge funds. Performance fees give the fund manager a share of any positive returns on a hedge fund. The average performance fee on hedge funds is approximately 20 percent but varies widely. For example, Steven Cohen’s SAC Capital Partners charges a performance fee of 50 percent. Performance fees are paid to the hedge fund manager before returns are paid to the funds investors. Hedge funds often specify a “hurdle” rate, which is a minimum annualized performance benchmark that must be realized before a performance fee can be assessed. Further, a “high water mark” is usually used for hedge funds in which the manager does not receive a performance fee unless the value of the fund exceeds the highest net asset value it has previously achieved. High water marks are used to link the fund manager’s incentives more closely to those of the fund investors and to reduce the manager’s incentive to increase the risk of trades. 24. Hedge funds that are organized in the U.S. are designated as domestic hedge funds. These funds require investors to pay income taxes on all earnings from the hedge fund. Funds located outside of the U.S. and structured under foreign laws are designated as offshore hedge funds. Many offshore financial centers encourage hedge funds to locate in their countries. The major centers include the Cayman Islands, Bermuda, Dublin, and Luxembourg. /the Cayman Islands is estimated to be the location of approximately 75 percent of all hedge funds. Offshore hedge funds are regulated in that they must obey the rules of the host country. However, the rules in most of these countries are not generally burdensome and provide anonymity to fund investors. Further, offshore hedge funds are not subject to U.S. income taxes on distributions of profit or to U.S. estate taxes on funds shares. When compared to domestic hedge funds, offshore hedge funds have been found to trade more intensely than domestic funds, due to the zero or lower capital gains tax for offshore funds. Further, offshore hedge funds tend to engage less often in positive feedback trading (rushing to buy when the market is booming and rushing to sell when the market is declining) than domestic hedge funds. Finally, offshore hedge funds have been found to herd (mimic each other’s behavior when trading while ignoring information about the fundamentals of valuation) less than domestic hedge funds. Many hedge fund managers maintain both domestic and offshore hedge funds. Given the needs of their client investors, hedge fund managers want to have both types of funds so as to attract all types of investors. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Problems: 1. The dollar return is $1.50 + $2.00 + ($52.50 - $50) - $2.00 = $4.00. The rate of return is $4/$50 = 8%. 2. a. NAVopen-end = (165 × $35 + 30 × $75)/1,000 = $8.025. NAVclosed-end = (75 × $35 + 72 × $75)/1,000 = $8.025. b. NAVopen-end = (165 × $36.25 + 30 × $72.292)/1,000 = $8.15. Percentage change in NAV = ($8.15 - $8.025)/$8.025 = 1.56%. NAVclosed-end = (75 × $36.25 + 72 × $72.292)/1,000 = $7.92377. Percentage change in NAV = ($7.92377 - $8.025)/$8.025 = -1.26%. Thus, the changes in prices lead to different effects. Fund A saw its NAV increase while Fund B saw it decline. The reason is Fund B had more shares that had a price decline than a price increase. c. NAVopen-end = ((165 + 155) × $35 + 30 × $75)/(1,000 + 676) = $8.025. Percentage change in NAV = ($8.025 - $8.025)/$8.025 = 0.00%. 3. a. NAV = (300 × $30 + 400 × $54)/1,000 = $30,600/1,000 = $30.60. b. Expected NAV = (300 × $34 + 400 × $48)/1,000 = $29,400/1,000 = $29.4, or a decline of 3.92% c. [(300 × $34) + (400 × PM)]/1,000 = $30.60, implies that PM = $51.00, a decrease of $3.00. 4. a. NAV = (2,000 × $64.75 + 1,000 × $63.10 + 2,500 × $31.50)/10,000 = $271,350/10,000 = $27.135 b. NAV = (2,000 × $66 + 1,000 × $68 + 2,500 × $30)/10,000 = $275,000/10,000 = $27.500, or an increase of $0.365. c. At today’s market price, the manager could buy 419 additional shares ($27,135/$64.75) of JPMorgan Chase. Thus, its new portfolio of shares has 2,419 in JPMorgan Chase, 1,000 in Walmart, and 2,500 in Pfizer. NAV = (2,419 × $66 + 1,000 × $68 + 2,500 × $30)/11,000 = $302,654/11,000 = $27.514, or an increase of $0.379. Note that the fund’s value changed over the month due to both capital appreciation and investment size. A comparison of the NAV in part b. with the one in this part indicates that the additional shares and the profitable investments made with the new funds from these shares resulted in a slightly higher NAV than had the number of shares remained static ($27.500 versus $27.514). 5. The dollar return is $3 + $4 + ($105 - $100) - $2 = $10, so the rate of return is $10/$100 or 10%. 6. The individual invests $20,000 in a load mutual fund with a load fee of 2.5 percent of the amount invested which is deducted from the original funds invested. Thus, the individual’s actual investment, after the load fee is deducted, is: $20,000 (1 - .025) = $19,500. Investments in the fund return 7 percent each year paid on the last day of the year. Thus, after one year his operating fees deducted and the value of his investment are: Annual operating expenses = average net asset value × annual operating expenses = ($19,500 + $19,500(1.07))/2 × .0055 = $111.00375 Value of investment at end of year 1 = $19,500(1.07) - $111.00375 = $20,753.99625 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e The investor’s return on the mutual fund investment after 1 year is: ($20,753.99625 - $20,000)/$20,000 = 3.77% In year 2, the investor earns another 7 percent on the beginning value and the investor=s fees deducted and investment value at the end of the year are: Annual operating expenses = ($20,753.99625 + $20,753.99625(1.07))/2 × .0055 = $118.142124 Value of investment at end of year 2 = $20,753.99625(1.07) - $118.142124 = $22,088.633814 After 2 years the investor has paid a total of $500 in load fees and $229.145874 in operating expenses, and he has made $2,088.633864 above his original $20,000 investment. Thus the investor’s annual return on the mutual fund is 5.09 percent (or, $20,000 = $22,088.633814/(1 + i)2 => i = 5.09%). 7. Initial investment in the fund Front-end load of 4.00% Total investable funds

= $10,000 = $400 = $9,600

Investment value at end of year one = $9,600 × 1.05 Operating expenses based on average NAV = $9,840 × .0085 Net investable funds for year two

= $10,080.00 = $83.64 = $9,996.36

Investment value at end of year two= $9,996.36 × 1.05 Operating expenses based on average NAV = $10,246.27 × .0085 Net investment at end of year two

= $10,496.18 = $87.09 = $10,409.09

Average annual compound return: $10,409.09 = $10,000(1 + g)2 => g = 2.025%

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 18 Questions: 1. Private pension funds are administered by private corporations (e.g., manufacturing, mining, or transportation firms). Public pension funds are those funds administered by a federal, state, or local government (e.g., Social Security). 2. Pension plans administered by life insurance companies (24.8 percent of the industry’s assets) are termed insured pension plans. The distinction is due not necessarily to the type of administrator, but to the classification of assets in which pension fund contributions are invested. Specifically, there is no separate pool of assets. Rather the funds are invested in the general asset accounts of the insurance company. The portion of the insurance company’s assets devoted to the pension fund is reported in the liability section under pension reserves. Noninsured pension plans (administered by mutual funds and other financial institutions) are managed by a trustee appointed by the sponsoring business, participant, or union. Trustees invest the contributions and pay the retirement benefits in accordance with the terms of the pension plan. 3. In a defined benefit pension plan, the employer (or plan sponsor) agrees to provide the employee a specific cash benefit upon retirement, based on a formula that considers such factors as years of employment and salary during employment. The formula is generally one of three types: flat-benefit, career-average, or final-pay formula. With a defined contribution pension plan the employer (or plan sponsor) does not commit to provide a specified retirement income. Rather, the employer contributes a specified amount to the pension fund during the employee’s working years. The final retirement benefit is then based on the total employer contributions, any additional employee contributions, and any investment gains or losses. 4. The three types of formulas used to determine pension benefits for defined benefit pension funds are flat-benefit formula, career-average formula, and final-pay formula. A flat benefit formula pays a flat amount for every year of employment. Two variations of career-average formulas exist; both base retirement benefits on the average salary over the entire period of employment. Under one formula retirees earn benefits based on a percentage of their average salary during the entire period they belonged to the pension plan. Under the alternate formula, the retirement benefit is equal to a percentage of the average salary times the number of years employed. A final-pay formula pays a retirement benefit based on a percentage of the average salary during a specified number of years at the end of the employee’s career times the number of years of service. 5. Defined contribution plans are increasingly dominating the private pension fund market. Indeed, many defined benefit funds are converting to defined contribution funds. Figure 18-1 shows that as equity market values fell in 2001 and in 2008 (during the financial crisis), pension fund asset values, particularly for defined contribution funds, fell as well. As the economy recovered and equity market values increased in the mid- then late-2000s, so did the value of pension fund assets. Figure 18-2 shows that from 1990 through 2016, defined benefit funds actually experienced a reduction in assets held, while defined contribution funds saw a continuous increase in new asset investments. One reason for this shift is that defined contribution funds do not require the employer to guarantee retirement benefits and thus managers do not need to monitor the funds’ performance once the required contribution are made. Thus, employees must bare more of the responsibility for monitoring fund performance. 6. Figure 18-3 shows the growth in 401(k) plans: from $385 billion in 1990 to $2,982 billion in 2007, and $4,860 billion in 2016. In 2016 there were over 81,000 401(k) plans and over 55 million participants. 7. Individual retirement accounts are self-directed retirement accounts set up by employees who are also covered by employer sponsored pension plans. Contributions to IRAs are made strictly by the employee. A Keogh account is retirement account available to self-employed individuals. Contributions by the individual may be deposited in tax deferred accounts administered by a life insurance company, a bank, or other financial institution. Similar to 401(k) plans the participant in a Keogh account is given some discretion in how the funds are invested. 8. Most state and local government pension funds are funded on a pay as you go basis, meaning that contributions collected from current employees are the source of payments to the current retirees. As result of the increasing Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e number of retirees relative to workers, some of these pension funds (e.g., the state of Illinois) have experienced a situation in which contributions have not been high enough to cover the increases in required benefit payments (or the pension funds are underfunded). In the early 2010s, U.S. states faced a total shortfall of at least $4 trillion in their funding of employees' pensions and retirement benefits, and their financial problems were only growing. Illinois was in the worst shape, with over $83 billion of its pension obligations unfunded in fiscal year 2016. During the 2000s, many states contributed only the minimum funds to the pension plans. In 2000, states were only required to pay $27 billion total into their funds. By fiscal 2008, that amount had more than doubled to a $64 billion deposit. As stock market returns fell and the U.S. economy entered a steep recession, state revenues fell dramatically. Yet states were calculating required pension contributions using assumptions based on interest rates and stock market growth rates experienced during boom markets. These unrealistic assumptions regarding reinvestment rates meant that states significantly under contributed to their pension funds. Under these circumstances, the minimum contributions made in “good times” were insufficient to keep up with promised payouts. In fiscal 2000, half of the 50 states had fully funded their pension systems. By fiscal 2016 only two states−South Dakota and Wisconsin−were able to cover their costs. The growing bill from promised pension payouts coming due to states could have significant consequences for taxpayers; resulting in higher taxes, less money for public services, and lower state bond ratings. 9. The federal government sponsors two types of pension funds. The first type are funds for federal government employees: civil service employees, military personnel, and railroad employees. Civil service funds cover all federal employees who are not members of the armed forces. This group is not covered by Social Security. Similar to private pension funds, the federal government is the main contributor to the fund, but participants may contribute as well. In addition to Social Security, career military personnel receive retirement benefits from a federal government– sponsored military pension fund. Contributions to the fund are made by the federal government, and participants are eligible for benefits after 20 years of military service. Employees of the nation’s railroad system are eligible to participate in the federal railroad pension system. Originated in the 1930s, contributions are made by railroad employers, employees, and the federal government. The second type of fund, and the largest federal government pension fund, is Social Security. Also known as the Old Age and Survivors Insurance Fund, Social Security provides retirement benefits to almost all employees and selfemployed individuals in the United States. Social Security was established in 1935 with the objective of providing minimum retirement income to all retirees. Social Security is funded on a pay as you go basis; current employer and employee Social Security taxes are used to pay benefits to current retirees. Historically, Social Security tax contributions have generally exceeded disbursements to retirees. Any surpluses are held in a trust fund that can be used to cover required disbursements in years when contributions are insufficient to cover promised disbursements. Contributions, also known as the FICA tax, are a specified percentage of an individual’s gross income (in 2016, 7.65 percent, for employees, and 15.30 percent, for self-employed individuals, of the first $115,500 earned). Employee contributions are matched with equivalent employer contributions. 10. Financial assets held by pension funds totaled $244.3 billion in 1975 and $10,883.0 billion in 2019. In 2019, 66.28 percent of pension fund contributions were in corporate equities or mutual funds shares. This compares to 44.61 percent in 1975. In fact, pension funds are the largest institutional investor in the stock market. Certainly, the booming stock markets of the 1990s are one reason for the switch to equities. 11. Figure 18-4 shows the distinction in private pension plan financial asset investments for defined benefit and defined contribution plans. In 2016, defined benefit plans have 30.73 percent of their funds invested in U.S. government securities and bonds compared to defined contributions plans with 6.37 percent. Also, defined benefit plans have 35.52 percent of their assets invested in corporate equities compared to 21.57 percent for defined contribution plans. In contrast, defined contribution plans have 52.59 percent of their funds invested in mutual fund shares compared to 14.83 percent for defined benefit plans. Defined benefit pension plans offer employees a promised payout, while defined contribution plans do not. The promise of guaranteed retirement payments is likely a major reason for the larger percentage of investments in fixed payout securities by defined benefit plans. Defined contribution plans do not offer a guaranteed retirement payout. Thus, administrators invest more of the funds in risky equities and mutual fund shares. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 12. Social Security contributions are invested in relatively low-risk, low-return Treasury securities. This, along with the fact that the growth of the population is slowing and the percentage of the population in retirement is increasing, has led to questions regarding the long-term viability of the Social Security fund (and the Social Security system in general). To bolster public confidence, the Social Security system was restructured in the mid-1990s by raising contributions and reducing retirees’ benefits. For example, full retirement age was 65 for many years. However, beginning with individuals born in 1938 or later, that age will gradually increase until it reaches 67 for people born after 1959. Further, the wage contribution increases virtually each year (e.g., the contribution as a percentage of an employee’s income was 6.2 percent of the first $72,600 in 1998 and 7.65 percent of $127,200 in 2017). In the late 1990s, several proposals were also introduced as possible ways of bolstering the Social Security fund’s resources. For example, in December 2001 the Bush administration’s Presidential Commission on Social Security Reform proposed changes to the Social Security system that included personal retirement accounts. After twelve years and several more suggestions for reform yet no major changes, in 2013 President Obama proposed changing the way the government adjusts Social Security benefits to a measure called the chained Consumer Price Index (CPI). Using a chained CPI, Social Security benefits would increase by a bit less each year than under the current formula; a gradual change whose savings would grow over time. According to Congressional Budget Office calculations, if the chained CPI were implemented, Social Security benefits would be about $30 a month lower by 2023. By 2033, Social Security payments were projected to be 3 percent lower than they would be using the current measure of inflation. Despite these calls for reform, no major reform of Social Security has been realized and, as mentioned above, in 2010 Social Security payouts exceeded revenues for the first time, six years earlier than the year 2016, which had been projected in 2009. Social Security's total costs are projected to exceed its total revenue (including interest) by 2023. 13. ERISA was passed when many workers who had contributed to pension funds for years were failing to receive their pension benefits. ERISA charged the Department of Labor with the job of overseeing pension funds. 14. The principal features of ERISA involve funding, vesting of benefits, fiduciary responsibility, transferability, and insurance. Funding: Prior to ERISA there were no statutory requirements forcing defined fund benefit administrators to adequately fund their plans. ERISA established guidelines for funding and set penalties for fund deficiencies. Vesting of Benefits: Frequently, while employers start contributing to an employee’s pension fund as soon as the employee is eligible to participate, benefits may not be paid to the employee until he or she has worked for the employer for a stated period of time (or until the employee is vested). ERISA requires that the plan must have minimum vesting requirements and set a maximum vesting period of ten years. Fiduciary Responsibilities: A pension plan fiduciary is a trustee or investment advisor charged with the management of the pension plan. ERISA set standards governing the management of a pension plan. Specifically, ERISA required that pension plan contributions be invested with the same diligence, skill, and prudence as a prudent person in like circumstances (the so-called prudent-man rule). Plan assets are required to be managed with the sole objective of providing the promised benefits to participants. To ensure a fund operates in this manner ERISA increased the requirement for pension plans to report on the current status of investments in the pension plan. Transferability: ERISA allowed employees to transfer pension credits from one employer plan to another when switching jobs. Insurance: ERISA established the Pension Benefit Guarantee Corporation (PBGC), an insurance fund for pension plan participants similar to the FDIC. The PBGC insures participants of defined benefit plans if the proceeds from the plan are unable to meet its promised pension obligations. 15. Reforms of pension systems in other countries have included benefit reductions, measures to encourage later retirement, and expansions of private funding for government pensions. For example, in many countries reforms include raising the age at which a person is eligible for pension benefits. This type of reform recognizes increased life expectancy. Finland has taken the step of indexing its full pension retirement age to life expectancy, and several countries have taken steps to encourage people to remain in the labor force as they get older. Some have done so by strengthening the link between contributions and benefits. For example, Sweden introduced notional accounts by which participants can see their potential pension benefits rise as they work longer and contribute more to the system. Other countries have taken steps to reduce payments to persons who retire before the established retirement Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e age. Many countries have traditionally offered generous benefits to people who choose to retire early, although early retirees typically receive a smaller annual pension than persons who wait until they are older to retire. However, the difference in retirement payments in many countries has not been sufficient to discourage large numbers of people from retiring early. The European debt crisis forced many countries to reform their pension systems. For example, France’s parliament approved a bill that increased the retirement age from 60 to 62. As part of the bailout plan organized by the International Monetary Fund, Greece made changes that increased the retirement age and cut automatic bonuses that retirees received at Christmas, Easter, and during the summer. Spain proposed to stop inflation linked increases in pensions and raised its retirement age from 65 to 67. The retirement age for British workers was raised to 68, at which time they can start getting their full pension. Politicians from Athens to Madrid targeted pension reform as a way to offset government debt. The reforms sparked weeks of strikes and protests. Unions across Europe took to the streets to protest the new rules. On June 23, 2010, French workers held more than 200 demonstrations nationwide. A strike in Madrid on June 29, 2010, led to clashes with police. Strikes in Greece shut down airports, ferry service, banks, and hospitals. Protests since the start of September repeatedly brought more than one million people onto the streets. Yet, with nearly everyone in Europe eligible for a public pension, governments approved the plans that were necessary to continue to finance national pension funds. Problems: 1. Annual benefits will be Years worked

Annual benefit

25 28 30

$2,500 × 25 = $62,500 $2,500 × 28 = $70,000 $2,500 × 30 = $75,000

2. Annual benefits will be Years worked

Annual benefit

30 33 35

$60,000 × 0.05 × 30 = $90,000 $62,500 × 0.05 × 33 = $103,125 $64,000 × 0.05 × 35 = $112,000

3. For retirement now, in 5 years, and in 10 years, the employee’s (estimated) annual retirement benefit payment is: Years Worked Retire now Retire in 5 years Retire in 10 years

Average Salary during Last Five Years of Service

25 30 35

4. EXCEL Problem:

Payment = $50,000 Payment = $56,105 Payment = $65,688 Payment = $78,800 Payment = $82,847

5. EXCEL Problem:

Payment = $40,000 Payment = $44,884 Payment = $52,551

$125,000 $135,000 $140,000

Annual benefit $125,000 × 0.035 × 25 = $109,375 $135,000 × 0.035 × 30 = $141,750 $140,000 × 0.035 × 35 = $171,500

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Payment = $60,640 Payment = $66,277 6. Annual benefits will be Years worked

Annual benefit

17 20 22

$40,000 × 0.03 × 17 = $20,400 $47,000 × 0.03 × 20 = $28,200 $50,000 × 0.03 × 22 = $33,000

7. Your annual investment is Employee’s contribution = $60,000 × 0.12 = Tax Savings = $7,200 × 0.31 = Employee’s cost Employer’s match = $60,000 × 0.50 × 0.05 = Total 401(k) investment at year start = $7,200 + $1,500 =

$7,200 $2,232 $4,968 $1,500 $8,700

Your one-year return is 1-year earnings = $8,700 × 0.10 = $870 Total 401(k) investment at year-end $9,570 Employee’s 1-year return = ($9,570 - $4,968)/$4,968 = 92.63% 8. Assuming the employee’s salary, tax rate, and 401(k) yield remains constant over a 25-year career, when the employee retires the 401(k) will be worth $8,700 {[(1 + 0.10)25 - 1]/0.10} = $855,619 Or on a financial calculator, PMT = 8,700, I = 10, n = 25, => CPT FV = 855,619 9. Your annual investment is Employee’s contribution = $120,000 × 0.10 = Tax Savings = $12,000 × 0.31 = Employee’s cost Employer’s match = $120,000 × 0.75 × 0.10 = Total 401(k) investment at year start

$12,000 3,720 $8,280 $9,000 $17,280

Your one-year return is 1-year earnings = $17,280 × 0.12 = $2,073.6 Total 401(k) investment at year-end $19,353.6 Employee’s 1-year return = ($19,353.6 - $8,280)/$8,280 = 133.739% 10. Assuming the employee’s salary, tax rate, and 401(k) yield remains constant over a 15-year career, when the employee retires the 401(k) will be worth $17,280 {[(1 + 0.12)15 - 1]/0.12} = $855,619 Or on a financial calculator, PMT = 17,280, I = 12, n = 15, => CPT FV = $644,193 11. The terminal value of the 401(k) plan, assuming all returns and contributions remain constant (at $16,500) over the twenty years, will be: Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Option 1: 16,500(0.6){[(1 + 0.12)20 - 1]/0.12} + 16,500(0.4){[(1 + 0.05)20 - 1]/0.05} = $931,554 Option 2: 16,500 (0.5){[(1 + 0.12)20 - 1]/0.12} + 16,500 (0.45){[(1 + 0.05)20 - 1]/0.05}+ 16,500 (0.05){[(1 + 0.03)20 - 1]/0.03} = $862,115 Option 3: 16,500 (0.4){[(1 + 0.12)20 - 1]/0.12} + 16,500 (0.5){[(1 + 0.05)20 - 1]/0.05} + 16,500 (0.1){[(1 + 0.03)20 - 1]/0.03} = $792,676

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 19 Questions:

Which country has the highest fintech adoption rate? Fintech’s adoption rate, which measures fintech users as a percentage of the digitally active population, varies by country. While the average fintech adoption rate globally was 64 percent in 2019, China and India led other countries at 87 percent, followed by Russia and South Africa at 82 percent. The fintech adoption rate for the United States was 46 percent, followed by Belgium and Luxembourg at 42 percent.

