Practice set and Solutions 1

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1 Practice set and Solutions 1 Financial Markets and Institutions Risk Management What to do with this practice set? Practice sets are handed out to help students master the material of the course and prepare for the final exam. These sets contain worked-out problems in corporate finance. These sets are not graded, and there is no need to hand-in the solutions. Students are strongly encouraged to solve them, discuss the solutions with other course participants, and use the teacher's ( ) to discuss any problems they might encounter. Questions in the final exam will/might/perhaps resemble some of the problems given here. Chapter 1 1. What are five risks common to financial institutions? 2. Identify and explain the two functions FIs perform that would enable the smooth flow of funds from household savers to corporate users. 3. Explain how financial institutions act as delegated monitors. What secondary benefits often accrue to the entire financial system because of this monitoring process? 4. What are five general areas of FI specialness that are caused by providing various services to sectors of the economy? 5. What are agency costs? How do FIs solve the information and related agency costs when household savers invest directly in securities issued by corporations? 6. How do financial institutions help individual savers diversify their portfolio risks? Which type of financial institution is best able to achieve this goal? 7. What are two of the most important payment services provided by financial institutions? To what extent do these services efficiently provide benefits to the economy? 8. Why are FIs among the most regulated sectors in the world? When is net regulatory burden positive? Chapter 3 1. What is the primary function of an insurance company? How does this function compare with the primary function of a depository institution? 2. What is the adverse selection problem? How does adverse selection affect the profitable management of an insurance company? 1

2 Chapter 4 1. Explain how securities firms differ from investment banks. In what ways are they financial intermediaries? 2. What are the key activity areas for securities firms? How does each activity area assist in the generation of profits and what are the major risks for each area? 3. What is the difference between an IPO and a secondary issue? Chapter 5 1. What is a mutual fund? In what sense is it a financial institution? 2. What are money market mutual funds? In what assets do these funds typically invest? What factors have caused the strong growth in this type of fund since the late 1970s? 3. What are long-term mutual funds? In what assets do these funds usually invest? What factors caused the strong growth in this type of fund from 1992 through 2007? 4. What is a hedge fund and how is it different from a mutual fund? 5. What are the different categories of hedge funds? 6. What are the economic reasons for the existence of mutual funds; that is, what benefits do mutual funds provide for investors? Why do individuals rather than corporations hold most mutual funds? Chapter 6 1. What is the primary function of finance companies? How do finance companies differ from commercial banks? 2

3 Solutions Chapter 1: 1) Default or credit risk of assets, interest rate risk caused by maturity mismatches between assets and liabilities, liability withdrawal or liquidity risk, underwriting risk, and operating cost risks. 2) F Is serve as conduits between users and savers of funds by providing a brokerage function and by engaging in an asset transformation function. The brokerage function can benefit both savers and users of funds and can vary according to the firm. FIs may provide only transaction services, such as discount brokerages, or they also may offer advisory services which help reduce information costs, such as full-line firms like Merrill Lynch. The asset transformation function is accomplished by issuing their own securities, such as deposits and insurance policies that are more attractive to household savers, and using the proceeds to purchase the primary securities of corporations. Thus, FIs take on the costs associated with the purchase of securities. 3) By putting excess funds into financial institutions, individual investors give to the FIs the responsibility of deciding who should receive the money and of ensuring that the money is utilized properly by the borrower. In this sense, depositors have delegated the FI to act as a monitor on their behalf. Further, the FI can collect information more efficiently than individual investors. The FI can utilize this information to create new products, such as commercial loans, that continually update the information pool. This more frequent monitoring process sends important informational signals to other participants in the market, a process that reduces information imperfection and asymmetry between the ultimate providers and users of funds in the economy. 4) First, FIs collect and process information more efficiently than individual savers. Second, FIs provide secondary claims to household savers which often have better liquidity characteristics than primary securities such as equities and bonds. Third, by diversifying the asset base FIs provide secondary securities with lower price-risk conditions than primary securities. Fourth, FIs provide economies of scale in transaction costs because assets are purchased in larger amounts. Finally, FIs provide maturity intermediation to the economy which allows the introduction of additional types of investment contracts, such as mortgage loans, that are financed with short-term deposits. 5) Agency costs occur when owners or managers take actions that are not in the best interests of the equity investor or lender. These costs typically result from the failure to adequately monitor the activities of the borrower. If no other lender performs these tasks, the lender is subject to agency costs as the firm may not satisfy the covenants in the lending agreement. Because the FI invests the funds of many small savers, the FI has a greater incentive to collect information and monitor the activities of the borrower. 6) Money placed in any financial institution will result in a claim on a more diversified portfolio. Banks lend money to many different types of corporate, consumer, and government customers. Insurance companies have investments in many different types of assets. Investments in a mutual fund may generate the greatest diversification benefit because of the fund s investment in a wide array of stocks and fixed income securities. 7) 8) I FIs are required to enhance the efficient operation of the economy. Successful financial institutions provide sources of financing that fund economic growth opportunities that ultimately raise the overall level of economic activity. Moreover, successful financial institutions provide transaction services to the economy that facilitate trade and wealth accumulation. 3