What were the supply factors that contributed to the recent emergence of fintechs? Supply factors that contributed to the emergence of fintechs include 2008 global financial crisis and macroeconomic conditions. 2008 global financial crisis left the brand image of banks severely shaken. In the wake of the financial crisis, banks shifted to comply with postcrisis regulatory developments and cost-cutting measures. As regulatory burdens increased and risk aversion rose, banks pulled back from some lending activities. With banks pulling back, some new players entered the marketplace with innovative products that used technology to overcome some of the advantages that incumbent banks had, including their network of branches. For example, some of the earliest peer-to-peer (P2P) lenders catered specifically to borrowers that banks were pulling back from, such as small businesses and riskier consumers. Another supply factor was macroeconomic conditions, the low interest rate environment in particular. The low interest rate environment put downward pressure on profits and increased the incentives of FIs to cut costs. We discussed in Chapter 17 how technology can be a way to help cut costs, and fintechs have focused on this. For example, online marketplace lenders have streamlined traditional loan under-writing processes in order to reduce costs.

What were the demand factors that contributed to the recent emergence of fintechs? One of the demand factors is the increasing prevalence of mobile technology. Ever since the first iPhone was released in June 2007, it leapfrogged far beyond the competition and launched the mobile revolution. The iPhone-led and Google Android-fueled mobile boom changed everything. When Steve Jobs first unveiled the iPhone, he described it as a “revolutionary mobile phone” and a “breakthrough Internet communications device.” Figure 18–3 shows the effect of this Internet device on the usage of mobile phones: the usage of voice services has been relatively steady, while the mobile Internet traffic has exploded. The explosion in data traffic was boosted by iOS and Android apps over the years. While Apple’s App Store launched in 2008 with 500 apps, by the end of 2017, it was offering 2.1 million apps. The Android Market, which later became Google Play, was launched three months after Apple’s App Store. By June 2017, Google Play reached the 3 million Android app mark. Apps have turned phones into everything from a bank to a motion-sensitive video game device, upending major industries such as the PC market, telecommunications companies, movie and TV business, gaming industry, health industry, and now the financial services industry. Global smartphone penetration (smartphone subscribers as a percentage of total population) reached 66 percent in 2017. Another demand factor for the emergence of fintech is demographics. According to the Pew Research Center, millennials became the largest generation in the labor force in 2016, representing 35 percent of the labor force participants in the United States. As a result, the financial, economic, and sociopolitical prominence of the millennials is continuing to grow at a rapid pace. Millennials are digital natives with high technological fluency. They are optimistic about technology and the benefits it may bring not only to their personal lives but also to society at large. They have a lingering distrust of banks because of what their parents went through during the financial crisis. Consistent with these arguments, the 2017 ComScore report noted that millennials appear to be by far the group most comfortable spending money to buy apps. Of millennials, 64 percent have paid to download an app within a year, and nearly one out of five paid to download an average of at least one app every month. A 2017 UBS Evidence Lab study found that millennials make 2.26 financial transactions per week on

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e average on their smartphones versus 0.83 through a branch. In addition to using their bank’s mobile app regularly, millennium are more likely than other generations to use P2P mobile payments, get online financial advice, or use digital currency like bitcoin. 4.

Describe the advantages and disadvantages of fintechs compared to incumbent banks. Compared to banks, fintechs have advantages such as being unburdened by regulators, legacy IT systems, branch networks, and not having the need to protect existing businesses. Additional advantages include an innovation mindset, agility, and a consumer-centric perspective. As for disadvantages, fintechs have to build their customer base from scratch, have a narrow focus on specific financial offerings, have limited compliance experience, and generally have much higher cost of capital.

Describe the advantages and disadvantages of incumbent banks compared to fintechs. Retail banks hold a huge advantage over fintechs. According to the Economist Intelligence Unit (EIU), they have three “big Cs” on their side: customers, compliance, and capital. Compared to fintechs, big banks have 10s of millions of trusting customers who interact with them every day. They can offer multiple financial products and serve as one-stop shop for all financial needs. They have decades of compliance experience and veteran legal teams. Finally, banks have a cost of capital close to zero. As for disadvantages, traditional banks and lenders still have significant work to do to repair consumer trust damaged during the last recession. It is a trauma that still manifests itself across consumers who experienced significant losses and disruptions to their financial lives. As a result, many traditional brands in financial services still have a stubborn, negative perception problem. Second challenge is the complexity of the existing systems and organizational structures, and incumbent culture that is not optimized for today’s digital market place.

What is Banking-as-a-Service? How are banks embracing a platform-based business model? Banking-as-a-Service (BaaS) is an end-to-end process that allows fintechs and other third parties to connect with banks' systems directly via APIs so they can build banking offerings on top of the providers' regulated infrastructure, as well as unlock the open banking opportunity reshaping the global financial services landscape. As fintechs have been encroaching on incumbent institutions in the banking game tech-savvy legacy banks are turning this looming threat into an opportunity by moving into the BaaS space. The BaaS process begins with a fintech or other third-party provider (TPP) paying a fee to access the BaaS platform. The financial institution opens its APIs to the TPP, thereby granting access to the systems and information necessary to build new banking products or offer white label banking services. In addition to getting ahead in open banking, legacy institutions that launch their own BaaS platforms are also opening up new revenue streams. The two main monetization strategies for BaaS include charging clients a monthly fee for access to the BaaS platform or charging a la carte for each service used. Recently IBM has found that around 79 percent of bank executives believe that the adoption of platform-based business concepts will help them obtain a viable competitive edge and ensure better innovation, profitability, and expansion to new markets. Overall, the value of the global digital banking platform market is projected to hit $8.67 billion by 2027. It's becoming clear that banking software as a service is integral to sustained growth strategies of global banks, and it's already proving its relevance in bringing the whole financial sector into the digital age.

What are four categories of fintech innovations according to the Basel Committee of Banking Supervision (BCBS)? Give specific examples for each category of innovations. BCBS categorizes fintech innovations into three product sectors, as well as market support services (Figure 18– 5). The three sectors relate directly to core banking services, while the market support services related to innovations and new technologies that are not specific to the financial sector but play a significant role in

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e fintech developments. Core banking services include: (i) credit, deposit, and capital-raising services, (ii) retail & wholesale services for payments, clearing and settlement, and (iii) investment management services. Fintech innovations regarding credit, deposit, and capital-raising services include services such as crowdfunding, lending marketplaces, mobile banks and credit scoring. Some of the largest crowdfunding fintechs to date include KickStarter, CrowdCube, Indiegogo and GoFundMe. Prominent fintechs in the lending marketplace space include LendingClub, OnDeck, Avant, GreenSky, Kabbage, and SoFi. Fintech innovations in retail services for payments, clearing and settlement include mobile wallets, peer-to-peer transfers, and digital currencies. Examples of mobile wallets include Google Pay, Apple Pay and Samsung Pay. Popular peer-to-peer money transfer apps include PayPal, Venmo, Square Cash and Zelle. Wholesale services for payments, clearing and settlement include value transfer networks, business-to-business payments, FX wholesale and digital exchange platforms. An example of a value transfer network related innovation is collaboration between a commercial payments provider FLEETCOR, enterprise blockchain solutions firm Ripple and international payments company Cambridge Global Payments, to improve international settlements using blockchain. An example of business-to-business payments (B2B) innovation is acquisition by payments technology giant Visa of its fintech partner Fraedom to press further into the B2B payments space. Qonto and Kantox’s partnership is providing solutions for FX management. Fintech innovations in investment management services include high-frequency trading, copy trading, e-trading and robo-advice. For example, copy trading allows millions of individuals trade FX on platforms such as Trade360, FxPro, Tradeo, eToro, ZuluTrade and TradingFloor. While early startups in robo-advising space were Wealthfront and Betterment, major financial institutions such as Vanguard, Schwab and Fidelity now offer roboadvisors as well. Finally, market support services include distributed ledger technology (blockchain, smart contracts), artificial intelligence and machine learning and internet-of-things (IoT). Distributed ledger technology (DLT) has been closely linked to digital currencies since its inception because it was invented as the underlying technology of the cryptocurrency Bitcoin. DLT can also be found on the capital markets infrastructure value chain: access to capital, trade execution, post-trade services, data, analytics and information services, and operations and technology. 8.

What are peer-to-peer (P2P) payments? What P2P apps have you used recently? P2P payment or transfer services let customers use a bank account or a credit/debit card to pay friends and family from their mobile phones. In addition to PayPal, Venmo and Zelle, there are other examples such as clearXchange, Circle and Snapcash.

What is cryptocurrency? Explain how cryptocurrency differs from crypto-asset. Digital currencies or cryptocurrencies combine new payments system with new currencies that are not issued by a central bank. The “crypto” in cryptocurrencies refers to complicated cryptography which allows for a particular digital token to be generated, stored and transacted securely and anonymously. Examples of privately issued digital currencies include Bitcoin (BTC), Litecoin (LTC), Ether (ETH) and XRP (XRP). Bitcoin and other digital currencies are underpinned by distributed ledger technology (DLT), which is an electronic ledger or database that records and verifies transactions made using the currency. Cryptocurrency can be said to also be a crypto-asset or a sub-class of crypto-assets, but not all crypto-assets are cryptocurrencies. In short, a cryptocurrency is a store of value and way to transfer that value among users of the currency. It doesn’t do much more than that. Crypto assets usually have many of the same features of a cryptocurrency in that there will be a token that serves as a store of value with the ability to transfer that value but there is usually a second layer of functionality added in that the technology/network enables certain functions to be performed. The most well-known example of this is Ethereum. This is a crypto-asset network where the token used as a currency is Ether. The network also enables the building of smart contracts that allow conditions to be set for what happens when a certain trigger event takes place.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 10. What are the three purposes of money? Does cryptocurrency fulfill these purposes? The three purposes of money are that money has to be (i) a good means of payment, (ii) a good unit of account, or (iii) suitable as a store of value. Agustin Carstens, General Manager of the Bank for International Settlements (BIS), argued that cryptocurrencies are not money. Instead, they are a form of an investment, as asset. According to him, cryptocurrencies fail dramatically on each of the three purposes of money. European Central Bank chief Mario Draghi also warned about Bitcoin, describing the cryptocurrency as a “very risky” and “entirely speculative” asset. 11. What is fiat currency? Is Bitcoin a fiat currency? Fiat money refers to paper money or coins of little or no intrinsic value in themselves and not convertible into gold or silver, but made legal tender by fiat (order) of the government. The U.S. dollar is fiat money, as are the euro and many other major world currencies. Bitcoin is not legal tender and not backed by a government, therefore it is not a fiat currency. 12. How does distributed ledger technology (DLT) work? What is blockchain? The emerging fintech industry has provided us with a radical alternative to record information: distributed ledger technology (DLT). Traditionally, centralized entities have been responsible for maintaining records. These centralized entities are trusted not to distort ledgers in their own favor because they stand to lose their franchise values in the event that the public discovers fraudulent activity. In contrast, a distributed ledger is a database held and updated independently by each participant (or node) in a large network. The distribution is unique: records are not communicated to various nodes by a central authority, but are instead independently constructed and held by every node. That is, every single node on the network processes every transaction, coming to its own conclusions and then voting on those conclusions to make certain the majority agree with the conclusions. Once there is consensus, the distributed ledger has been updated, and all nodes maintain their own identical copy of the ledger. Such ledgers can contain different types of shared data, such as transaction records, attributes of transactions, credentials, or other pieces of information. Blockchain is a particular type of a DLT. Blockchain organizes data into blocks (or batch of transactions), which are chained together in an append-only data structure. New additions to the database are initiated by one of the members (nodes), who creates a new “block” of data, for example containing several transaction records. This approach can be used to record transactions on any asset which can be represented in a digital form (see Figure 18-7). 13. What are the risks associated with DLT? In most instances, the risks associated with payment, clearing and settlement activities are the same irrespective of whether the activity occurs on a single central ledger or a synchronized distributed ledger. That said, DLT may pose new or different risks, including: (i) potential uncertainty about operational and security issues arising from the technology; (ii) the lack of interoperability with existing processes and infrastructures; (iii) ambiguity relating to settlement finality; (iv) questions regarding the soundness of the legal underpinning for DLT implementations; (v) the absence of an effective and robust governance framework; and (vi) issues related to data integrity, immutability and privacy. DLT is an evolving technology that has not yet been proven sufficiently robust for wide scale implementation. 14. What is a difference between Bitcoin and Ethereum? Bitcoin (BTC) is a cryptocurrency, just like Litecoin (LTC), Ether (ETH) and XRP (XRP). Ethereum is a crypto-asset network, where the token used as a currency in the network is Ether. 15. Describe applications of artificial intelligence and machine learning in financial services industry.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Artificial intelligence (AI) and machine learning are being rapidly adopted for a range of applications in the financial services industry. According to Accenture, optimal efficiencies are likely to first be seen in back-office functions, where robotic process automation (RPA) is already having a significant impact. But a greater use of intelligent automation – that is, virtual workforces that can learn and adapt to the needs of the business – is already filtering through to some middle- and front-office operations. That includes, for example, the use of robo-advisory services. Many applications, or “use cases”, of AI and machine learning already exist. According to the Financial Stability Board (FSB), some of the current and potential use cases of AI and machine learning include:  FIs and vendors are using AI and machine learning methods to assess credit quality, to price and market insurance contracts, and to automate client interaction.  FIs are optimizing scarce capital with AI and machine learning techniques, as well as back-testing models and analyzing the market impact of trading large positions.  Hedge funds, broker-dealers, and other firms are using AI and machine learning to find signals for higher and uncorrelated returns and optimize trading execution.  Both public and private sector institutions may use these technologies for regulatory compliance, surveillance, data quality assessment, and fraud detection.

16. Describe applications of internet-of-things (IoT) in financial services industry. The IoT is made up of connected devices from simple sensors to smartphones and wearables. Wearable devices have arguably been the easiest “win” for banks so far, thanks to a growing ecosystem of devices and the relative low cost associated with getting started. Many banks now provide applications for popular wearables like Apple Watch and FitPay, which is already working with the Bank of America. Some banks have even launched their own devices, with Barclays unveiling bPay wearable contactless payment solutions and other wearable bands coming from Caixa Bank, Hellenic Bank and Australia’s WestPac (with PayWear). In a recent experiment, Clydesdale and Yorkshire Banking Group’s (CYBG) customer innovation lab opened a test bed in London where it tested a number of smart devices to improve the customer experience. For example, facial detection technology was used to judge how users interacted with the space, while web access was offered through interactive touchscreens. Bluetooth beacons also represent an opportunity for retail banks to reinvigorate underused high street branches.1 US Bank, WestPac in New Zealand and Citi are all using beacon technology, while it was recently revealed that Chase is testing beacon technologies to pre-announce customers that opt into the service before they approach a human bank teller or ATM. At Barclays, beacons have been used to help disabled passengers navigate branches. 17. What is crowdfunding? Have you used any crowdfunding apps recently? Crowdfunding is a way of raising money through the collective effort of family, friends, individual investors and customers. This method taps into the collective efforts of many people—primarily online through crowdfunding and social media platforms. Nonprofits use crowdfunding to gather donations. They often refer to crowdfunding as “online fundraising,” “social media fundraising” or “peer-to-peer fundraising.” Some of the largest crowdfunding fintechs to date include KickStarter, CrowdCube, Indiegogo and GoFundMe.

1 A beacon is a small Bluetooth radio transmitter, powered by batteries. Beacons are similar to a lighthouse in functionality. These small hardware devices incessantly transmit Bluetooth Low Energy (BLE) signals. The Bluetooth enabled smartphones are capable of scanning and displaying these signals. Beacons could be deployed on store-fronts, real estate properties, amusement parks, events and other public venues to broadcast contextually-relevant advertisements and notifications. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 18. Explain one of the reasons why high frequency trading (HFT) has hit a speed bump. Do you think fintechs will experience the same difficulties that HFT firms have experienced? While HFT sector was once highly lucrative, it became increasingly difficult to compete on speed alone. As deals get executed in billionths of a second, the costs of staying in the technology race have squeezed profit margins. The HFT rush unleashed frenzied investment in wireless capacity, efficient computer switches and coding talent. Rather than outpace each other with competing paths, top companies in the space formed a consortium to build a single route, sharing bandwidth and costs. The consolidation wave could result in only a few large players that are able to invest in the best technology and a bottom tier of niche specialists, making mid-sized firms uncompetitive, industry executives say. HFTs were once seen as profit-generating machines and destructive participants in the market ecosystem. But now it seems competition has tamed and commodified the HFT product. This shift has partly been caused by competitive pressure, and partly by the fact that the market is reflexive. In this case, reflexivity refers to the phenomenon of market participants (e.g., HFT firms) losing their competitive advantage because their presence and actions in the market change market behaviors as other participants adjust. It is likely that financial technology will diffuse through the market as incumbent FIs adapt and fintech firms will face the difficulties HFTs are experiencing. 19. What is a fintech sandbox? Regulatory sandbox is a framework set up by a financial regulator to allow early-stage fintech startups to test out their offerings in a controlled environment under the regulator’s supervision. In 2015, the UK Financial Conduct Authority (FCA) launched the first regulatory sandbox for fintech startups. Fintech sandboxes are now at various stages of development and implementation in countries including Australia, Hong Kong, Indonesia, Malaysia, Singapore, Switzerland, Thailand and United Arab Emirates. In the U.S., Arizona became the first state to launch a fintech sandbox in March 2018. Unlike the FCA’s sixmonth program, Arizona is giving companies two years to test their fintech offerings. At that point, they can apply for a license to operate as a money services business. If that is granted, it is then relatively easy to apply for a license in the 16 other states that have signed up to an agreement that standardizes key elements of the licensing process. These include Texas and Illinois but not such key states as New York and California. 20. Explain the European Union’s General Data Protection Regulation (GDPR) and how it might benefit the fintechs. Two significant changes to European Union (EU) regulations have given the fintech industry a major shot in the arm and strengthened its position as a competitor to traditional banking: GDPR and PSD2. In 2016, the EU adopted the GDPR, which gave citizens the right to control the use of personally identifiable information. It replaced the 1995 Data Protection Directive which was adopted at a time when the internet was in its infancy. The GDPR is now recognized as law across the EU. Member States had two years to ensure that it is fully implementable in their countries by May 25, 2018. GDPR’s provisions require that any personal data exported outside the EU is protected and regulated. One result of the GDPR is that businesses will have access to honestly sourced data from consumers using a transparent opt-in model, which will be a rich source of information for discovering user patterns in large datasets, according to a recent report by Juniper Research. 21. Explain the European Union’s Payment Services Directive 2 (PSD2) and how it might benefit the fintechs. The purpose of PSD2, which was passed in 2015, was to regulate the emerging payment services industry and increase competition by allowing participation by non-banks, such as fintech companies. It came into force in January 13, 2018. For fintechs this is a crucial issue as the directive provides the basis of a new marketplace for them through the use of the existing banking and payment infrastructures. The directive also considers the significant operational changes for all payment service providers, not least for the security of online payments and the protection of customers’ financial data. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 22. Explain the European Union’s Open Banking standards and how they might benefit the fintechs. Open Banking phenomenon emerged from PSD2, which forced the EU and UK’s biggest banks to release their data in a secure, standardized form, so that it can be shared more easily between authorized organizations online. This data includes some simple records, such as the location of branches and the exact details of certain banking products. It should make it easier to find banks with disabled access, for instance, or compare the features of different personal and business accounts in order to get the best deal. The more important release concerns the data contained in transactions. Banks hold the authoritative record of everything we spend, lend and borrow – everything from electricity bills to mortgage payments to weekly spend on train travel and coffee – but, for the most part, they don’t make much use of it. Open Banking makes it possible to pass this rich information to third parties, who can use it to create new products. Open Banking standards in the EU and the U.K. are friendly to fintech companies as they streamline access to a growing network of bank data. Fintechs within the U.S. must create individual data sharing agreements with each bank partner, and the negotiations for each partnership can be resource intensive. However, in the EU a fintech can get access to all bank APIs through registering as an account information service provider (AISP) or payment initiation service provider (PISP). This could create a situation where the U.S. may lose out on technology investments and see innovative financial professionals leave the nation to work in the rapidly advancing open-banking environment within the EU.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 20 Questions: 1. Credit risk is the risk that promised cash flows from loans and securities held by FIs may not be paid in full. FIs that lend money for long periods of time, whether as loans or by buying bonds, are more susceptible to this risk than those FIs that have short investment horizons. This means, for example, that depository institutions and life insurers are more exposed to credit risk than are money market mutual funds and property–casualty insurers, since depository institutions and life insurers tend to hold longer maturity assets in their portfolios than mutual funds and property–casualty insurers. For example, life insurance companies and depository institutions generally must wait a longer time for returns to be realized than money market mutual funds and property-casualty insurance companies. 2. Firm-specific credit risk refers to the likelihood that individual assets may deteriorate in quality. Thus, if S&P lowers its rating on IBM stock and if an investor is holding only this particular stock, she will face significant losses as a result of this downgrading. However, as portfolio theory in finance has shown, firm-specific credit risk can be diversified away if a portfolio of well-diversified stocks is held. Diversification across assets, such as loans exposed to credit risk, reduces the overall credit risk in the asset portfolio and thus increases the probability of partial or full repayment of principal and/or interest. Similarly, if an FI holds well-diversified assets, that is, assets of varying quality, it will be left only with systematic credit risk, which will be affected by the general condition of the economy, that is factors that simultaneously increase the default risk of all firms in the economy (e.g., an economic recession). 3. This was principally credit risk, but the main issue is whether this represents systematic credit risk or firm specific credit risk. It would seem that this example is closer to a demonstration of firm specific risk in that it would have been possible to diversify some of this risk away by making loans to firms less dependent on the oil industry in particular or the regional economy more generally. 4. Liquidity risk is the risk that a sudden surge in liability withdrawals may require an FI to liquidate assets in a very short period of time and at less than fair market prices. In times of normal economic activity, depository institutions meet cash withdrawals by accepting new deposits and borrowing funds in the short-term money markets. However, in times of harsh liquidity crises, the FI may need to sell assets at significant losses in order to generate cash quickly. 5. The most liquid asset of all is cash, which FIs can use directly to meet liability holders’ demands to withdraw funds. Although FIs limit their cash asset holdings because cash earns no interest, low cash holdings are generally not a problem. Day-to-day withdrawals by liability holders are generally predictable, and large FIs can normally expect to borrow additional funds to meet any sudden shortfalls of cash in the money and financial markets. At times, however, FIs face a liquidity crisis. For example, because of a lack of confidence in an FI or some unexpected need for cash, liability holders may be led to demand larger withdrawals than usual. When all, or many, FIs face abnormally large cash demands, the cost of purchased or borrowed funds rises and the supply of such funds becomes restricted. As a consequence, FIs may have to sell some of their less liquid assets to meet the withdrawal demands of liability holders. This results in a more serious liquidity risk, especially as some assets with “thin” markets generate lower prices when the sale is immediate than when an FI has more time to negotiate the sale of an asset. As a result, the liquidation of some assets at low or “fire-sale” prices (the price the FI receives if the assets must be liquidated immediately at less than their fair market value) could threaten an FI’s profitability and solvency. 6. Asset transformation by an FI involves purchasing primary assets and issuing secondary assets as a source of funds. The primary securities purchased by the FI often have maturity and liquidity characteristics that are different from the secondary securities issued by the FI. For example, a bank buys medium- to long-term bonds and makes medium-term loans with funds raised by issuing short-term deposits. Interest rate risk occurs because the prices and reinvestment income characteristics of long-term assets react differently to changes in market interest rates than the prices and interest expense characteristics of short-term deposits. Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 7. Refinancing risk is the risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments. This risk occurs when an FI is holding assets with maturities greater than the maturities of its liabilities. For example, if a bank has a ten-year fixed-rate loan funded by a 2-year time deposit, the bank faces a risk in that new deposits may only be obtained, and the loans refinanced, at a higher rate in two years. These interest rate increases would reduce net interest income. The bank would benefit if interest rates fall as the cost of renewing the deposits would decrease, while the interest rate earned on the loan would not change. In this case, net interest income would increase. 8. Reinvestment risk is the risk that the returns on funds to be reinvested will fall below the cost of funds. This risk occurs when an FI holds assets with maturities that are shorter than the maturities of its liabilities. For example, if a bank has a two-year loan funded by a ten-year fixed-rate time deposit, the bank faces the risk that it might be forced to lend or reinvest the money at lower rates after two years, perhaps even below the deposit rates. Also, if the bank receives periodic cash flows, such as coupon payments from a bond or monthly payments on a loan, these periodic cash flows will also be reinvested at the new lower (or higher) interest rates. Besides the effect on the income statement, reinvestment risk may cause realized yields on assets to differ from the a priori expected yields. 9. Although the fund's asset portfolio is comprised of default (or credit) risk free securities, it is still exposed to interest rate risk. For example, if interest rates increase significantly, the market value of the fund's Treasury security portfolio may decrease. Moreover, although it is virtually impossible for the federal government to go bankrupt (at least in terms of local currency, where it always can print more money to meet its obligations), in times of political or economic turmoil, the government may refuse to meet its debt obligations. 10. When interest rates increase (or decrease), the value of fixed-rate assets decreases (or increases) because of the discounted present value of the cash flows. To the extent that the change in market value of the assets differs from the change in market value of the liabilities, the difference is realized in the economic or market value of the equity of the FI. For example, for most depository institutions, an increase in interest rates will cause asset values to decrease more than liability values. The difference will cause the market value, or share price, of equity to decrease. 11. A policy of maturity matching will allow changes in market interest rates to have approximately the same effect on both interest income and interest expense. An increase in rates will tend to increase both income and expense, and a decrease in rates will tend to decrease both income and expense. The changes in income and expense may not be equal because of different cash flow characteristics of the assets and liabilities. The asset-transformation function of an FI involves investing short-term liabilities in long-term assets. Maturity matching clearly works against successful implementation of this process. 12. The interest rate risk would increase as the bonds are being paid back more slowly and so the cash flows would be exposed to interest rate changes for a longer period of time. 13. The zero coupon bond would have more interest rate risk. Since the entire cash flow from the zero coupon is not received until the bond matures, the entire cash flow is exposed to interest rate changes over the entire life of the project. The coupon paying bond returns its cash flows sooner, exposing less of them to interest rate changes. In this sense, the coupon paying bond "pays back" sooner. A more formal explanation of the interest rate risk inherent in the two bonds will be presented in the next chapter after students have learned about duration. 14. In this case the coupon-paying bond has more interest rate risk. The zero-coupon bond will generate exactly the expected return at the time of purchase because no interim cash flows will be realized. Thus, the zero-coupon bond has no reinvestment risk. The coupon-paying bond faces reinvestment risk each time a coupon payment is received. The results of reinvestment will be beneficial if interest rates rise, but decreases in interest rate will cause the realized return to be less than the expected return. 15. The mutual fund faces the risk of interest rates rising and the value of the securities falling. 16. Off-balance-sheet activities are contingent commitments to undertake future on-balance-sheet investments. The usual benefit of committing to a future activity is the generation of immediate fee income without the normal recognition of the activity on the balance sheet. As such, these contingent investments may be exposed to credit risk Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e (if there is some default risk probability), interest rate risk (if there is some price and/or interest rate sensitivity), and foreign exchange rate risk (if there is a cross currency commitment). 17. Foreign exchange risk is the risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in non-domestic currencies. An FI is net long in foreign assets when the foreign currency-denominated assets exceed the foreign currency-denominated liabilities. In this case, an FI will suffer potential losses if the domestic currency strengthens relative to the foreign currency when repayment of the assets will occur in the foreign currency. An FI is net short in foreign assets when the foreign currency-denominated liabilities exceed the foreign currency-denominated assets. In this case, an FI will suffer potential losses if the domestic currency weakens relative to the foreign currency when repayment of the liabilities will occur in the domestic currency. 18. FIs have increasingly recognized that both direct foreign investment and foreign portfolio investment can extend the operational and financial benefits available from purely domestic investments. To the extent that the returns on domestic and foreign investments are imperfectly correlated, FIs can reduce risk through domestic-foreign activity/investment diversification. The returns on domestic and foreign direct investments and portfolio investments are not perfectly correlated for two reasons. First, the technologies and firms across various economies differ from each other in terms of growth rates, extent of development, etc. Second, exchange rate changes may not be perfectly correlated across various economies. 19. The U.S. FI would prefer to be net short (liabilities greater than assets) in its asset position. The depreciation of the franc relative to the dollar means that the U.S. FI would pay back the net liability position with fewer dollars. In other words, the decrease in the foreign assets in dollar value after conversion will be less than the decrease in the value of the foreign liabilities in dollar value after conversion. 20. Matching the size of the foreign currency book will not eliminate the risk of the international transactions if the maturities of the assets and liabilities are mismatched. To the extent that the asset and liabilities are mismatched in terms of maturities, or more importantly durations, the FI will be exposed to foreign interest rate risk. 21. In this case, the insurance company is worried about the value of the British pound falling. If this happens, the insurance company would be able to buy fewer dollars with the British pounds received. This would happen if the exchange rate rose to say, ₤1.88/$ since now it would take more British pound to buy one dollar. 22. If the franc is expected to depreciate, an FI loses if it is net long in assets (i.e., it has more assets denominated in francs than liabilities). However, if it is net short in assets, a depreciation of the franc will benefit the FI. This is because the fall of the assets in dollar value after conversion will be lower than the fall in the value of its liabilities. 23. Country risk is the risk that repayments to foreign lenders or investors may be interrupted because of restrictions, intervention, or interference from foreign governments. A lender FI has very little recourse in this situation unless the FI is able to restructure the debt or demonstrate influence over the future supply of funds to the country in question. This influence likely would involve significant working relationships with the IMF and the World Bank.

24. Technology risk refers to the uncertainty surrounding the implementation of new technology in the operations of an FI. For example, if an FI spends millions on upgrading its computer systems but is not able to recapture its costs because its productivity has not increased commensurately or because the technology has already become obsolete, it has invested in a negative NPV investment in technology. Operational risk refers to the failure of the back-room support operations necessary to maintain the smooth functioning of the operation of FIs, including settlement, clearing, and other transaction-related activities. For example, in August 2018 the FBI sent out an alert to banks that cybercriminals were preparing to imminently carry out a global fraud scheme known as an “ATM cash-out.” Cash-out means that thieves use a bank or payment card processor and cloned cards at cash machines to potentially withdraw millions of dollars in a few hours. Just prior to executing the ATM cash-outs, cybercriminals remove many fraud controls at the financial institution, such as maximum ATM withdrawal amounts and any limits on the number of customer ATM transactions daily. The FBI urged banks to review how they handle security, such as implementing strong password requirements and two-factor Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e authentication using a physical or digital token when possible for local administrators and business critical roles. Operational risk is not exclusively the result of technological failure. Other sources of operational risk can result in direct costs (e.g., loss of income), indirect costs (e.g., client withdrawals and legal costs), and opportunity costs (e.g., forgone business opportunities) that reduce an FI’s profitability and market value. 25. Neither. The costs as a percent of assets have increased from 15.38% to 19.44% for Bank 1. This represents diseconomies of scale. 26. Financial technology, or fintech, refers to the use of technology to deliver financial solutions in a manner that competes with traditional financial methods. Fintech risk involves the risk that fintech firms could disrupt business of financial services firms in the form of lost customers and lost revenue. 27. While similar to technology risk discussed above, the Financial Stability Board defines fintech as “Technologyenabled innovation in financial services that could result in new business models, applications, processes or products with an associated material effect on the provision of financial services. Thus, fintech risk is broader and wider ranging than technology risk. 28. While fintechs are facing increased regulatory oversight, financial institutions are facing an increasing need to update their technological operating models for new competition, cut costs by simplifying outdated systems, build technology capabilities to better understand customer needs, and employ talent and skills necessary to execute and be successful in their fintech strategies. That said, traditional financial institutions have used risk management in a certain way for many years. They have large teams of highly-skilled and experienced employees with years of experience in dealing with risk issues. Fintech firms, on the other hand, tend to have small teams using risk management processes that have been developed over a relatively short timeframe and which are untested in dealing with major risk events. Further, a risk even at a fintech firm can result in losses that are substantially more damaging. There is less history to create a protocol for a risk event and to provide confidence that the firm can manage through a problem. 29. 1. a, b 2. a, b 3. a, d, e 4. a, b, c, d, e, f 5. a, c 6. a, b, d, e 7. a, b, c 30. Insolvency risk is the risk that an FI may not have enough capital to offset a sudden decline in the value of its assets. This risk involves the shortfall of capital in times when the operating performance of the institution generates accounting losses. These losses may be the result of one or more of interest rate, market, credit, liquidity, sovereign, foreign exchange, technological, and off-balance-sheet risks. 31. Measuring each source of FI risk exposure individually creates the false impression that they are independent of each other. For example, the interest rate risk exposure of an FI could be reduced by requiring customers to take on more interest rate risk exposure through the use of floating-rate products. However, this reduction in FI risk may be obtained only at the possible expense of increased credit risk. That is, customers experiencing losses resulting from unanticipated interest rate changes may be forced into insolvency, thereby increasing the FI’s default risk. Similarly, off-balance-sheet risk encompasses several risks since off-balance-sheet contingent contracts typically have credit risk and interest rate risk as well as currency risk. Moreover, the failure of collection and payment systems may lead corporate customers into bankruptcy. Thus, technology risk may influence the credit risk of FIs. As a result of these interdependencies, FIs have focused on developing sophisticated models that attempt to measure all of the risks faced by the FI at any point in time.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e

Problems: 1. a. Interest income Interest expense Net interest income (NII)

$1,000 600 $400

$10,000 × 0.10 $10,000 × 0.06

$1,000 700 $300

$10,000 × 0.10 $10,000 × 0.07

Interest income Interest expense Net interest income (NII)

The change in NII is the result of refinancing risk. Refinancing risk occurs when the cost of rolling over the CD liability occurs at the new higher 7% rate. Reinvestment risk is not incurred in this example. Reinvestment risk is when the cash earned on the assets is reinvested at a lower interest rate. This did not occur in this case. c.

Cash Bond Total assets

$1,000 $9,446 $10,446

Certificate of deposit Equity Total liabilities and equity

$10,000 $ 446 $10,446

d. The market value of the equity would be higher because the value of the bond (assets) would be higher and the value of the CD would remain unchanged. e. The operating performance has been affected by the changes in the market interest rates that have caused the corresponding changes in interest income, interest expense, and net interest income. These specific changes have occurred because of the unique maturities of the fixed-rate assets and liabilities. Similarly, the economic or market value of the firm has changed because of the effect of the changing rates on the market value of the bond. 2. a. Expected interest income: Expected interest expense: Expected net interest income:

($50m × 0.10) + ($50m × 0.07) = $8.5m. ($70m × 0.06) + ($20m × 0.06) = $5.4m $ 8.5m - $5.4m = $3.1m.

b. After the 200 basis point interest rate increase, net interest income declines to (50m(0.12) + 50m(0.07)) - (70m(0.08) + 20m(0.06)) = $9.5m - $6.8m = $2.7m, a decline of $0.4 m. 3. There would be no impact on net interest income during the first year. However, net interest income would decrease in the second year: Year 1 interest income = $50m × 0.10 = Year 1 interest expense = $50m × 0.08 = Net interest income Year 2 interest income = $50m × 0.10 = Year 2 interest expense = $50m × 0.09 = Net interest income

$5.0m $4.0m _____ $1.0m $ 5.0m $ 4.5m ______ $ 0.5m < $1.0m

4. a. The dollar appreciated against the euro. It takes more euros to buy a dollar. b. Interest received in € Interest paid Net interest margin

= = =

€12 million €6 million €6 million

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Interest received in dollars Interest paid in dollars Net interest margin

= = =

$8 million $4 million $4 million

After Devaluation Interest received in dollars Interest paid in dollars Net interest margin

= = =

$6 million $3 million $3 million

Thus, the devaluation of the euro reduced net interest margin by $1 million. c. The assets before depreciation were worth $100 million (€150m/1.50) but after devaluation they are worth $75 million. The liabilities were worth $66.67 million but are now worth $50 million. Since assets declined by $25 million and liabilities by $16.67 million, net worth declined by $8.33 million using current spot rates. 5. At Issue Date: Dollar Transaction Values (in millions) British $60 Euro $100 loan CD U.S. $40 T-bill _________________________________ $100 $100 Today: Dollar Transaction Values (millions of dollars) British $77.52 Euro $129.21 loan CD U.S. $40 T-bill ______________________________ $117.52 $129.21

£ Transaction Values (in millions) British £92.29 |Euro £153.82 loan CD U.S. £61.53 T-bill _________________________________ £153.82 £153.82

£ Transaction Values (millions of £) British £92.29 Euro

£153.82 loan CD U.S. £47.62 T-bill ___________________________________ £139.91 £153.82

a. Today's principal value on the Euro CD is £153.82 and $129.21m (153.82/1.1905). b. Today's principal value on the loan is £92.29 and $77.52 (92.29/1.1905). c. Today's principal value on the U.S. Treasury bill is $40m and £47.62 (40 × 1.1905). Although for a U.S. bank this does not change in value. d. Qualitybank's loss is $11.69m or £13.91. 6. a. Beginning of the Year Price of Bond = SF80{[1-(1/(1 + 0.08)10)]/0.08} + SF1,000/(1 + 0.08)10 = SF1,000 On a financial calculator: N = 10, I = 8, PMT = 80, FV = 1,000, => PV = SF1,000 End of Year Price of Bond = SF80{[1-(1/(1 + 0.10)9)]/0.10} + SF1,000/(1 + 0.10)9 = SF884.82 On a financial calculator: N = 9, I = 10, PMT = 80, FV = 1,000, => PV = SF884.82 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Loss to Swiss investor (SF884.82 + SF80 - SF1,000)/$1,000 = -3.52%. b. Price beginning of year = SF1,000 × 0.66667 = $666.67 Price at end of year = SF884.82 × 0.74074 = $655.42 Interest received at end of year = SF80 × 0.74074 = $59.26 Gain to U.S. investor = ($655.42 + $59.26 - $666.67)/$666.67 = +7.20%. Thus, the Swiss investor who was exposed to interest rate risk faced a loss of 3.52%. However, the U.S. investor faced both interest rate and foreign exchange risk. In the case of the latter, the appreciation of the Swiss franc helped to moderate the interest rate loss. It could have resulted in a bigger loss to the U.S. investor if the Swiss franc had depreciated against the dollar.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 21 Questions: 1. Credit risk management is important for FI managers because it determines several features of a loan: interest rate, maturity, collateral and other covenants. Riskier projects require more analysis before loans are approved. If credit risk analysis is inadequate, default rates could be higher and push an FI into insolvency, especially if lending markets are competitive and the margins are low. 2. Two considerations dominate an FI’s decision to approve a mortgage loan application: (1) the applicant’s ability and willingness to make timely interest and principal repayments and (2) the value of the borrower’s collateral. Ability and willingness of the borrower to repay debt outstanding is usually established by application of qualitative and quantitative models. The character of the applicant is also extremely important. Stability of residence, occupation, family status (e.g., married, single), previous history of savings, and credit (or bill payment) history are frequently used in assessing character. The loan officer must also establish whether the applicant has sufficient income. In particular, the loan amortization (i.e., principal and interest payments) should be reasonable when compared with the applicant’s income and age. The loan officer should also consider the applicant’s monthly expenditures. Family responsibilities and marital stability are also important. Monthly financial obligations relating to auto, personal, and credit card loans should be ascertained, and an applicant’s personal balance sheet and income statement should be constructed. 3. Credit scoring models are used to calculate the probability of default or to sort borrowers into different default risk classes. The primary benefit of credit scoring models is to improve the accuracy of predicting borrower’s performance without using additional resources. This benefit results in fewer defaults and chargeoffs to the FI. The models use data on observed economic and financial borrower characteristics to assist an FI manager in (a) identifying factors of importance in explaining default risk, (b) evaluating the relative degree of importance of these factors, (c) improving the pricing of default risk, (d) screening bad loan applicants, and (e) more efficiently calculating the necessary reserves to protect against future loan losses. 4. The techniques used for mortgage loan credit analysis are very similar to those applied to individual and small business loans. Individual consumer loans are scored like mortgages, often without the borrower ever meeting the loan officer. Unlike mortgage loans for which the focus is on a property, however, nonmortgage consumer loans focus on the individual’s ability to repay. Thus, credit scoring models put more weight on personal characteristics such as annual gross income, the TDS score, and so on. Small business loans are more complicated because the FI is frequently asked to assume the credit risk of an individual whose business cash flows require considerable analysis, often with incomplete accounting information available to the credit officer. The payoff for this analysis is also small, by definition, because loan principal amounts are usually small. A $50,000 loan with a 3 percent interest spread over the cost of funds provides only $1,500 of gross revenues before loan loss provisions, monitoring costs, and allocation of overheads. This low profitability has caused many FIs to build small business scoring models similar to, but more sophisticated than, those used for mortgages and consumer credit. These models often combine computer-based financial analysis of borrower financial statements with behavioral analysis of the owner of the small business. 5. Although definitions of mid-market corporates vary, they typically have sales revenues from $5 million to $100 million a year, have a recognizable corporate structure (unlike many small businesses), but do not have ready access to deep and liquid capital markets (as do large corporations). Credit analysis of a mid-market corporate customer differs from that of a small business because, while still assessing the character of the firm’s management, its main focus is on the business itself. There is also a better defined corporate structure and a clearer delineation of the corporate assets from the personal assets of the owners. The mid-market borrower is also more likely to have a track record to use as a basis for future performance. 6. One particular consideration is the life of the company. Typically, loans are made to small businesses to help start up the company. This creates several problems. There is less history to base the loan on. Numerical scoring rules may be less useful in this case. A start-up business that fails may also have less collateral value compared to a larger Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e company. Because of this, the personal assets of the small business owner may be used as collateral on the loan. A loan to a small business will necessarily be small, so the size of the profits to be earned by the FI from the loan is not likely to be very substantial. 7. Having gathered information about the credit applicant, an account officer decides whether it is worthwhile to pursue the new business, given the applicant’s needs, the FI’s credit policies, the current economy, and the competitive lending environment. If it is, the account officer structures and prices the credit agreement with reference to the FI’s credit granting policy. This includes several areas of analysis, including the five Cs of credit, cash flow analysis, ratio analysis, and financial statement comparisons (described below). At any time in this process, conditions could change or new information could be revealed, significantly changing the borrower’s situation and forcing the account officer to begin the process again. Once the applicant and an account officer tentatively agree on a loan, the account officer must obtain internal approval from the FI’s credit risk management team. Generally, even for the smallest mid-market credit, at least two officers must approve a new loan customer. Larger credit requests must be presented formally (either in hard copy or through a computer network) to a credit approval officer and/or committee before they can be signed. This means that, during the negotiations, the account officer must be very well acquainted with the FI’s overall credit philosophy and current strategy. 8. Calculation of financial ratios is useful when performing financial statement analysis on a mid-market corporate applicant. Although stand-alone accounting ratios are used for determining the size of the credit facility, the analyst may find relative ratios more informative when determining how the applicant’s business is changing over time (i.e., time series analysis) or how the applicant’s ratios compare to those of its competitors (i.e., cross-sectional analysis). Ratio analysis almost always includes a comparison of one firm’s ratios relative to the ratios of other firms in the industry, or cross-sectional analysis. Key to cross-sectional analysis is identifying similar firms that compete in the same markets, have similar size assets, and operate in a similar manner to the firm being analyzed. Since no two firms are identical, obtaining such a comparison group is no easy task. Thus, the choice of companies to use in cross-sectional analysis is at best subjective. 9. Liquidity provides the defensive cash and near-cash resources for firms to meet claims for payment. Liquidity ratios express the variability of liquid resources relative to potential claims. When considering the liquidity of a loan applicant, high levels of liquidity effectively guard against liquidity crises but at the cost of lower returns on investment. Note that a company with a very predictable cash flow can maintain low levels of liquidity without much liquidity risk. Account officers frequently request detailed cash flow projections from an applicant that specify exactly when cash inflows and outflows are anticipated. 10. Conditions precedent are those conditions specified in the credit agreement that must be fulfilled before drawdowns are permitted. These include various title searches, perfecting of collateral, and the like. Following drawdown, the credit must be monitored throughout the loan’s life to ensure that the borrower is living up to its commitments and to detect any deterioration in the borrower’s creditworthiness so as to protect the FI’s interest in the loan being repaid in full with the promised interest return. 11. An FI’s bargaining strength is severely diminished when it deals with large creditworthy corporate customers. Large corporations are able to issue debt and equity directly in the capital markets as well as to make private placements of securities. Also, they typically maintain credit relationships with several FIs and have significant inhouse financial expertise. They manage their cash positions through the money markets by issuing their own commercial paper to meet fund shortfalls and use excess funds to buy Treasury bills, banker’s acceptances, and other companies’ commercial paper. Moreover, large corporate clients are not seriously restricted by international borders but have operations and access to international capital markets and FIs in many parts of the world. Large corporate clients are very attractive to FIs because, although spreads and fees are small in percentage terms, the transactions are often large enough to make them very profitable as long as a default does not occur and they offer the potential for cross-selling other FI products to the client. Specifically, the FI’s relationship with large corporate clients goes beyond lending. The FI’s role as broker, dealer, and advisor to a corporate client may rival or exceed the importance of its role as a lender. A large corporate client is likely to investigate several avenues for obtaining credit and to compare, for example, the flexibility and cost of a bond, a private placement, and borrowing from different FIs. The client may periodically poll FIs to determine Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e opportune times to tap financial markets, even if this means inventorying funds. The FI’s loan account officer must often liaise with the FI’s investment banker to obtain information and indicative pricing on new security issues. Clearly, the amount of time this involves means that an FI’s senior corporate account officer manages far fewer accounts than colleagues providing mid-market credits. 12. Although X3, or EBIT/total assets, has the highest coefficient (3.3), it is not necessarily the most important variable. Since the value of X3 is likely to be small, the product of 3.3 and X3 may be quite small. For some firms, particularly those in the retail business, the asset turnover ratio, X5 may be quite large and the product of the X5 coefficient (1.0) and X5 may be substantially larger than the corresponding number for X3. Generally, the factor that adds most to Z score varies from firm to firm. 13. An increase in risk premiums indicates a riskier pool of clients who are more likely to default by taking on riskier projects. This reduces the repayment probability and lowers the expected return to the lender. 14. A compensating balance is the portion of a loan that a borrower must keep on deposit with the credit-granting FI. Thus, the funds are not available for use by the borrower. As the amount of compensating balance for a given loan size increases, the effective return on the loan increases for the lending institution. 15. Loan portfolio risk, as the name implies, refers to the risk of a portfolio of loans as opposed to the risk of a single loan. Inherent in the distinction is the elimination of some of the risks of individual loans because of benefits from diversification. 16. Modern portfolio theory has demonstrated that a well-diversified portfolio can provide opportunities for individuals to invest in a set of efficient frontier portfolios, defined as those portfolios that provide the maximum returns for a given level of risk or the lowest risk for a given level of returns. By choosing portfolios on the efficient frontier, a banker may be able to reduce credit risk to its fullest. A manager’s selection of a particular portfolio on the efficient frontier is determined by his or her risk-return trade-off. Problems: 1. The monthly payment for this mortgage will be $587 ($80,000 = PMT{[1 - (1/(1 + 0.08/12)30(12))]/0.08/12} ), the tax payment is $100 per month and she earns $2,500 per month. So her GDS = (587+100)/2,500 = 0.2748, or 27.48%. Thus, Jane is eligible for the loan. 2. Joan Doe’s credit score is calculated as follows: Characteristic Value Annual gross income $45,000 TDS 10% Relations with FI Checking account Major credit cards 5 Age 27 Residence Own/Mortgage Length of residence 2 1/2 years Job stability 5 1/2 years Credit history Missed 2 payments 1 year ago Score

Score 20 40 10 10 25 20 25 50 -15 185

The loan request will go to the credit committee for review and decision. 3. Net change in cash and marketable securities = $1,025,000 - $950,000 = $75,000 Cash Flows from Operating Activities

= $6,101,000

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Cash Flows from Investing Activities Cash Flows from Financing Activities Net Change in Cash and Marketable Securities 4.

= - 2,567,000 = - 3,459,000 = $75,000

Statement of Cash Flows for Year Ending December 31, 2022 (in millions of dollars)

A. Cash Flows from Operating Activities Net income Additions (sources of cash): Depreciation Increase accrued wages and taxes Increase accounts payable Subtractions (uses of cash): Increase accounts receivable Increase inventory

$16 4 4 1 -1 -7

Net cash flow from operating activities:

$17

B. Cash Flows from Investing Activities Subtractions: Increase fixed assets Increase other long-term assets

-$18 0

Net cash flow from investing activities:

-$18

C. Cash Flows from Financing Activities Additions: Increase notes payable Increase long-term debt Increase common and preferred stock Subtractions: Pay preferred stock dividends Pay common stock dividends

$1 4 0 -1 -3

Net cash flow from financing activities:

D. Net Change in Cash and Marketable Securities

5. A. Cash Flows from Operating Activities Net income Additions (sources of cash): Depreciation Increase accrued wages and taxes Increase accounts payable Subtractions (uses of cash): Increase accounts receivable Increase inventory Net cash flow from operating activities:

-$ 0

$315m. 46m. 15m. 20m. -18m. (=$340m.-$315m.-$46m.-$15m.-$20m.+$38m.) -38m. $340m.

Thus, end of year balance of accounts receivable = $50m. + $18m. = $68m. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 6.

a. 96,000/42000 = 2.29X b. 52,000 × 365/200000 = 94.9 days c. 200,000/140,000 = 1.43X d. 40,000 × 365/130,000 = 112.3 days e. (42,000+36,000)/140,000 = 0.557 = 55.7% f. (42,000+8000)/78,000 = 0.64 = 64% g. 26,040/140,000 = 0.186 = 18.6% h. 26,040/62,000 = 0.42 = 42%

7. The ratios can be compared to industry averages and trends over time. In addition, we could use the financial statement information to calculate the appropriate ratios for Altman’s Z-score. 8. a. Current ratio b. Quick ratio c. Days sales in receivables d. Days sales in inventory e. Sales to working capital f. Sales to fixed assets g. Total assets turnover h. Debt-to-assets i. Times interest earned j. Cash flow to debt k. Gross margin l. Profit margin m. ROA n. ROE o. Dividend payout ratio

Lake of Egypt Marina, Inc. 390/210=1.86 times (390-200)/210=0.90 times (115 × 365)/515=81.50 days (200 × 365)/260=280.77 515/(390 - 210)=2.86 times 515/520=0.99 times 515/910=0.57 times (210 + 300)/910=56.04% 233/33=7.06 times (233 + 22)/33=7.73 times 255/515=49.51% 138/515=26.80% 138/910=15.16% 138/400=34.50% 65/138=47.10%

days

Industry 2.0 times 1.2 times 32.50 days 151.39 days 4.25 times 1.15 times 1.18 times 62.50% 9.50 times 8.25 times 55.55% 28.75% 19.75% 36.88% 35%

Lake of Egypt Marina is performing below the industry in all areas. Liquidity is lower, asset management is poorer, and profit ratios are lower. 9. This question represents an opportunity to break down the ROE into its components: ROE = PM × AU × EM = 0.03 × 1.5 × (1/(1 - 0.66)) = 0.1324 = 13.24% 10. a. Altman’s discriminant function is given by: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 X1 = (20 + 90 + 90 -30 - 90 -30) / 700 = 0.0714 X2 = 22 / 700 = 0.0314 X3 = 140 / 700 = 0.20 X4 = 400 / 150 = 2.67 X5 = 500 / 700 = 0.7143

X1 = Working capital/total assets (TA) X2 = Retained earnings/TA X3 = EBIT/TA X4 = Market value of equity/long term debt X5 = Sales/TA

Z = 1.2(0.0714) + 1.4(0.0314) + 3.3(0.20) + 0.6(2.67) + 1.0(0.7143) = 3.106 0.0857 + 0.044 + 0.66 + 1.6 + 0.7143 = 3.106 b. Since the Z-score of 3.106 is greater than 1.81, ABC, Inc.’ s, application for a capital expansion loan should be approved. c.

ABC’s net income would be $12,000, then:

X1 = (20 + 90 + 90 - 30 - 90 - 30) / 700 = 0.0714 X2 = 12 / 700 = 0.0171 X3 = 90 / 700 = 0.1286 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e X4 = 100 / 150 = 0.6667 X5 = 450 / 700 = 0.6429 Since ABC's Z-score falls to 1.577 < 1.81, credit should be denied. d. There are several problems with using a discriminant function model such to evaluate credit risk: i) It discriminates only between two extreme cases, default or no default. ii) It is a static model and forecasts the likelihood of borrower default as if there is no change in the borrower's circumstances over time. If the loan applicant's earnings are cyclical, this point estimate may not be indicative of firm profitability. iii) It ignores qualitative factors, such as reputation and other private information. iv) Accounting variables are updated infrequently (e.g., quarterly or annually). This allows scores to be changed at generally infrequent intervals. 11. Z = 1.2(0.10) + 1.4(0.20) + 3.3(0.22) + 0.6(0.60) + 1.0(0.9) = 2.386 According to the Altman’s Z-score, this firm should be placed in the indeterminate bankruptcy risk class. 12. The true cost will be 0.10/(1 - 0.10) = 0.1111 = 11.11% 13. 1+k = 1 + (0.0025 + 0.09)/(1 - (0.10)(0.94)) = 1 + 0.0925/0.906 = 1.102, k = 0.102 = 10.2% 14. RAROC = One-year net income on loan/ Loan or capital risk Expected interest = 0.1028 × $5,000,000 Up-front fees = 0.0010 × $5,000,000 Service fees = 0.0005 × $5,000,000 Less cost of funds = 0.10 × $5,000,000 Net interest and fee income

= $514,000 = $5,000 = $2,500 = ($500,000) = $21,500

RAROC = $21,500/($5,000,000)(0.03)(0.90) = 21,500/135,000 = 0.1593 = 15.93% Since RAROC is higher than the cost of funds to the bank, the bank should make the loan. 15. a. Expected return of A = 0.2(0.02) + 0.8(0.14) = 0.116 = 11.6% Expected return of B = 0.2(0.00) + 0.8(0.18) = 0.144 = 14.4% b. Expected return in state 1 = 0.5(0.02) + 0.5(0.00) = 0.01 = 1.0% Expected return in state 2 = 0.5(0.14) + 0.5(0.18) = 0.16 = 16.0% c. Expected return on the portfolio = 0.5(0.116) + 0.5(0.144) = 0.13 = 13.0%

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 22 Questions: 1. Due to the nature of their asset and liability contracts, depository institutions are the FIs most exposed to liquidity risk. Mutual funds, hedge funds, pension funds, and PC insurance companies are the least exposed. In the middle are life insurance companies. 2. In the case of a bank, it could be due to a deposit drain caused by a bank run. For an insurance company, it could be caused by unusual losses. For a mutual fund, it might be the result of investors' cashing in their shares. 3. Liquidity risk occurs because of situations that develop from economic and financial transactions that are reflected on either the asset side of the balance sheet or the liability side of the balance sheet of an FI. Asset side risk arises from transactions that result in a transfer of cash to some other asset, such as the exercise of a loan commitment or a line of credit. Liability side risk arises from transactions whereby a creditor, depositor, or other claim holder demands cash in exchange for the claim. The withdrawal of funds from a bank is an example of such a transaction. Another type of asset side liquidity risk arises from the FI’s investment portfolio. During the sell-off, liquidity dries up and investment securities can be sold only at fire-sale prices. A fire-sale price refers to the price of an asset that is less than the normal market price because of the need or desire to sell the asset immediately under conditions of financial distress. 4. a. This DI is decreasing in size because less core deposits are being added to the DI than are being withdrawn. On average, the rate of decrease of deposits is 2%. b. If the DI has a net deposit drain, it needs to either increase its purchased liquidity (by borrowing funds or issuing equity) or reduce its stored liquidity. An institution can reduce its assets by drawing down on its cash reserves, selling securities, or calling back (or not renewing) its loans. It can increase liabilities by issuing more Federal funds, long-term debt, or new issues of equity. If a DI offsets the drain by increasing liabilities, the size of the firm remains the same. However, if it offsets the drain by reducing its assets, the size of the DI is reduced 5. Core deposits are those deposits that will stay with the DI over an extended period of time. These deposits are relatively stable sources of funds and consist mainly of demand, savings, and retail time deposits. Because of their stability, a higher level of core deposits will increase the predictability of forecasting net deposit drains from the DI. 6. They are likely to be positively related. During times when cash or credit is short, corporations may draw down their cash balances as well as using their lines of credit and loan commitments, thus reducing bank deposits and at the same time banks are obligated to lend out additional funds. 7. a. The entire distribution shifts to the right (an increase in the expected amount of withdrawals) as individuals spend more. Moreover, the standard deviation decreases as the distribution narrows. b. The entire distribution shifts to the right (an increase in the expected amount of withdrawals) as individuals spend more. Moreover, the standard deviation decreases as the distribution narrows. c. The entire distribution shifts to the right and may have a positive mean value as withdrawals average more than deposits. However, as the opportunity cost of holding money declines, some depositors may increase their net deposits. The impact will be to widen the distribution. d. The entire distribution shifts to the right and may have a positive mean value as withdrawals average more than deposits. Inflation may cause a general flight from cash that will cause the distribution to narrow. 8. If the DI has a net deposit drain, it needs to either increase its liabilities (by borrowing funds or issuing equity, i.e., purchased liquidity management) or reduce its assets (i.e., stored liquidity management). An institution can reduce its assets by drawing down on its cash reserves, selling securities, or calling back (or not renewing) its loans. It can increase liabilities by issuing more federal funds, long-term debt, or equity. If a DI offsets the drain by increasing liabilities, the size of the firm remains the same. However, if it offsets the drain by reducing its assets, the Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e size of the firm is reduced. If it has a net negative deposit drain, then it needs to follow the opposite strategy. The operational benefit of addressing a net deposit drain is to restore the financial stability and health of the DI. However, this process does not come without costs. On the asset side, liquidating assets may occur only at fire-sale prices that will result in realized losses of value, or asset-mix instability. Further, not renewing loans may result in the loss of profitable relationships that could have negative effects on profitability in the future. On the liability side, entering the borrowed funds market normally requires paying market interest rates that are above those rates that it had been paying on low interest deposits. 9. A DI can use either purchased liquidity management or stored liquidity management. Purchased liquidity management involves borrowing funds in the money/purchased funds market. Stored liquidity management involves selling cash-type assets, such as Treasury bills, or simply reducing excess cash reserves to the minimum level required to meet regulatory imposed reserve requirements. 10. a. This statement identifies the total sources of liquidity as the amount of cash-type assets that can be sold with little price risk and at low cost, the amount of funds the DI can borrow in the money/purchased funds market, and any excess cash reserves over the necessary reserve requirements. The statement also identifies the amount of each category the DI has utilized. The difference is the amount of liquidity available for the DI. This amount can be tracked on a day-to-day basis. b. DIs can easily compare their liquidity with peer group institutions by looking at several easy to calculate ratios. High levels of the loan to deposit and borrowed funds to total asset ratios and/or a low level of the core deposits-tototal assets ratio will identify reliance on borrowed funds markets, while heavy amounts of loan commitments to assets may reflect a heavy amount of potential liquidity need in the future. c. The liquidity index measures the amount of potential losses suffered by a DI from a fire-sale of assets compared to a fair market value established under the conditions of normal sale. The lower is the index, the less liquidity the DI has on its balance sheet. The index should always be a value between 0 and 1. d. The financing gap can be defined as average loans minus average deposits, or alternatively, as negative liquid assets plus borrowed funds. A negative financing gap implies that the DI must borrow funds or rely on liquid assets to fund the non-liquid assets. Thus, the financing requirement can be expressed as the financing gap plus liquid assets. This relationship implies that some level of loans and core deposits as well as some amount of liquid assets determine the need for the DI to borrow or purchase funds. 11. A liquidity plan requires forward planning so that an optimal mix of funding can be implemented to reduce costs and unforeseen withdrawals. In general, a plan could incorporate the following: i) Assigning a team that will take charge in the event of a liquidity crisis. ii) Identifying the account holders that will most likely withdraw funds in the event of a crisis. iii) Estimating the size of the run-offs and the sources of borrowing that will be required to stem the run-offs. iv) Establishing maximum limits for borrowing by subsidiaries and affiliates, including inter-affiliate loans, and the maximum risk premium to be paid during crisis borrowing. v) Specifying the sequencing of asset disposal in the event of a crisis. Such planning will ensure that during a crisis, there is an orderly procedure to stem the rush of withdrawals and avert a total breakdown. This is very important for firms that rely on deposits or short-term funds as a source of borrowing because of the difficulty in rolling over debt in periods of crisis. 12. A bank run is an unexpected increase in deposit withdrawals from a DI. Bank runs can be triggered by several economic events including (a) concerns about solvency relative to other DIs, (b) failure of related DIs, and (c) sudden changes in investor preferences regarding the holding of nonbank financial assets. The first-come, first-serve (full pay or no pay) nature of a demand deposit contract encourages priority positions in any line for payment of deposit accounts. Thus, even though money may not be needed, customers have an incentive to withdraw their funds. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 13. Because of the serious effects that a contagious run on DIs could have on the economy (e.g., inability to transfer wealth from period to period, inability to implement monetary policy, inability to allocate credit to various sectors of the economy in special need of financing—see Chapter 1), government regulators of depository institutions have established guarantee programs offering deposit holders varying degrees of insurance protection to deter runs. Specifically, the FDIC was created in 1933 in the wake of the banking panics of 1930–1933, when some 10,000 commercial banks failed. The original level of individual depositor insurance coverage at depository institutions was $2,500, which was increased (six times since 1934), to $100,000 in 1980, and to $250,000 in October 2008. With deposit insurance guarantees in place, if a deposit holder believes his or her claim is totally secure, even if the DI is in trouble, the holder has no incentive to run. The deposit holder’s place in line no longer affects his or her ability to retrieve funds deposited in the DI. Thus, deposit insurance deters runs as well as contagious runs and panics. 14. The Fed took additional unprecedented steps, expanding the usual function of the discount window, to address the financial crisis. While the discount window had traditionally been available to DIs, in the spring of 2008 (as Bears Stearns nearly failed) investment banks gained access to the discount window through the Primary Dealer Credit Facility (PDCF). In the first three days, securities firms borrowed an average of $31.3 billion per day from the Fed. The largest expansion of the discount window’s availability to all FIs occurred in the wake of the Lehman Brothers failure, as a series of actions were taken in response to the increasingly fragile state of financial markets. After March, several new broad-based lending programs were implemented, providing funding to a wide array of new parties, including U.S. money market mutual funds, commercial paper issuers, insurance companies, and others. These programs rapidly expanded the current lending programs offered via the Fed. Over the next 18 months, in response to a weakening economy and a growing financial crisis, the Fed significantly reduced the level of short-term interest rates by lowering its target federal funds rate to near zero. The overall reduction in the target federal funds rate since late 2007 was been dramatic, going from 5.26 percent in September 2007 to a range of 0 percent to 0.25 percent as of December 16, 2008 (see Figure 21-2). It also significantly reduced the spread (premium) between the discount rate and the federal funds target to just a quarter of a point, bringing the discount rate down to a half percent. With lower rates at the Fed's discount window and inter-bank liquidity scarce as many lenders cut back their lending, more financial institutions chose to borrow at the window. The magnitude and diversity of nontraditional lending programs and initiatives developed during the crisis were unprecedented in Federal Reserve history. The lending programs were all designed to "unfreeze" and stabilize various parts of the credit markets, with the overall goal that parties receiving credit via these new Fed programs would, in turn, provide funding to creditworthy individuals and firms. 15. P&C insurers’ greatest liquidity exposure occurs when policyholders cancel or fail to renew policies with an insurer because of pricing, competition, or safety and solvency reasons. This may cause an insurer’s premium cash inflow, when added to its investment returns, to be insufficient to meet policyholder claims. Alternatively, large, unexpected claims may materialize as a result of disasters such as Hurricane Andrew in 1991 and the East Coast blizzard of the century in 1996. 16. In the case of a liquidity crisis in DIs and insurance firms, there are incentives for depositors and policyholders to withdraw their money or cash in their policies as early as possible. Late comers will be penalized because the financial institution may be out of liquid assets. They will have to wait until the institution sells its assets at fire-sale prices, resulting in a lower payout. In the case of mutual funds, the net asset value for all shareholders is lowered or raised as the market value of assets change, so that everybody will receive the same price if they decide to withdraw their funds. Hence, the incentive to engage in a run is minimized. Problems: 1. a.

Assets (in millions) Cash 15 Other Assets 155 170

Liabilities Deposits Borrowed Funds Other liabilities

90 40 40 170

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e b.

2. a.

Assets (in millions) Cash 30 Other Assets 155 185

Liabilities Deposits Borrowed Funds Other liabilities

Assets (in millions) Cash 10 Securities 15 Loans 50 75 Assets (in millions)

Liabilities Deposits Borrowed Funds Equity

Cash Securities Loans

Deposits

Equity

7 60

0 10 50 60

90 55 40 185 53 15 7 75

Liabilities

3. a. Cost of the drain = (5% - 2%) × $1 million = $30,000 The average size of the firm will be $9 million after the drain. b. Cost of the drain = (3.5% - 2%) × $1 million = $15,000 The average size of the firm will be $10 million after the drain. 4. a. Financing gap = $15 million, = average loans - average deposits = $30m - $15 m b. Financing requirement = $25 million = financing gap + liquid assets = $15m + $10 m 5. a. The DI’s available resources for liquidity purposes are $10m + $5m + $5m = $20 million. b. The DI’s current uses of liquidity are $6m + $2m = $8 million. c. The DI’s net liquidity is $20m - $8m = $12 million. d. The net liquidity of $12 million suggests that the DI can withstand unexpected withdrawals of $12 million without having to reduce its less liquid assets at potential fire-sale prices. 6. I = (10,000/30,000) × (9,900/10,500) + (5,000/30,000) × (4,000/4,500) + (15,000/30,000) × (13,000/14,000) = 0.927 7. I = ($20m/$90m)(1.00/1.00) + ($20m/$90m)(0.99/1.00) + ($50m/$90m)(0.90/1.00) = 0.942 8. a.

Value of fixed income securities if sold in four days Value of stock if sold in four days Total

$40m × 0.96 = $40m × 0.96 =

$38.4m 38.4m $76.8m

Shareholder A will receive $76.8m × 0.05 = $3.84m down from the current value of $4.00m. Shareholder B will receive $76.8m × 0.07 = $5.376m down from the current value of $5.60m. Value of fixed income securities if sold in two days Value of stock if sold in two days Total

$40m × 0.98 = $40m × 0.98 =

$39.2m 39.2m $78.4m

Shareholder A will receive $78.4m × 0.05 = $3.92m down from the current value of $4.00m. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Shareholder B will receive $78.4m × 0.07 = $5.488m down from the current value of $5.60m. b. This differs from a run on a bank in that the claimants of the assets all receive the same amount, as a percentage of their investments. In the case of bank runs, the first to withdraw receives the full amount, leaving the likelihood that some depositors may not receive any money at all. One way of mitigating this problem is for regulators to offer deposit insurance such as that provided by the FDIC. This reduces the incentive to engage in bank runs. 9. a. NAV = Market value of shares/number of shares = $10m/1m = $10 per share b.

At the current NAV, it can absorb up to $1 million (from cash), i.e. 100,000 shares.

Its loss by selling 10,000 shares of IBM at $35 instead of $40 = -$5 × 10,000 = -$50,000. New NAV = $9,950,000 /1m = $9.95 Cash = $1 million + $350,000 = $1.35 million and $8.60 million in securities. d.

If 100,000 shares are redeemed, it needs to pay $9.95 × 100,000 = $995,000.

Its NAV will remain the same, i.e., $8,955,000/900,000 = $9.95. No, it does not need to sell any extra shares since it has $1.35 million in cash, more than enough to cover the $995,000 in share redemptions. 10. Central Bank has the following balance sheet (in millions of dollars). Assets Cash Deposits at the Fed Treasury bonds Qualifying marketable securities GNMA bonds Loans to AA- corporations Mortgages Premises Total

Liquidity level $ 15 Level 1 30 Level 1 145 Level 1 50 Level 1 60 Level 2A 540 Level 2A 285 40 $1,165

Liabilities and Equity Stable retail deposits $190 Less stable retail deposits 70 CDs maturing in 6 months 100 Unsecured wholesale funding from: Stable small business deposits 125 Less stable small business deposits 100 Nonfinancial corporates 450 Equity 130 Total $1,165

Run-off factor 3% 10 0 5 10 75

Cash inflows over the next 30 days from the bank’s performing assets are $7.5 million. Calculate the LCR for Central Bank. The liquidity coverage ratio for Central Bank is calculated as follows: Level 1 assets = $15 + $30 + $145 + $50 = Level 2A assets = ($60 + $540) × 0.85 = $510.00 Capped at 40% of high-quality liquid assets = $240 × 0.40 = Stock of high-quality liquid assets Cash outflows: Stable retail deposits Less stable retail deposits CDs maturing in 6 months Stable small business deposits Less stable small business deposits Non-financial corporates Total cash outflows over next 30 days

240 96 $336

$190 × 0.03 = $5.70 $70 × 0.10 = 7.00 $100 × 0.00 = 0.00 $125 × 0.05 = 6.25 $100 × 0.10 = 10.00 $450 × 0.75 = 337.50 $366.45

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Total cash inflows over next 30 days Total net cash outflows over next 30 days

7.50 $358.95

Liquidity coverage ratio = $336m/$358.95m = 93.61%. The bank is not in compliance with liquidity requirements based on the LCR. 11. Assets Cash Deposits at the Fed Treasury securities GNMA securities Loans to AA rated corporations Loans to BB rated corporations Premises Total

Liquidity level $ 12 Level 1 19 Level 1 125 Level 1 94 Level 2A 138 Level 2A 106 Level 2B 20 $514

Run-off factor 3% 10

Liabilities and Equity Stable retail deposits $ 55 Less stable retail deposits 20 Unsecured wholesale funding from: Stable small business deposits 80 Less stable small business deposits 49 Nonfinancial corporates 250 Equity 60 Total $514

5 10 75

The liquidity coverage ratio for WallsFarther Bank is calculated as follows: Level 1 assets = $12 + $19 + $125 = Level 2A assets = ($94 + $138) × 0.85 = $197.20 Level 2B assets = $106 × 0.85 = $90.10 Cash outflows: Stable retail deposits Less stable retail deposits Stable small business deposits Less stable small business deposits Non-financial corporates Total cash outflows over next 30 days

156 Capped at 40% of Level 1 = $156 × 0.40 = 62.4 40% cap on Level 2 assets already met 0.0 Stock of highly liquid assets $218.4

$55 × 0.03 = $ 1.65 $20 × 0.10 = 2.00 $80 × 0.05 = 4.00 $49 × 0.10 = 4.90 $250 × 0.75 = 187.50 $200.05

Total cash inflows over next 30 days Total net cash outflows over next 30 days

5.50 $194.55

Liquidity coverage ratio = $218.4m/$194.55m = 112.26%. The bank is in compliance with liquidity requirements based on the LCR. 12. FirstBank has the following balance sheet (in millions of dollars). Required stable

Available

stable Funding funding Assets factor Cash 95% Deposits at the Fed Treasury securities GNMA securities Loans to A rated corporations (maturity > 1 year) Loans to B rated corporations (maturity < 1 year) Premises

factor

Liabilities and Equity

$ 12

Stable retail deposits

19 125 94 138

0 5 15 65

106

Less stable retail deposits Unsecured wholesale funding from: Stable small business deposits Less stable small business deposits Nonfinancial corporates Equity Total

100

$ 55 20

80 49 250 60 $514

95 90 50 100

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Total

$514

Calculate the NSFR for FirstBank. The net stable funding ratio for FirstBank is calculated as follows: Available amount of stable funding = $60 × 1.00 + ($55 + $80) × 0.95 + ($20 + $49) × 0.90 + $250 × 0.50 = $375.35m Required amount of stable funding = ($12 + $19) × 0.00 + $125 × 0.05 + $94 × 0.15 + $138 × 0.65 + $106 × 0.50 + $20 × 1.00 = $183.05m Net stable funding ratio = $375.35m/$183.05m = 205.05%. The bank is in compliance with liquidity requirements based on the NSFR. 13. BancTwo has the following balance sheet (in millions of dollars). Required stable Available stable funding funding Assets factor Cash 95% Deposits at the Fed 90 Treasury bonds 0 Qualifying marketable securities (maturity < 1 year) 95 FNMA bonds 90 Loans to AA- corporations 50 (maturity > 1 year) 100 Mortgages (unencumbered) Premises Total

factor

Liabilities and Equity

$ 20

Stable retail deposits

Less stable retail deposits

145

CDs maturing in 6 months

100

Unsecured wholesale funding from: Stable small business deposits

125

$190

Less stable small business deposits

100

540

Nonfinancial corporates

450

Equity 285 35 $1,165

65 100

130 Total

$1,165

Calculate the NSFR for BancTwo. The net stable funding ratio for BancTwo is calculated as follows: Available amount of stable funding = $130 × 1.00 + ($190 + $125) × 0.95 + ($70 + $100) × 0.90 + $450 × 0.50 = $807.25m Required amount of stable funding = ($20 + $30) × 0.00 + $145 × 0.05 + $60 × 0.15 + ($540 + $285) × 0.65 + $35 × 1.00 = $587.50m Net stable funding ratio = $807.25m/$587.50m = 137.40%. The bank is in compliance with liquidity requirements based on the NSFR.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 23 Questions: 1. Through its daily open market operations, such as buying and selling Treasury bonds and Treasury bills, the Fed seeks to influence the money supply, inflation, and the level of interest rates. When the Fed finds it necessary to slow down the economy, it tightens monetary policy by taking actions that raise interest rates. The normal result is a decrease in business and household spending (especially that financed by credit or borrowing). Conversely, if business and household spending decline to the extent that the Fed finds it necessary to stimulate the economy it allows interest rates to fall (an expansionary monetary policy). The drop in rates promotes borrowing and spending. 2. The repricing gap is a measure of the difference between the dollar value of assets that will reprice and the dollar value of liabilities that will reprice within a specific time period, where repricing can be the result of a rollover of an asset or liability (e.g., a loan is paid off at or prior to maturity and the funds are used to issue a new loan at current market rates) or because the asset or liability is a variable rate instrument (e.g., a variable rate mortgage whose interest rate is reset every quarter based on movements in a prime rate). Rate sensitivity represents the time interval where repricing can occur. The model focuses on the potential changes in the net interest income variable. In effect, if interest rates change, interest income and interest expense will change as the various assets and liabilities are repriced, that is, receive new interest rates. 3. The maturity bucket is the time window over which the dollar amounts of assets and liabilities are measured. The length of the repricing period determines which of the securities in a portfolio are rate-sensitive. The longer the repricing period, the more securities either mature or will be repriced, and, therefore, the more the interest rate risk exposure. An excessively short repricing period omits consideration of the interest rate risk exposure of assets and liabilities are that repriced in the period immediately following the end of the repricing period. That is, it understates the rate sensitivity of the balance sheet. An excessively long repricing period includes many securities that are repriced at different times within the repricing period, thereby overstating the rate sensitivity of the balance sheet. 4. The CGAP effect describes the relations between changes in interest rates and changes in net interest income. According to the CGAP effect, when CGAP is positive the change in NII is positively related to the change in interest rates. Thus, an FI would want its CGAP to be positive when interest rates are expected to rise. According to the CGAP effect, when CGAP is negative the change in NII is negatively related to the change in interest rates. Thus, an FI would want its CGAP to be negative when interest rates are expected to fall. 5. According to the CGAP effect, when CGAP is positive the change in NII is positively related to the change in interest rates. Thus, an FI would want its CGAP to be positive when interest rates are expected to rise. a. Yes. This change will increase RSAs, which will increase GAP. b. No. This change will decrease RSAs, which will decrease GAP. c. No. This change will increase RSLs, which will decrease GAP. d. No. This change will have no impact on either RSAs or RSLs. So, the change will have no impact on GAP. e. Yes. This change will increase RSAs, which will increase GAP. 6. When rates rise, the bank manager would want to set the repricing gap greater than zero. As rates rise, interest income will increase by more than interest expense, resulting in an increase in net interest income. If rates are about to fall the manger would like to set the repricing gap less than zero. As rates fall, interest income will decrease by less than interest expense, resulting in an increase in net interest income. 7. The following are rate sensitive: a, b, d, f, g, h, i, and j. 8. The gap to total assets ratio (commonly referred to as the gap ratio) is the ratio of the cumulative gap position to the total assets of the FI. The cumulative gap position is the sum of the individual gaps over several time buckets. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e The value of this ratio is that it tells the direction of the interest rate exposure and the scale of that exposure relative to the size of the FI. This version of the gap ratio is used by regulators to measure interest rate risk. 9. The spread effect is the effect that a change in the spread between rates on RSAs and RSLs has on net interest income (NII) as interest rates change. The spread effect is such that, regardless of the direction of the change in interest rates, a positive relation exists between changes in the spread and changes in NII. Whenever the spread increases (decreases), NII increases (decreases). 10. a. The repricing model has four general weaknesses: i. It ignores market value effects of interest rate changes. ii. It ignores cash flow patterns within a maturity bucket. iii. It fails to deal with the problem of rate-insensitive asset and liability cash flow runoffs and prepayments. iv. It ignores cash flows from off-balance-sheet activities. b. Large banks are able to reprice securities every day using their own internal models so reinvestment and repricing risks can be estimated for each day of the year. 11. Taking the first derivative of a bond’s (or any fixed-income security) price (P) with respect to the yield to maturity (R) provides the following:

P  D dR (1  R ) The economic interpretation is that D is a measure of the percentage change in the price of a bond for a given percentage change in yield to maturity (interest elasticity). This equation can be rewritten to provide a practical application:

 dR  dP   D  P 1  R  In other words, if duration is known, then the change in the price of a bond due to small changes in interest rates, R, can be estimated using the above formula. 12. The change in the net worth of an FI for a change in interest rates is given by the following equation: E = - D A - D L k * A *

R (1 + R)

where k = L/A. Thus, three factors are important in determining ΔE: i. [DA - DL k] or the leveraged adjusted duration gap. The larger this gap, the more exposed is the FI to changes in interest rates. ii. A, or the size of the FI. The larger A, the larger the exposure to interest rate changes. iii. ΔR/1 + R, or interest rate shocks. The larger the shock, the larger the FI’s exposure. 13. In this case, the actual return earned would exceed the original yield. The benefits from a higher reinvestment rate would exceed the price reduction effect if the investor gets to hold the security long enough. 14. When rates rise, the bank manager would want to set the duration gap less than zero. As rates rise, the value of the liabilities will decrease by more than the value of assets, resulting in an increase in the market value of equity. If rates are about to fall the manger would like to set the duration gap greater than zero. As rates fall, the value of the assets will increase by more than the value of liabilities, resulting in an increase in the market value of equity. 15. The three criticisms are: Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e i. Duration matching can be costly because it is not easy to restructure the balance sheet periodically, especially for large FIs. ii. Immunization is a dynamic problem because duration changes over time. Thus, it is necessary to rebalance your portfolio as your assets and liabilities change over time. iii. Duration is not an appropriate tool for immunizing portfolios when the expected interest rate changes are large because of the existence of convexity. Convexity exists because the relationship between bond price changes and interest rate changes is not linear, which is assumed in the estimation of duration. Using convexity to immunize a portfolio will reduce the problem. 16. Convexity is the degree of curvature of the price-yield curve around some interest rate level. The duration model predicts that the relationship between an interest rate change (or shock) and a bond’s price change will be proportional to the bond’s D (duration). By precisely calculating the true change in the bond’s price, however, we would find that for large interest rate increases, duration overpredicts the fall in the bond’s price, and for large interest rate decreases, it underpredicts the increase in the bond’s price. That is, the duration model predicts symmetric effects for rate increases and decreases on the bond’s price. In actuality, the capital loss effect of rate increases tends to be smaller than the capital gain effect of rate decreases. This is the result of the bond’s price-yield relationship exhibiting a property called convexity rather than linearity, as assumed by the basic duration model. 17. Book value accounting reports assets and liabilities at the original issue values. Market value accounting is an economist’s definition of capital. Specifically, the economist’s definition of an FI’s capital, or owners’ equity stake, is the difference between the market values of its assets and its liabilities. This is also called an FI’s market value. This is the economic meaning of capital. A problem with book value accounting is that current market values may be different from book values because of changes in market conditions, such as interest rates or prices. This is especially a problem if an asset or liability has to be liquidated immediately. If the asset or liability is held until maturity, then the reporting of book values does not pose a problem. For an FI, a major factor affecting asset and liability values is interest rate changes. If interest rates increase, the value of both loans (assets) and deposits and other debt (liabilities) fall. If assets and liabilities are held until maturity, interest rate changes do not affect the valuation of the FI. However, if deposits or loans have to be refinanced, then market value accounting presents a better picture of the condition of the FI. The process by which changes in the economic value of assets and liabilities are accounted is called marking to market. The changes can be beneficial as well as detrimental to the total economic value of the FI. 18. The book value definition of capital is the value of assets minus liabilities as found on the balance sheet. This amount often is referred to as accounting net worth. The economic definition of capital is the difference between the market value of assets and the market value of liabilities. The market value of equity is more relevant than book value because, in the event of bankruptcy, the liquidation (market) value determines the FI’s ability to pay various claimants. a. The loss in value caused by credit risk is borne first by the equity holders, and then by the liability holders. With market value accounting, the adjustments to equity value are made simultaneously as the losses due to this risk element occur. Thus, economic insolvency may be revealed before accounting value insolvency occurs. b. Because book value accounting recognizes the value of assets and liabilities at the time they were placed on the books or incurred by the firm, losses are not recognized until the assets are sold or regulatory requirements force the firm to make balance sheet accounting adjustments. In the case of credit risk, these adjustments usually occur after all attempts to collect or restructure the loans have occurred. 19. Market values produce a more accurate picture of the bank’s current financial position for both stockholders and regulators. Stockholders could more readily see the effects of changes in interest rates on the bank’s equity. As noted in the next problem, it also accurately reflects the liquidation value of a distressed bank. Among the arguments against market value accounting are that market values are sometimes difficult to estimate, particularly for small banks with non-traded assets. In addition, some argue that market value accounting would produce higher volatility in the earnings of banks. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 20. The market value of equity is more relevant than book value because in the event of a bankruptcy, the liquidation (market) values will determine the FI's ability to pay the various claimants. Problems: 1. a. Repricing gap = RSA - RSL = $100 - $50 million = +$50 million. Δ NII = ($50 million)(0.01) = +$.5 million, or $500,000. b. Repricing gap = RSA - RSL = $50 - $150 million = - $100 million. Δ NII = (-$100 million)(0.01) = -$1 million, or -$1,000,000. c. Repricing gap = RSA - RSL = $75 - $70 million = +$5 million. $Δ NII = ($5 million)(0.01) = $.05 million, or $50,000. d. The FIs in parts (a) and (c) are exposed to interest rate declines (positive repricing gap), while the FI in part (b) is exposed to interest rate increases. The FI in part (c) has the least amount of interest rate risk exposure since the absolute value of the repricing gap is the lowest, while the opposite is true for part (b). 2. a. Rate-sensitive assets = $200 million. Rate-sensitive liabilities = $100 million. Repricing gap = RSA - RSL = $200 - $100 million = +$100 million. NII = ($100 million)(0.01) = +$1.0 million, or $1,000,000. Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $150 million. Repricing gap = RSA - RSL = $100 - $150 million = -$50 million. NII = (-$50 million)(0.01) = -$0.5 million, or -$500,000. Rate-sensitive assets = $150 million. Rate-sensitive liabilities = $140 million. Repricing gap = RSA - RSL = $150 - $140 million = +$10 million. NII = ($10 million)(0.01) = +$0.1 million, or $100,000. b. NII = ($100 million)(-0.01) = -$1.0 million, or -$1,000,000. NII = (-$50 million)(-0.01) = +$0.5 million, or $500,000. NII = ($10 million)(-0.01) = -$0.1 million, or -$100,000. c. The FIs in parts (1) and (3) are exposed to interest rate declines (positive repricing gap), while the FI in part (2) is exposed to interest rate increases. The FI in part (3) has the lowest interest rate risk exposure since the absolute value of the repricing gap is the lowest, while the opposite is true for the FI in part (1). 3. a.

Expected interest income: Expected interest expense: Expected net interest income:

($60m × 0.1) + ($90m × 0.07) = $12.3m ($105m × 0.06) + ($25m × 0.06) = $7.8m $12.3m - $7.8m = $4.5m

b. After the 200 basis point interest rate increase, net interest income declines to 60m(0.12) + 90m(0.07) - (105m(0.08) + 25m(0.06)) = $13.5m - $9.9m = $3.6m, a decline of $0.9 m. c. Watchover Saving’s repricing, or funding, gap is $60m - $105m = -$45m. The change in net interest income is (-$45m)(0.02) = -$0.9m.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 4. a. Current expected interest income: $50m(0.10) + $50m(0.07) = $8.5m. Expected interest expense: $70m(0.06) + $20m(0.07) = $5.6m. Expected net interest income: $8.5m - $5.6m = $2.9m. b. After the 200 basis point interest rate increase, net interest income declines to: 50(0.12) + 50(0.07) - 70(0.08) - 20(.07) = $9.5m - $7.0m = $2.5m, a decline of $0.4m. c. Watchovia’s repricing, or funding, gap is $50m - $70m = -$20m. The change in net interest income using the funding gap model is (-$20m)(0.02) = -$.4m. d. After the unequal rate increases, net interest income will be 50(0.12) + 50(0.07) - 70(0.07) - 20(0.07) = $9.5m $6.3m = $3.2m, an increase of $0.3m. It is not uncommon for interest rates to adjust in an unequal manner on RSAs versus RSLs. Interest rates often do not adjust solely because of market pressures. In many cases the changes are affected by decisions of management. Thus, you can see the difference between this answer and the answer for part a. 5. a.

Repricing GAP = $550,000 - $375,000 = $175,000 Percentage Gap = $175,000/$1,570,000 = 11.15%

II = $550,000(0.0045) = $2,475 IE = $375,000(0.0035) = $1,312.50 NII = $2,475 - $1,312.50 = $1,162.50

c. The CGAP affect worked to increase net interest income. That is, the CGAP was positive while interest rates increased. Thus, interest income increased by more than interest expense. The result is an increase in NII. The spread effect also worked to increase net interest income. The spread increased by 10 basis points. According to the spread affect, as spread increases, so does net interest income. 6. a. Funding or repricing gap using a 30-day planning period = $75m - $170m = -$95 million. Funding gap using a 91-day planning period = ($75m + $75m) - $170m = -$20 million. Funding gap using a two-year planning period = ($75m + $75m + $50m + $25m) - $170m = +$55 million. b. Net interest income will decline by $475,000. That is, Δ NII = GAP(Δ R) = -95m(0.005) = $475,000 c. Funding or repricing gap over the 1-year planning period = ($75m + $75m + $10m + $20m + $25m) -$170m = + $35 million. d. Net interest income will increase by $175,000. That is, ΔNII = GAP(Δ R) = 35m(0.005) = $175,000. 7. a.

Time 1 2

cash flows 100 1,100

PVCF 87.72 846.41 934.13 Duration = 1,780.54/934.13 = 1.906 years

PVCF × t 87.72 1,692.82 1,780.54

b. ΔP/P = -D(ΔR/(1 + R)) or ΔP = P × (-D)(ΔR/(1 + R)) = $934.13 × (-1.906) × (-0.0050)/(1 + 0.14) = $7.81 increase in the price of the bond. 8. a. Duration of the two-year liability = 1.897 years. Time 0.5 1.0 1.5 2.0

cash flow 32,625 32,625 32,625 932,625

PVCF 31,484 30,382 29,320 808,814 900,000

PVCF × t 15,742 30,382 43,979 1,617,629 1,707,732

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Duration=1,707,732/900,000 = 1.8975 Leveraged adjusted duration gap = [9.94 - (900,000/1,000,000)(1.8975)] = 8.23 years b. Change in net worth using leveraged adjusted duration gap is given by: = -[9.94 - (0.9m/1m)(1.8975)](1m)(-0.002) = $16,464.54 9. a. Duration of GBI’s fixed-rate loan portfolio: Time 1 2 3 4 5

cash flow 65 × 0.12 65 × 0.12 65 × 0.12 65 × 0.12 (65 × 0.12) + 65

PVCF 6.9646 6.2181 5.5519 4.9570 41.3087 65.0000 Duration = 262.43/65 = 4.037 years.

PVCF × t 6.96 12.44 16.66 19.83 206.54 262.43

b. DA = 30/220 (0) + (20 + 105)/220 (0.36) + 65/220 (4.037) = 1.397 years c. Duration of GBI's core deposits: Time 1 2

cash flow 20 × 0.08 (20 × 0.08) + 20

PVCF 1.4815 18.5185 20.0000

PVCF × t 1.48 37.04 38.52

Duration = 38.52/20 = 1.926 years. d. DL = 20/200 × (1.926) + (50 + 130)/200 × (0.401) = .5535 years e. GBIs leveraged adjusted duration gap is: 1.397 - 200/220 × (0.5535) = .8942 years Since GBI's duration gap is positive, an increase in interest rates will lead to a decline in net worth. For a 1% increase, the change in net worth is: ΔE = -0.8942 × $220m × (0.01) = -$1,967,292 (new net worth will be $18,032,708). 10. a. The market value of the loan declines by $2.55 million, to $97.448 million. MVA = $10m/(1 + 0.115)1 + $110m/(1 + 0.115)2 = (10m × 0.8969) + (110m × 0.8044) = $97.448 million. b. The duration of the loan is 1.909 years. Time 1 2

cash flow 10 110

PVCF 9.0909 90.9091 100.0000

PVCF × t 9.09 181.82 190.91

D = 190.91/100 = 1.909 years. c. The approximate change in the market value of the loan for a 150 basis points change is: MVA = -1.909 × $100m × (0.015/1.1) = -2.603 million The expected market value of the loan using the above formula is $97.397 million.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e d. The market value of the liability declines $1.233 million, to $88.767 million. MVL = ($90m + ($90m × 8%)) (1/(1 + (8% + 1.5%)))1 = $97.2m × .9132 = $88.767 million e. The duration is one year because it is a pure discount (zero-coupon) instrument. 11. a. The weighted average duration of the assets is: (0.5)(90/3,045) + (0.9)(55/3,045) + (4.393)(176/3,045) + (7)(2,724/3,045) = 6.55 years b. The weighted average duration of the FI's liabilities is: (1)(2,092/2,330) + (0.01)(238/2,330) = 0.90 years c. The FI's leveraged adjusted duration gap is: DGAP = DA - kDL = 6.55 - (2,330/3,045)(0.90) = 5.86 years The duration gap is positive, indicating that an increase in interest rates will lead to a decline in net worth. d. The market value of the equity will change by the following for an approximate 50 basis point change in interest rates (i.e. ΔR/(1 + R) = 0.0050) for both assets and liabilities: ΔMVE = -DGAP × (A) × ΔR/(1 + R) = -5.86(3,045)(0.0050) = -$89,206.44. The loss in equity of $89,206.44 will reduce the equity (net worth) to $625,793.56. e. If instead, ΔR/(1 + R) is -0.0025, the change in the value of equity is: ΔMVE = -5.86(3,045)(-0.0025) = $44,603.22 The market value of equity (net worth) will increase by $44,603.22, to $759,603.22. 12. a. For Bank A, an increase of 100 basis points in interest rate will cause the market values of assets and liabilities to decrease as follows: Loan:

$120,000 × PVAn=10,i=13% + $1,000,000 × PVn=10,i=13% = $945,737.57

CD:

$100,000 × PVAn=10,i=11% + $1,000,000 × PVn=10,i=11% = $941,107.68

The loan value decreases $54,262.43 and the CD value falls $58,892.32. Therefore, the decrease in value of the asset is $4,629.89 less than the liability, which is, in turn, the increase in the market value of equity for Bank A. For Bank B: Bond:

$1,976,362.88 × PVn=7,i=13% = $840,074.08

CD:

$82,750 × PVAn=10,i=11% + $1,000,000 × PVn=10,i=11% = $839,518.43

The bond value decreases $53,932.12 and the CD value falls $54,487.79. Therefore, the decrease in value of the asset is $555.67 less than the liability, which is, in turn, the increase in the market value of equity for Bank B. b. The assets and liabilities of Bank A change in value by different amounts because the durations of the assets and liabilities are not the same, even though the face values and maturities are the same. For Bank B, the maturities of the assets and liabilities are different, but the current market values and durations are the same. Thus, the change in interest rates causes a smaller change in value for both liabilities and assets. c. Ten-year CD Bank B

(values in thousands of $s)

Par value = $1,000 R = 10% t CFt DFt 1 82.75 0.9091 2 82.75 0.8264 3 82.75 0.7513 4 82.75 0.6830

Coupon rate = 8.275% Annual payments Maturity = 10 years CFt × DFt CFt × DFt × t 75.23 75.23 68.39 136.78 62.17 186.51 56.52 226.08

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 5 82.75 6 82.75 7 82.75 8 82.75 9 82.75 10 1,082.75

0.6209 0.5645 0.5132 0.4665 0.4241 0.3855

51.38 46.71 42.46 38.60 35.09 417.45 894.01

256.91 280.26 297.25 308.83 315.85 4,174.47 6,258.15

Duration = $6,258.15/894.01 = 7.00 The duration on the CD of Bank B is calculated above to be 7.00 years. Since the bond is a zero-coupon, the duration is equal to the maturity of 7 years. Using the duration formula to estimate the change in value: =Value =

Bond:

D

ΔR 0.01 P   7.00 $894,006.20   $55,875.39 1 R 1.12

D

ΔR 0.01 P   7.00 $894,006.20   $56,891.30 1 R 1.10

Value =

CD:

The difference in the change in value of the assets and liabilities for Bank B is $1,015.91 using the duration estimation model. The difference in this estimate and the estimate found in part (a) above is due to the convexity of the two financial assets. The duration estimates for the loan and CD for Bank A are presented below: Ten-year Loan Bank A (values in thousands of $s) Par value = $1,000 Coupon rate = 12% R = 12% Maturity = 10 years t 1 2 3 4 5 6 7 8 9 10

CFt 120 120 120 120 120 120 120 120 120 1,120

DFt 0.8929 0.7972 0.7118 0.6355 0.5674 0.5066 0.4523 0.4039 0.3606 0.3220

CFt × DFt 107.14 95.66 85.41 76.26 68.09 60.80 54.28 48.47 43.27 360.61 1,000.00 Duration = $6,328.25/$1,000 = 6.3282

CFt × DFt × t 107.14 191.33 256.24 305.05 340.46 364.77 379.97 387.73 389.46 3,606.10 6,328.25

Ten-year CD Bank A (values in thousands of $s) Par value = $1,000 Coupon rate = 10% R = 10% Maturity = 10 years t 1 2

CFt 100 100

DFt 0.9091 0.8264

CFt × DFt 90.91 82.64

Annual payments

CFt × DFt × t 90.91 165.29

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 3 4 5 6 7 8 9 10

100 100 100 100 100 100 100 1,100

0.7513 0.6830 0.6209 0.5645 0.5132 0.4665 0.4241 03855

75.13 68.30 62.09 56.45 51.32 46.65 42.41 424.10 1,000.00 Duration = $6,759.02/$1,000 = 6.7590

225.39 273.21 310.46 338.68 359.21 373.21 381.69 4,240.98 6,759.02

Using the duration formula to estimate the change in value: Loan:

CD:

Value = D

R 0.01 P   6.3282 $1,000,000   $56,501.79 1 R 1.12

D

R 0.01 P   6.7590 $1,000,000   $61,445.45 1 R 1.10

Value =

The difference in the change in value of the assets and liabilities for Bank A is $4,943.66 using the duration estimation model. The difference in this estimate and the estimate found in part (a) above is due to the convexity of the two financial assets. The reason the change in asset values for Bank A is considerably larger than for Bank B is because of the difference in the durations of the loan and CD for Bank A.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 24 Questions: 1. The major differences between futures and forward contracts are: i. Futures contracts are traded in open exchanges in standardized units, with fixed maturities. Forward contracts are bilateral agreements between two counter parties. Hence, they can be tailor-made to the buyer’s satisfaction. ii. Futures contracts are marked to market every day while forward contracts are not. Consequently, default risk is higher for the latter. iii. Futures contracts are rarely delivered. Instead, they are closed out (reversed) prior to maturity. Delivery usually takes place for most forward contracts. 2. a. b. c. d. e. f.

Sell forward Buy forward Sell forward Sell forward Sell forward Buy forward

3. A hedge involves protecting the price of or return on an asset from adverse changes in price or return in the market. A naive hedge usually involves the use of a derivative instrument that has the same underlying asset as the asset being hedged. Thus, if a change in the price of the cash asset results in a gain, the same change in market value will cause the derivative instrument to generate a loss that offsets the gain in the cash asset. 4. a. You are obligated to take delivery of a $100,000 face value 20-year Treasury bond at a price of $95,000 at some predetermined later date. b. This is a long hedge, undertaken to protect the FI against falling interest rates. c. You lose $1,000, since you are obliged to pay $95,000 although the current futures price is only $94,000. d. You gain $2,000 since you are obliged to pay $95,000 while the current futures price is $97,000. 5. A microhedge uses a derivative contract such as a forward or futures contract to hedge the risk exposure of a specific transaction, while a macrohedge is a hedge of the duration gap of the entire balance sheet. FIs that attempt to manage their risk exposure by hedging each balance sheet position will find that hedging is excessively costly, because the use of a series of microhedges ignores the FI’s internal hedges that are already on the balance sheet. That is, if a long-term fixed-rate asset position is exposed to interest rate increases, there may be a matching longterm fixed-rate liability position that also is exposed to interest rate decreases. Putting on two microhedges to reduce the risk exposures of each of these positions fails to recognize that the FI has already hedged much of its risk by taking matched balance sheet positions. The efficiency of the macrohedge is that it focuses only on those mismatched positions that are candidates for off-balance-sheet hedging activities. 6. Because spot bonds and futures on bonds are traded in different markets, the shift in yields, Δ R /(1 + R ), affecting the values of the on-balance-sheet cash portfolio may differ from the shifts in yields, Δ R F /(1 + R F ), affecting the value of the underlying bond in the futures contract. That is, changes in spot and futures prices or values are not perfectly correlated. This lack of perfect correlation is called basis risk. Basis risk occurs for two reasons. First, the balance sheet asset or liability being hedged is not the same as the underlying security on the futures contract. For instance, an FI might hedge interest rate changes on the FI’s entire balance sheet with T-bond futures contracts written on 20-year maturity bonds with a duration of 9.5 years. The interest rates on the various assets and liabilities on the FI’s balance sheet and the interest rates on 20-year T-bonds do not move in a perfectly correlated (or one-to-one) manner. The second source of basis risk comes from the difference in movements in spot rates versus futures rates. Because spot securities (e.g., government bonds) and futures contracts (e.g., on the same bonds) are traded in different markets, the shift in spot rates may differ from the shift in futures rates (i.e., they are not perfectly correlated). 7. a. The FI can either (i) buy a call option, or (ii) sell a put option on interest rate instruments, such as T-bonds, to generate positive cash flows in the event that interest rates decline. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e b. An FI can use call options on T-bonds to hedge an underlying cash position that decrease in value as interest rates decline. This would be true if, in the case of a macrohedge, the FI's duration gap were negative and the repricing gap positive. In the case of a microhedge, the FI can hedge a single fixed-rate liability against interest rate declines. c. An FI is better off purchasing calls as opposed to writing puts. This is for two reasons. First, regulatory restrictions limit an FI's ability to write “naked” short options. Second, since the potential positive cash inflow on the short put option is limited to the size of the put premium, there may be insufficient cash inflow in the event of interest rate declines to offset the losses in the underlying cash position. 8.

a. June US Treasury Bond calls at 17800: 5 07/64 or $5,109.375 per $100,000 contract b. June 5-year Treasury Note puts at 12450: 63/64 or $984.375 per $100,000 contract c. December Eurodollar calls at 9887: 0.5250 percent or $5,250 per $1,000,000 contract

9. a. 1. The value of the call decreases, 2. the value of the call increases. b. 1. The value of the put increases, 2. the value of the put increases. 10. A hedge with futures contracts produces symmetric gains and losses with interest rate increases and decreases. That is, if the FI loses value on the bond resulting from an interest rate increase, it enjoys a gain on the futures contract to offset this loss. If the FI gains value on the bond due to an interest rate decrease, a loss on the futures contract offsets this gain. By comparison, a hedge with an option contract completely offsets losses but only partly offsets gains. That is, gains and losses from hedging with options are no longer symmetric for interest rate increases and decreases. For example, if the FI loses value on the bond due to an interest rate increase, a gain on the options contract offsets the loss. However, if the FI gains value on the bond due to an interest rate decrease, the gain is offset only to the extent that the FI loses the fixed option premium (because it never exercises the option). Thus, the option hedge protects the FI against value losses when interest rates move against the on-balance-sheet securities but, unlike futures hedging, does not fully reduce value gains when interest rates move in favor of on-balance-sheet securities. Thus, many FIs prefer option-type contracts to future/forward type contracts. 11. a. The bank faces the risk that interest rates will increase. The FI should buy a put option. If rates rise, the CDs can be issued only at a lower price. But, the increase in interest rates also lowers the price of the security underlying the put option. Thus, the FI can purchase the underlying security and the gain from the option exercise will offset the loss in value from the lower issue value of the CDs the FI experiences in the spot market. b. The insurance company (IC) is concerned that interest rates will fall, and thus the price of the bonds will rise. The IC should buy call options on bonds. As rates fall, the underlying bond prices increase, but can be bought for less than the market price by exercising the call option. The bonds purchased with the options can be sold immediately for a gain that can be applied against the increase in the price of the bonds bought by the IC in the spot market and held on the balance sheet. Alternatively, the bonds bought through the exercise of the call option can be kept and placed in the IC’s portfolio if they are the desired type of asset. c. The thrift will incur a loss on the sale if rates rise and the value of the bonds falls. The thrift should buy a put option on Treasury securities that allows the sale of the bonds at or near the current price. d. The U.S. bank will incur a loss on the loan if the dollar appreciates (euros depreciate). Thus, the bank should buy a put to sell euros at or near the current exchange rate. e. The mutual fund will incur a loss on the sale if the dollar appreciates (£s depreciate). Thus, the fund should buy a put to sell £ at or near the current exchange rate. f. The FI is concerned that interest rates will fall, causing the value of the liabilities to rise more than the value of the assets which would cause the value of the equity to decrease. Thus, the finance company should buy a call option on bonds. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 12. In the case of writing a call option, the manager is obligated to sell the interest rate futures contract to the call option buyer at the price of $114,000 per $100,000 contract. If the call option buyer chooses to exercise the option and the call writer does not own the security at the time of exercise, he or she must purchase it first. The call writer will have received $859.38 from the writing of the option. 13. a. The pension fund manager is exposed to interest rate declines (price increases). b. This interest rate risk exposure can be hedged by buying call options on either financial securities or financial futures. 14. Buying a cap means buying a call option or a succession of call options on interest rates. Specifically, if interest rates rise above the cap rate, the seller of the cap—usually a bank—compensates the buyer—for example, another FI —in return for an up-front premium. As a result, buying an interest rate cap is like buying insurance against an (excessive) increase in interest rates. Buying a floor is similar to buying a put option on interest rates. If interest rates fall below the floor rate, the seller of the floor compensates the buyer in return for an up-front premium. As with caps, floor agreements can have one or many exercise dates. A collar occurs when an FI takes a simultaneous position in a cap and a floor, such as buying a cap and selling a floor. The idea here is that the FI wants to hedge itself against rising rates but wants to finance the cost of the cap. One way to do this is to sell a floor and use the premiums on the floor to pay the premium on the purchased cap. Thus, these three over-the-counter instruments are special cases of options; FI managers use them like options to hedge the interest rate risk of an FI’s portfolio. 15. A forward contract requires delivery or taking delivery of some commodity or financial security at a specified time in the future at a price specified at the time of origination. In a swap, each party promises to deliver and/or receive a pre-specified series of payments at specific intervals over a specified time horizon. In this way, a swap can be considered to be the same as a series of forward contracts. 16. The swap buyer makes the fixed-rate payments in an interest rate swap. The swap seller makes the variable-rate payment in the swap. This distinction is by convention. 17. First, FIs remain more likely to fail because of credit risk than either interest rate risk or FX risk. Second, credit swaps allow for the maintenance of long-term relationships without the FI bearing the full exposure to the credit risk of the customer. 18. A total return swap involves swapping an obligation to pay interest at a specified fixed or floating rate for payments representing the total return on a loan or a bond of a specific amount. The swap can be designed to cover any change in value of the principal as well as just the interest. This type of swap often is used when there is exposure to a change in the credit risk of the counterparty. 19. The total return swap includes an element of interest rate risk, while the pure credit swap has stripped this risk from the contract. In a pure credit swap, the lender makes a fixed fee or payment premium to the counterparty in exchange for the potential coverage of any loss due to a specific borrower defaulting on a loan. The swap is not tied to interest rate changes. The pure credit swap is similar in payoff to a digital default option with the exception that the premium is paid over the life of the swap rather than at the initiation of the risk coverage as with the option. 20. The credit risk on a swap is lower than that of a loan for the following reasons: a)

Swaps do not involve the exchange of principal payments. They only involve the swapping of interest payments, so the most a counterparty can lose is the difference in the interest payments.

b) In most cases, payments are made through netting by novation, which nets all payments with one counterparty, further reducing the possibility of default. c)

Swaps made by parties with poor credit ratings are usually backed by lines of credit, effectively making them collateralized loans, and further reducing their risks.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e

Problems: 1. a. Interest plus principal expense on six-month CD = $1m × (1 + 0.065/2) = $1,032,500 Interest and principal earned on Swedish bond = $1,000,000/0.18 = SKr5,555,555.56 × (1 + 0.075/2) = SKr5,763,889 In dollars if hedged: SKr5,763,889 × 0.1810 = $1,043,264 Spread = ($1,043,264 - $1,032,500)/$1m = $10,764/$1,000,000 = 1.0764% for six months, or 2.15% per year. b. Net interest income should be = 0.005 × $1,000,000 = $5,000 => $1,032,500 + $5,000 = $1,037,500 => SKr5,763,889/$1,037,500 = 5.556SKr for 1 U.S. dollar or $0.18/SKr For the spread to remain at 1% the spot and the forward will have to be the same. 2. The finance company will pay a fixed rate, while the insurance company pays a LIBOR based rate. One such feasible swap would be for the insurance company to pay the finance company LIBOR + 2.5% and the finance company to pay the insurance company 12%. The insurance company would receive (LIBOR + 0.01) - 0.10 + 0.12 (LIBOR + 0.025) = 0.005, while the finance company receives 0.14 - (LIBOR + 0.04) + (LIBOR + 0.025) - 0.12 = 0.005. Thus the swap protects both companies from interest rate risk and allows them to make a profit of 50 basis points. 3. a. The commercial bank is at risk for a drop in rates that would lower interest income, while the savings association is at risk of an interest rate increase, thus raising the cost of funds. b. One feasible swap would be for the bank to send the savings association (T-bill + 1%), while the savings association sends the bank a fixed payment of 9%. c. With this swap, the bank receives (T-bill + 0.02) - 0.09 + 0.09 - (T-bill + 0.01) = 0.01, the savings association receives 0.13 - (T-bill + 0.03) + (T-bill + 0.01) - 0.09 = 0.02. Each FI has locked in a profitable spread in the returns from its assets and the cost of its liabilities. d. It is possible that the floating rate asset might not be tied to the same rate as the floating rate liability. This would result in basis risk. Also, if the mortgages are amortizing, the interest payments on the mortgages would not match those on any nonamortizing security. 4. a. Ex ante, this is a profitable transaction since the spread is 2%. The 2% spread on $100 million (150 million) is $2 million. Converted into British pounds at the spot exchange rate, this yields an annual expected cash flow of 3 million. The cash flows are as follows: t 1 2 3

Eurodollar CD Cash Outflow (U.S.$) 7m 7m 107m

() 10.5m 10.5m 160.5m

British Loan Cash Inflow () Spread () 13.5m 3m 13.5m 3m 163.5m 3m

However, this spread will be reduced or eliminated if the pound depreciates relative to the U.S. dollar. That is, if it takes more pounds to purchase U.S. dollars, it will be more costly for the bank to repay the Eurodollar CD using British pound loan proceeds. The British bank will undertake a short currency hedge if it wants to protect itself against exchange rate risk exposure.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e b. Expected future exchange rates are: End of year 1: 1.65/U.S.$ End of year 2: 1.815/U.S.$ End of year 3: 2.00/U.S.$ t 1 2 3

Eurodollar CD Cash Outflow(U.S.$) () 7m 11.55m 7m 12.70m 107m 214.0m

British Loan Cash Inflow () Spread () 13.5m 1.95m 13.5m 0.80m 163.5m (50.5m)

Cash Flow ()

Swap Payments ()

Net Swap Cash Flow ()

Total Cash Flow

1 2 3

11.55om 12.705m 214.000m

10.50m 10.50m 160.50m

1.05m 2.20m 53.500m

3m 3m 3m

In the last column, the cash flows of the underlying cash position (in part b) are added to the cash flows from the swap hedge. That is, at the end of the first year, the spread on the loan versus the CD is £1.95m. The swap generates a net cash flow of £1.05m for a total end of year 1 spread of £3 million. At the end of year 2, the £.795m loan versus CD spread plus the £2.205m net swap cash flow equals £3m. At the end of year 3, the £50.5m loss on the loan-CD position is offset by the £53.5m gain on the swap for a total cash flow of £3m. Therefore, the hedged position locks in the annual 2% spread. 5. a. There is a feasible swap because of the comparative advantage inherent in the two sets of borrowing rates. b. Bank 1 has a comparative advantage in the fixed rate market and Bank 2 has a comparative advantage in the floating rates since the difference in the floating rate CDs is 1%, while the difference in the fixed rates is 2%. c. There is more than one feasible swap, but one such swap would be the following: Bank 1 pays Bank 2 LIBOR + 3.5%, while Bank 2 pays Bank 1 13%. Now Bank 1 can issue fixed rate CDs at 11%, pay LIBOR + 3.5%, and receive 13%. Net cost = -0.11 - (LIBOR + 0.035) + 0.13 = -0.11 - LIBOR - 0.035 + 0.13 = -LIBOR - 0.015 -(LIBOR + 1.5%) which is less than its current variable rate payment. Bank 2 can issue floating rate CDs at (LIBOR + 3%), pay 13%, and receive (LIBOR + 3.5%). Its net cost is 12.5% which is less than its current fixed payment. The following problems are related to Appendix 24A, 24B, and 24C material. 6. a. The 20-year 8% coupon $100,000 Treasury bond has a duration of 10.292 years. Discount Time Exponent CF Factor PVCF PVCF × t 0.5 1.0 1.5 2.0 2.5 3.0 3.5

1 2 3 4 5 6 7

4,000 4,000 4,000 4,000 4,000 4,000 4,000

0.9615 0.9246 0.8890 0.8548 0.8219 0.7903 0.7599

3,846.2 3,698.2 3,556.0 3,419.2 3,287.7 3,161.3 3,039.7

1,923.1 3,698.2 5,334.0 6,838.4 8,219.3 9,483.8 10,639.0

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0 10.5 11.0 11.5 12.0 12.5 13.0 13.5 14.0 14.5 15.0 15.5 16.0 16.5 17.0 17.5 18.0 18.5 19.0 19.5 20.0

8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40

4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 104,000

0.7307 2,922.8 11,691.0 0.7026 2,810.3 12,647.0 0.6756 2,702.3 13,511.0 0.6496 2,598.3 14,291.0 0.6246 2,498.4 14,990.0 0.6006 2,402.3 15,615.0 0.5775 2,309.9 16,169.0 0.5553 2,221.1 16,658.0 0.5339 2,135.6 17,085.0 0.5134 2,053.5 17,455.0 0.4936 1,974.5 17,771.0 0.4746 1,898.6 18,036.0 0.4564 1,825.5 18,255.0 0.4388 1,755.3 18,431.0 0.4220 1,687.8 18,566.0 0.4075 1,622.9 18,663.0 0.3901 1,560.5 18,726.0 0.3751 1,500.5 18,756.0 0.3607 1,442.8 18,756.0 0.3468 1,387.3 18,728.0 0.3335 1,333.9 18,675.0 0.3207 1,282.6 18,598.0 0.3083 1,233.3 18,499.0 0.2965 1,185.8 18,381.0 0.2851 1,140.2 18,244.0 0.2741 1,096.4 18,990.0 0.2636 1,054.2 17,922.0 0.2534 1,013.7 17,739.0 0.2437 974.7 17,544.0 0.2343 937.2 17,338.0 0.2253 901.1 17,122.0 0.2166 866.5 16,896.0 0.2083 21,662.0 433,240.0 Sum 100,000.00 1,029,200

Duration = 1,029,200/100,000 = 10.292 b. ΔP/P = -D(ΔR/(1 + R/2)) => ΔP = -D(ΔR/(1 + R/2))P = -10.292(0.005/(1 + 0.04))$100,000 = -4,948.08 The price decline of the $100,000 Treasury bond is $2,474.04 c. A bid-ask quote of 101 - 130 = $101 13/32 per $100 face value. Since the Treasury bond futures contracts are for $100,000 face value, the quoted price is $101,406.25. 7. The expected change in the spot position = -9.4 × (0.01/1.07) × 10,400,000 = -$913,645. This would mean a price change from 104 to 94.86355 per $100 face value. By entering into a two month forward contract to sell a $10,000,000 of 15 year bonds at 104, the FI will have hedged its spot position. If rates rise by 1% and the bond value falls by $913,645, the FI can close out its forward position by receiving 104 for bonds worth 94.86355. The profit on the forward position will offset the loss in the spot market. 8. a. DGAP = DA – k DL = 6 – (0.9)(4) = 6 – 3.6 = 2.4 years b. Expected E = -DGAP[R/(1 + R)]A = -2.4(-0.01/1.10)$150m = $3.272 million Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e c. Expected E = -DGAP[R/(1 + R)]A = -2.4(0.01/1.10)$150 = -$3.272. d. Solving for the impact on the change in equity under this assumption involves finding the impact of the change in interest rates on each side of the balance sheet, and then determining the difference in these values. The analysis is based on the equation: Expected E = A - L A = -DA[RA/(1 + RA)]A = -6[0.01/1.10]$150m = -$8.1818 million and L = -DL[RL/(1 + RL)]L = -4[0.01/1.06]$135m = -$5.0943 million Therefore, E = A - L = -$8.1818m – (-$5.0943m) = - $3.0875 million 9. a. The bank should sell futures contracts since an increase in interest rates would cause the value of the equity and the futures contracts to decrease. But the bank could buy back the futures contracts to realize a gain to offset the decreased value of the equity. b. The number of contracts to hedge the bank is:  (DA  kD L )A (6  (0.9)4)$150m NF     365 contracts D F x PF 10.3725x $95,000 c. For an increase in rates of 100 basis points, the change in the cash balance sheet position is: Expected E = -DGAP[R/(1 + R)]A = -2.4(0.01/1.10)$150m = -$3,272,727.27. The change in bond value = -10.3725(0.01/1.085295)$95,000 = -$9,079.41, and the change in 365 contracts is -$9,079.41 × -365 = $3,313,986.25. Since the futures contracts were sold, they could be repurchased for a gain of $3,313,986.25. The sum of the two values is a net gain of $41,258.98. For a decrease in rates of 50 basis points, the change in the cash balance sheet position is: Expected E = -DGAP[R/(1 + R)]A = -2.4(-0.005/1.10)$150m = $1,636,363.64. The change in each bond value = -10.37255(-0.005/1.085295)$95,000 = $4,539.71 and the change in 365 contracts is $4,539.71 × -365 = -$1,656,993.13. Since the futures contracts were sold, they could be repurchased for a loss of $1,656,993.13. The sum of the two values is a loss of $20,629.49. d. If Treasury bill futures contracts are used, the duration of the underlying asset is 0.25 years, the face value of the contract is $1,000,000, and the number of contracts necessary to hedge the bank is:  (D A  kD L )A  (6  (0.9)4)$150m  $360,000,000 NF      1,469contracts D F x PF 0.25 x $980,000 $245,000 e. In cases where a large number of Treasury bonds are necessary to hedge the balance sheet with a macrohedge, the FI may need to consider whether a sufficient number of deliverable Treasury bonds are available. The number of Treasury bill contracts necessary to hedge the balance sheet is greater than the number of Treasury bonds, the bill market is much deeper and the availability of sufficient deliverable securities should be less of a problem. 10. The number of contracts necessary to hedge the bank would increase to 397 contracts. This can be found by dividing $360,000,000 by (10.3725 × $95,000 × 0.92). 11. a. The mutual fund needs to enter into a contract to buy Treasury bonds at 98-24 in four months. The fund manager fears a fall in interest rates (meaning the T-bond’s price will increase) and by buying a futures contract, the profit from a fall in rates will offset a loss in the spot market from having to pay more for the securities. b. The number of contracts can be determined by using the following equation: Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e NF 

DxP D F x PF



12 x $481,250 8.5 x $98,750

 6.88 contracts

Rounding this up to the nearest whole number is 7.0 contracts. c. In this case the value of br = 1.12, and the number of contracts is 6.88/1.12 = 6.14 contracts. This may be adjusted downward to 6 contracts. d. One reason for the difference in price sensitivity is that the futures contracts and the cash assets are traded in different markets. 12. a. The duration gap is 10 - (860/950)(2) = 8.19 years. b. The FI is exposed to interest rate increases. The market value of equity will decrease if interest rates increase. c. The FI can hedge its interest rate risk by selling future or forward contracts. d. E = - 8.19(950,000)(0.01) = -$77,800 e. F = -9(96,000)(.01) = -$8,640 per futures contract. Since the macrohedge is a short hedge, this will be a profit of $8,640 per contract. f. To macrohedge, the Treasury bond futures position should yield a profit equal to the loss in equity value (for any given increase in interest rates). Thus, the number of futures contracts must be sufficient to offset the $77,800 loss in equity value. This will necessitate the sale of $77,800/8,640 = 9.005 contracts. Rounding down, to construct a macrohedge requires the FI to sell 9 Treasury bond futures contracts. 13. In problem 12, we assumed that basis risk did not exist. That allowed us to assert that the percentage change in interest rates (R/(1+R)) would be the same for both the futures and the underlying cash positions. If there is basis risk, then (R/(1+R)) is not necessarily equal to (Rf/(1+Rf)). If the FI wants to fully hedge its interest rate risk exposure in an environment with basis risk, the required number of futures contracts must reflect the disparity in volatilities between the futures and cash markets. a. If br = 0.9, then:  (D - kD ) A  8.19(950,000,000) A L = = =  10,005contracts N F D x P x br (9)(96,000)(0.90) F F b. br = 0.90 means that the implied rate on the deliverable bond in the futures market moves by 0.9 percent for every 1 percent change in discounted spot rates (R/(1+R)). c. If br = 0.9 then the percentage change in cash market rates exceeds the percentage change in futures market rates. Since futures prices are less sensitive to interest rate shocks than cash prices, the FI must use more futures contracts to generate sufficient cash flows to offset the cash flows on its balance sheet position. 14.  (DA  kD L )A  (14  (0.875)4)$240m NF     2728contracts D F x PF 9 x $102,656 15. a. Np 

DxP δ xDxB



5 x $100,000,000 0.625 x 10.1 x $96,157

 823.74 824contracts

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e b. A $100,000 20-year, eight percent bond selling at $96,157 implies a yield of 8.4 percent. P = Np × p = 824 × (-0.625) × (-10.1) × $96,157 × 0.01/1.084 = $4,614,028 gain c. B = -5 × $100,000,000 × 0.01/1.08 = -$4,629,630 d

P = 824 × 3,250 = 824 × (-0.625) × (-10.1) × $96,157 × R /1.084 Solving for the change in interest rates gives R = ($3,250 × 1.084)/(0.625 × 10.1 × $96,157) = 0.005804 or 0.58 percent.

B = 3,250 × 824 = -5 × $100,000,000 × R /1.08 Again solving for R = ($3,250 × 824 × 1.08)/(5 × $100,000,000) = -0.0057845 or -0.58 percent.

16. a. The duration gap for the bank is [12 – (720/840)7] = 6. Therefore, the bank is concerned that interest rates may increase, and it should purchase put options. As rates rise, the value of the bonds underlying the put options will fall, but they will be puttable at the higher put option exercise price. b. The bonds underlying the put options have a market value of $104,531.25. Thus, Np 

DGAPxA δ xDxB



6 x $840,000,000 0.4 x 8.17 x $104,531.25

 14,753.75or14,754contracts

c. The change in equity value is ΔE = –DGAP × A × (R/(1 + R)) = -6($840,000,000)(0.005/1.0756) = -$23,428,784. d. P = Np(‌‌|| × D × B × R/(1+R)) = 14,754 × 0.4 × 8.17 × $104,531.25 × 0.005/1.0756 = $23,429,185 gain e. A price quote of $0.875 is per $100 face value of the put contract. Therefore, the cost per contract is $875, and the cost of the hedge is $875 × 14,754 = $12,909,750. f. The cost of the put options = $12,909,750 Solving the equation in part (c) above for R. Then R = $12,909,750x1.0756/($840,000,000x(-6)) = -0.002755 or -0.2755 percent. g. Use the equation in part (d) above and solve for R. Then, R = ($12,909,750 × 1.0756)/[14,754 × 0.4 × 8.17 × $104,531.25] = 0.002755 or 0.2755 percent. 17. a.

MD = D/(1 + 0.10) = 7/1.10 = 6.3636 years

b. Np =

[ DA - k DL]x A

= [6.5 - 4.5(0.80)] × $200,000,000/[(-0.3) × (-7.0) × (96,000)] = 2,876.98 or 2,877

δ x Dx B

contracts c. The change in equity value is ΔE = –DGAP × A × (R/(1+R)) = -2.9($200,000,000)(0.005/1.10) = -$2,636,364 d. P = Np(|| × D × B × R/(1=R)) = 2,877 × 0.3 × 7 × $96,000 × 0.005/(1.10) = $2,636,378 gain e. Let E = $3,596,250, and solve the equation in part (c) above for R. Then R = $3,596,250 × 1.10/($200,000,000 × -2.9) = -0.00682 or -0.68 percent. Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e f. Use the equation in part (d) above and solve for R. Then R = $3,596,250/[2,877 × (-0.3) × (-6.3636) × $96,000] = 0.00682 or 0.68 percent. 18. a. The mutual fund is concerned about interest rates falling which would imply that bond prices would increase. Therefore, the FI should buy call options to guarantee a certain purchase price. b.

NC =

D xA δxDxB



11 x $10,000,000 0.5 x 9 x $103,250

 236.75or 237 call options

c. The quote for T-bond options is 1-25, or 1 25/64 =1.390625 per $100 face value. This converts to $1,390.625 per $100,000 option contract. The total cost of the hedge is 237 × $1,390.625 = $329,578.125. d. For a rate increase, the B = -11 × $10,000,000 × (0.005)/1.0768 = -$510,773. If rates decrease, the value of the bonds will increase by $510,773. e. If interest rates decrease, the value of the underlying bonds, and thus the option value, increases. C = Nc( × (-D) × B × R/(1+R)) = 237 × 0.5 × (-9) × $103,250 × (-0.005/(1.0768)) = $511,312. This occurs because the FI can buy the bonds at the exercise price and sell them at the higher market price. If rates rise, the option values would theoretically fall by $511,312. However, the option holder (the FI) is not obligated to take this whole loss. The option holder is only obligated to lose up to the purchase price of the options, or 1 25/64% × $100,000 × 237 = $329,578. The options will expire without value because the bonds will be priced lower in the market. 19. a. Premium for purchasing the cap = 0.0065 × $200 million = $1,300,000. If interest rates rise to 10 percent, cap purchasers receive $200 million × 0.01 = $2,000,000. The net savings is $700,000. b. If the FI also purchases the floor: Premium = 0.0069 × $200 million = $1,380,000, and the total premium = $1,380,000 + $1,300,000 = $2,680,000. If interest rates rise to 11 percent, the cap purchaser receives 0.02 × $200m = $4,000,000, and the net savings = $4,000,000 - $2,680,000 = $1,320,000. If interest rates fall to 3 percent, the floor purchaser receives 0.01 × $200 million = $2,000,000, and the net savings = $2,000,000 - $2,680,000 = -$680,000. c. If the FI sells the floor, it receives net $1,380,000 minus the cost of the cap of $1,300,000 = +$80,000. If interest rates rise to 11 percent, cap purchasers receive 0.02 × $200m = $4,000,000. The net the net savings = $4,000,000 + $80,000 = $4,080,000. If interest rates fall to 3 percent, floor purchasers receive 0.01 × $200 million = $2,000,000. The net savings to the FI = $-2,000,000 + 80,000 = -$1,920,000. d. The FI needs to sell: NVf × 0.0069 = $1,300,000, or NVf = $188,405,795 worth of 4 percent floors.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e Answers to Chapter 25 Questions: 1. Loan securitization has increased in volume as a result of the creation of an active secondary market and the implicit and explicit government guarantees on pass-through securities. The loan sales market has suffered from credit risk exposure, high information and monitoring costs, and costly validation and transactions costs. Loan sales have only been dominant in loan categories such as commercial and industrial loans that are too large and heterogenous to package into securities. 2. Loans sold without recourse means that after selling the loan the originator of the loan can take it off the balance sheet. In the event the loan is defaulted, the buyer of the loan has no recourse to the seller for any claims, transferring the credit risk entirely to the buyer. For the originator, it has completely eliminated this loan from its books. In the case of a sale with recourse, credit risk is still present for the originator because the buyer could transfer ownership of the loan back to the originator. Thus, from the perspective of the buyer, loans with recourse bear the least credit risk. 3. Short-term loan sales usually consist of maturities between one and three months and are secured by the assets of a firm. They are usually sold in units of $1 million or more and are made to firms that have investment grade credit ratings. Banks have originated and disposed of short-term loans as an effective substitute for commercial paper, which have similar characteristics to short-term loans. The accessibility of commercial paper by more and more corporations has reduced the volume of these short-term loans for loan sales purposes. 4. Commercial paper issuers are generally blue chip corporations that have the best credit ratings. Banks may sell the loans of less creditworthy borrowers, thereby raising required yields. Indeed, since commercial paper issuers tend to be well-known companies, information, monitoring, and credit assessment costs are lower for commercial paper issues than for loan sales. Moreover, since there is an active secondary market in commercial paper, but not for loan sales, the commercial paper buyer takes on less liquidity risk than does the buyer of a loan sale. 5. In a loan participation, the buyer does not obtain total control over the loan, while in an assignment, all rights are transferred upon sale, thereby giving the buyer a direct claim on the borrower. Transactions costs are higher for loan assignments than for loan participations since the loan must be transferred via a Uniform Commercial Code filing. Moreover, current holders of the loan must be verified as well as any impediments to transfer, thereby further increasing transactions costs upon loan sale under assignment. Monitoring incentives are higher and costs are lower under loan assignments as opposed to loan participations. This is because the buyer is the sole holder of the loan and thus there is no free-rider problem. Monitoring costs are lower since the loan assignment buyer need only monitor the borrower's activities, while the loan participation buyer must monitor both the borrower and the originating bank. Risk exposure is greater under loan participations than under loan assignments since participations have a “double-risk” exposure. The buyer of the loan participation is exposed to the credit risk of the originating bank (still controlling the loan) as well as the credit risk exposure of the borrower. 6. A highly leveraged transaction is a loan to finance an acquisition or merger. Often the purchase is a leverage buyout with a resulting high leverage ratio for the borrower. U.S. federal bank regulators have adopted a definition that identifies an HLT loan as one that (1) involves a buyout, acquisition, or recapitalization and (2) doubles the company’s liabilities and results in a leverage ratio higher than 50 percent, results in a leverage ratio higher than 75 percent, or is designated as an HLT by a syndication agent. 7. The buyers of loans are: i. Investment banks (since they are often involved with the initial transaction that leads to the issuance of the debt); ii. Vulture funds (since they invest in portfolios of risky loans); iii. Other domestic banks (in order to circumvent regional banking and branching restrictions so as to increase regional and customer diversification); iv. Foreign banks (to obtain a presence in the U.S. market without incurring the costs of a branch network); v. Insurance companies and pension funds (to earn higher yields, when permissible); vi. Closed-end bank loan mutual funds (to earn fee income on loan syndications); and vii. Non-financial corporations (to earn higher yields). Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e

The sellers of loans are: i. Major money center banks (to reduce capital requirements, diversify the loan portfolio, reduce reserve requirements, and increase liquidity); ii. Foreign banks (to reduce capital requirements, diversify the loan portfolio, reduce reserve requirements, and increase liquidity); iii. Investment banks (as market makers); iv. Small regional or community banks; and v. the U.S. government and its agencies. 8. The reasons for an increase in loan sales, apart from hedging credit risk, include: (a) Removing loans from the balance sheet by sale without recourse reduces the amount of deposits necessary to fund the FI, which in turn decreases the amount of regulatory reserve requirements that must be kept by the FI. (b) Originating and selling loans is an important source of fee income for the FIs. (c) One method to improve the capital ratio for an FI is to reduce assets. This approach often is less expensive than increasing the amount of capital. (d) The sale of FI loans to improve the liquidity of the FIs has expanded the loan sale market. This has made FI loans even more liquid and reduced FI liquidity risk even farther. Thus, by creating the loan sales market, the process of selling the loans has improved the liquidity of the asset for which the market was initially developed. 9. The three levels of taxes faced by FIs when making loans are; a) capital requirements on loans to protect against default; b) reserve requirements on demand deposits for funding the loans; and c) deposit insurance to protect the depositors. If the loans are securitized, FIs end up only servicing the loans. As a result, no capital is required to protect against default risk. However, reserve requirements and deposit insurance will be reduced if liabilities are also reduced. If the cash proceeds from the loan sales are used to invest in other assets, then the taxes will still remain in place. 10. The sale or securitization of a loan converts a long term asset on the balance sheet into cash, thus reducing the maturity and increasing the liquidity of the assets. 11. At the conclusion of the securitization process, the FI will have (1) exchanged a loan balance for cash, (2) significantly reduced the maturity mismatch of its assets and liabilities, and (3) reduced the regulatory tax burden. The risk profile is potentially reduced in two ways. First, exchanging loans for cash removes any risk-based capital requirements for the FI. Second, if the cash is used to repay deposits, reserve requirements may be reduced. 12. Prepayment is the process of paying principal on a debt before the due date. In the case of an amortized loan that has fixed periodic payments, prepayment means that the lender will receive fewer of the fixed periodic payments, one or more payments of extra principal, and the final payment will be made before the final payment due date. The two primary factors that cause prepayment are (1) the refinancing of the loan by the borrower because of better interest rates and (2) the economic reality of having the cash to repay before maturity. In the case of residential mortgages, this economic reality usually occurs with the sale of a house because of relocation. In the first case, investors must reinvest at lower rates and thus realize lower rates of return over their entire investment horizon. Housing turnover risk may or may not translate into losses for pass-through holders because interest rates could remain the same, allowing them to reinvest the early payments in other instruments paying similar rates. 13. A CMO is a series of pass-through securities that have been allocated into different groups or tranches. Each tranche typically has a different interest rate (coupon), and any prepayments on the entire CMO typically are allocated to the tranche with the shortest maturity. Thus, prepayment risk does not affect the tranches with longer lives until the earlier tranches have been retired. Many of the tranches in the CMO receive interest rates that are lower than the average pass-through requirement because of the limited prepayment risk protection. 14. Mortgage backed bonds differ from collateralized mortgage obligation in two key ways. CMO help banks and thrifts remove mortgages from their balance sheets, MBBs normally remain on the balance sheet. Also, CMOs have a direct link between the cash flows on the underlying mortgages and the cash flow on the bond vehicles, while with

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e MBBs the relationship is one of collateralization, so that the cash flows on the mortgages backing the bond are not necessarily used to make interest and principal payments on the MBB. 15. In the process of intermediation on behalf of its customers, the FI assumes risk exposure. The FI can reduce that risk exposure by altering its product base, thereby affecting the portfolio mix obtained in the course of intermediation. However, this is likely to be quite costly in terms of customer good will and loss of business. Securitization enables FIs to manage risk exposure by changing their portfolio mix without alienating customers. That is, customers are still serviced and the FI continues to intermediate. Balance sheet alterations are made subsequent to and independent of the intermediation activity. Thus, the FI can make portfolio changes and still fulfill the franchise of the intermediary. Interest rate risk exposure is reduced by matching the durations of assets and liabilities. Securitization enables the FI to accomplish this since the FI can determine which loans to package and sell off. Credit risk exposure is minimized by selling loans without recourse. Foreign exchange rate risk exposure is reduced by matching the foreign currencies in which the assets and liabilities are denominated. Securitization allows the FI to sell off unmatched assets. Finally, securitization reduces liquidity risk, since the FI does not have to fund the asset. 16. Buyers of CMOs incur prepayment risks depending upon the class of tranches they have purchased. Purchasers of Tranche A incur the most risk because all prepayments will be passed on to them. Prepayments usually occur when interest rates are low and thus posing high reinvestment risks to this group of buyers. On the other hand, Tranche C purchasers are protected from prepayment until Tranche B is exhausted and as a result are less likely to incur prepayments unless interest rates reach so low as to create above-average levels of refinancing. 17. Conceptually, the answer is that they can, so long as doing so is profitable or the benefits to the FI from securitization outweigh its costs. With heterogeneous loans, it is important to standardize the salient features of loans. Default risks, if significant, have to be reduced by diversification. Expected maturities have to be reasonably similar. As mechanisms are developed to overcome these difficulties, it is perfectly reasonable to expect securitization to grow.

Problems: 1. a. If the bank sells with recourse, it should expect: (0.08 × 10m){[1 - (1/(1 + 0.085)3)]/0.085} + 10m/(1 + 0.085)3 = $9.8723 million b. If the bank sells without recourse, it should expect: (0.08 × 10m){[1 - (1/(1 + 0.0875)3)]/0.0875} + 10m/(1 + 0.0875)3 = $9.8093 million c. If sold with recourse and expected probability of default is taken into account, it should expect to receive: (0.995) × $9.8723m = $9.8229m, which is still higher than selling it without recourse. So, it should sell it with recourse. 2. a. Market value of loan: (0.10 × 2m){[1 - (1/(1 + 0.12)10)]/0.12} + 2m/(1 + 0.12)10 = $1.774 million b. The prices of these loans are being quoted at 88 cents and 89 cents to the dollar. In the case of the above loan, it will translate into $1.56 ($1.774 million × 0.88) and $1.58 million ($1.774 million × 0.89), i.e., a dealer is willing to buy such loans at $1.56 million and sell them at $1.58 million. c. This loan is categorized as distressed since it is selling at prices below $0.90 to the dollar. It usually indicates lower than average liquidity and more default risk, making it a less tradable instrument. 3. a. The duration of the existing loan is: 0 + $15m/$20m(X) = 3.5 years => Existing loan duration = 4.667 years

Saunders/Cornett/Erhemjamts Financial Markets and Institutions, 8e If it purchases $5 million of loans with an average duration of 7 years, its portfolio duration will increase to $5m/ $20m(7) + $15m/$20m(4.667) = 5.25 years. In this case, the average duration will be above 5 years (of its liabilities). The FI may be better off seeking another loan with a slightly lower duration. b. The FI should seek to purchase a loan of the following duration: $5m/$20m(X) + $15m/$20m(4.667 years) = 5 years =>X = duration = 6 years. 4. a. Since commercial loans have a 100 percent risk weighting, the minimum capital required on commercial loans = $100m × 1.0 × 0.08 = $8 million. b. Since there is an interaction between the demand deposits and cash reserves held, the answer requires solving the following, assuming the $8 million is funded by equity and the reserve requirements are kept as cash: $100m + (0.10 × DD) = DD + 8m => 92m = 0.9DD=> DD = 92/0.9 = $102.22 c.

Assets Cash

10.22 100.00 110.22

Liabilities Demand deposits Equity

102.22 8.00 110.22

5. a. There are 120 quarterly payments over 30 years. The quarterly mortgage payments are: $200m = PMT × {[1 - (1/(1 + 0.10/4)120)]/0.10/4}. Thus, PMT = $5,272,358.60. b. Quarter Balance 1 2 3 4 c.

$200m 199.728 199.449 199.163

Payment (PMT) (Fixed) $5.272m 5.272 5.272 5.272

Interest Payment $5m 4.993 4.986 4.979

Principal Payment $0.272m 0.279 0.286 0.293

Remaining Principal $199.728m 199.449 199.163 198.870

Tranche A: 9%/4 × $50 million = $1,125,000 quarterly Tranche B: 10%/4 × $100 million = $2,500,000 quarterly Tranche C: 11%/4 × $50 million = $1,375,000 quarterly Total interest payments: $5 million quarterly

d. Regular Tranche A payments are $1.125 million quarterly. If there are no prepayments, then the regular GNMA quarterly payment of $5.272 million is distributed among the three tranches. Five million is the total coupon payment for all three tranches. Therefore, $.272 million of principal is repaid each quarter, even if there are no prepayments. Tranche A receives all principal payments. Tranche A cash flows are $1.125 million + $.272 million = $1.397 million quarterly. Quarter

Balance

1 2 3 4

$50m 49.728 49.450 49.166

Payment (PMT) (Fixed) $1.397m 1.397 1.397 1.397

Interest Payment $1.125m 1.119 1.113 1.106

Principal Payment $0.272m 0.278 0.284 0.291

Remaining Principal $49.728m 49.450 49.166 48.875

e. Quarterly prepayments on the entire mortgage pool are $10 million. They are credited entirely to Tranche A until all principal is paid off. The payments are distributed as follows: Quarter

Balance

1 2

$50m 39.188

Payment (PMT) (Fixed) $11.937m 11.937

Interest Payment $1.125m 0.882

Principal Remaining Payment Principal $10.812m $39.188 m 11.055 28.133

3 4

28.133 16.829

11.937 11.937

0.633 0.379

11.304 11.558

16.829 5.271

f. The way the terms of the CMO are structured, the average coupon rate on the three classes equals the mortgage coupon rate on the underlying mortgage pool. However, given the more desirable cash flow characteristics of the individual classes, the FI may be able to issue the CMO classes at lower coupon rates. The difference between the sum of all coupon payments promised on all CMO tranches and the mortgage coupon rate on the underlying mortgage pool is the FI's servicing fee. 6. a. There are 120 quarterly payments over 30 years. The quarterly mortgage payments are: $100m = PMT × {[1 - (1/(1 + 0.05/4)120)]/0.05/4} => PMT = $1,613,350. b.

(Fixed) Payment $1,613,350 1,613,350 1,613,350 1,613,350

Quarter Balance 1 $100,000,000 2 99,636,650 3 99,268,759 4 98,896,269 c. Principal amount Interest rate Quarterly interest on initial balance Quarterly amortization

Interest Payment $1,250,000 1,245,458 1,240,859 1,236,203

Principal Payment $363,350 367,891 372,490 377,146

Remaining Principal $99,636,650 99,268,759 98,896,269 98,519,123

Tranche A $25 million 9 percent

Tranche B $50 million 10 percent

Tranche C $25 million 11 percent

Total Issue $100 million 10 percent

$250,000

$625,000

$375,000

$1,250,000 $1,613,350

d. Regular tranche A interest payments are $250,000 quarterly. If there are no prepayments, then the regular GNMA quarterly payment of $1,613,350 is distributed among the three tranches. Five million is the total coupon interest payment for all three tranches. Therefore, $363,350 of principal is repaid each quarter. Tranche A receives all principal payments. Tranche A cash flows are $250,000 + $363,500 = $613,500 quarterly. The cash flows to tranches B and C are the scheduled interest payments. Tranche A amortization schedule: Quarter 1 2 3 4

Balance $25,000,000 24,636,500 24,269,365 23,898,559

Payment $613,500 613,500 613,500 613,500

Interest Payment $250,000 246,365 242,694 238,986

Principal Payment $363,500 367,135 370,806 374,514

Remaining Principal $24,636,500 24,269,365 23,898,559 23,524,044

Payment $625,000 625,000 625,000 625,000

Interest Payment $625,000 625,000 625,000 625,000

Principal Payment $0.0m 0.0m 0.0m 0.0m

Remaining Principal $50.000m 50.000m 50.000m 50.000m

Payment $375m 375m 375m 375m

Interest Payment $375m 375m 375m 375m

Principal Payment $0.0m 0.0m 0.0m 0.0m

Remaining Principal $25.000m 25.000m 25.000m 25.000m

Tranche B amortization schedule: Quarter 1 2 3 4

Balance $50.000m 50.000m 50.000m 50.000m

Tranche C amortization schedule: Quarter 1 2 3 4

Balance $25.000m 25.000m 25.000m 25.000m

e. The quarterly prepayments of $5 million will be credited entirely to tranche A until tranche A is completely retired. Then prepayments will be paid entirely to tranche B. The amortization schedule for tranche A for the first year is shown below. This amortization schedule assumes that the trustee has a quarterly payment amount from the mortgage pool of $1,613,350. Quarter 1 2 3 4

Balance $25,000,000 19,636,500 14,219,365 8,748,059

Payment $5,613,500 5,613,500 5,613,500 5,613,500

Interest Payment $250,000 196,365 142,194 87,481

Principal Payment $5,363,500 5,417,135 5,471,306 5,526,019

Remaining Principal $19,636,500 14,219,365 8,748,059 3,222,039

However, since some of the mortgages will be paid off early, the actual payment received by the trustee from the mortgage pool will decrease each quarter. Thus, the payment for the second quarter will decrease from $1,613,350 to $1,532,385 (n = 119 quarters, i = 5 percent, mortgage principal = $94,636,500). The CMO amortization schedule for tranche A given that the mortgage payments decrease with the prepayments is given below. The revised mortgage payment for each quarter is shown in the last column. Quarter 1 2 3 4

Balance $25,000,000 19,636,500 14,300,480 8,992,143

Payment $5,613,500 5,532,385 5,451,342 5,370,210

Interest Payment $250,000 196,365 143,005 89,921

Principal Payment $5,363,500 5,336,020 5,308,337 5,280,289

Remaining Principal $19,636,500 14,300,480 8,992,143 3,711,854

Mortgage Payment $1,613,350 1,532,385 1,451,342 1,370,210

f. The amortization schedules for tranches A and B are shown below. Again the mortgage payments from the mortgage holders are assumed to decrease as the prepayments occur. Amortization schedule for tranche A: Tranche Quarter Balance Payment 5 $3,711,854 $10,288,986

Interest Payment $37,119

Principal Payment $10,251,867

Remaining Principal -$6,540,013

Mortgage Payment $1,288,986

Interest Payment $625,000 543,250

Principal Payment $6,540,013 11,274,489

Remaining Principal $43,459,987 32,185,498

Mortgage Payment $1,288,986 1,817,739

Amortization schedule for tranche B: Quarter 5 6

Balance $50,000,000 43,459,987

Tranche Payment $7,165,283 11,817,739

7. a. The average payment is: $20,000,000 = PMT ×{[1 - (1/(1 + 0.09)10)]/0.09}. Thus, PMT = $3,116,401.80. b. $20,000,000 = PMT ×{[1 - (1/(1 + 0.085)10)]/0.085}. Thus, PMT = $3,048,154.10. 8. a. There are 180 monthly payments (15 years × 12 months). The GNMA monthly coupon rate is 8.5% - 0.5% = 8 percent per year, and the monthly GNMA pass-through payment is: $10m= {[1 - (1/(1 + 0.08/12)180)]/0.08/12} × PMT => PMT = $95,565.21. The present value of the GNMA at a 5 percent market rate is: PV = $95,565.21 × {[1 - (1/(1 + 0.05/12)180)]/0.05/12}= $12,084,721.63. b. Assume that the GNMA is only half amortized. There is a lump sum payment at the maturity of the GNMA that equals 50 percent of the mortgage pool's face value. If there is a 50 percent amortization, the monthly GNMA pass-through payments are:

$10m = PMT × {[1 - (1/(1 + 0.08/12)180)]/0.08/12} + $5m/(1 + 0.08/12)180 => PMT = $81,115.94 The present value of the GNMA at a 5 percent market rate is: PV = $81,115.94 ×{[1 - (1/(1 + 0.05/12)180)]/0.05/12} + $5m/(1 + 0.05/12)180 = $12,623,051.35. 9. a.

The monthly mortgage payment, PMT, is (the monthly interest rate is 0.10/ 12 = 0.00833): $20m = {[1 - (1/(1 + 0.10/12)360)]/0.10/12} × (PMT) => PMT = $175,514.31

b. The GNMA's annual interest rate is 0.10 - 0.0044 - 0.0006 = 9.5 percent. The monthly interest rate is 0.095/12 = 0.0079167 or 0.79167 percent. c. The monthly GNMA payment, PMT, is: $20m = {[1 - (1/(1 + 0.095/12)360)]/0.095/12}x PMT => PMT = $168,170.84 d. The first monthly servicing fee, SF, is (the monthly fee rate is 0.44%/12 = 0.0367%): SF = (0.000367)$20m = $7,333. e. The first monthly insurance payment, IP, is (monthly insurance rate is 0.06%/12 = 0.005%): IP = (0.00005)$20m = $1,000 10. a. The mortgage pool's value, PV, is (the monthly discount rate is 10.5%/12 = 0.875%): PV = $175,514.31 × {[1 - (1/(1 + 0.105/12)360)]/0.105/12} = $19,187,359 b. The GNMA's value, PV, is (the monthly discount rate is 10%/12 = 0.8333%): PV= $168,170.84 × {[1 - (1/(1 + 0.10/12)360)]/0.10/12} = $19,163,205.

This Page is Intentionally Left Blank