4 Chapter 3: Conversely, distressed FIs create negative externalities for the entire economy. That is, the adverse impact of an FI failure is greater than just the loss to shareholders and other private claimants on the FI's assets. For example, the local market suffers if an FI fails and other FIs also may be thrown into financial distress by a contagion effect. Therefore, since some of the costs of the failure of an FI are generally borne by society at large, the government intervenes in the management of these institutions to protect society's interests. This intervention takes the form of regulation. However, the need for regulation to minimize social costs may impose private costs to the FIs that would not exist without regulation. This additional private cost is defined as a net regulatory burden. Examples include the cost of holding excess capital and/or excess reserves and the extra costs of providing information. Although they may be socially beneficial, these costs add to private operating costs. To the extent that these additional costs help to avoid negative externalities and to ensure the smooth and efficient operation of the economy, the net regulatory burden is positive. 1) The primary function of an insurance company is to provide protection from adverse events. Insurance companies accept premium payments in exchange for compensation in the event that certain 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) The adverse selection problem occurs because customers who are most in need of insurance are most likely to acquire insurance. However, the premium structure for various types of insurance typically is based on an average population proportionately representing all categories of risk. Thus, the existence of a proportionately larger share of high-risk customers may cause the premium revenue received by the insurance provider to underestimate the revenue needed to cover the insured liabilities and to provide a reasonable profit for the insurance company. Chapter 4: 1) Securities firms specialize primarily in the purchase, sale, and brokerage of securities, while investment banks primarily engage in originating, underwriting, and distributing issues of securities. In more recent years, investment banks have undertaken increased corporate finance activities such as advising on mergers, acquisitions, and corporate restructuring. In both cases, these firms act as financial intermediaries in that they bring together economic units who need money with those units who wish to invest money. Both segments have undergone substantial structural changes in recent years. Some of the most recent consolidations include the acquisition of Bears Stearns by J.P. Morgan Chase, the bankruptcy of Lehman Brothers and the acquisition of Merrill Lynch by Bank of America. Indeed, as discussed later in the chapter, the investment banking industry has seen the failure or acquisition of all but two of its major firms (Goldman Sachs and Morgan Stanley) and these two firms converted to commercial bank holding companies in ) The seven major activity areas of security firms are: 4

5 a) 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 affect directly the revenue stream of the companies. b) 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. 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) 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. f) Mergers and Acquisitions: Most investment banks provide advice to corporate clients who are involved in mergers and acquisitions. This activity has been extremely beneficial from a fee standpoint during the 1990s and 2000s. g) 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. 5

6 3) An IPO is the first time issue of a company s securities, whereas a secondary offering is a new issue of a security that is already offered. Chapter 5: 1) A mutual fund represents a pool of financial resources obtained from individuals and companies, which is invested in the money and capital markets. This process represents another method for economic savers to channel funds to companies and government units that need extra funds. 2) Money market mutual funds (MMMFs) invest in assets that have maturities of less than one year. These assets primarily are Treasury bills, negotiable certificates of deposit, repurchase agreements, and commercial paper. The growth in MMMFs since the late 1970s initially occurred because of rising interest rates in the money markets, while Regulation Q restricted interest rates on accounts in depository institutions. Many investors moved their short-term savings from the depository institutions to the MMMFs as the spread in the earnings rate reached double digits. A result of this activity was to introduce many investors to the capital markets for the first time. At the end of 2008, the share of long-term funds plunged to 59.1 percent of all funds, while money market funds increased to 40.9 percent. 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. As financial markets tumbled in 2008, money market mutual funds moved investments out of corporate and foreign bonds (12.4 percent of the total in 2007 and 5.0 percent in 2009) into safer securities such as U.S. government securities (13.6 percent of the total investments in 2007 and 31.6 percent in 2009). 3) Long-term mutual funds primarily invest in assets that have maturities of more than one year. The most common assets include long-term fixed-income bonds, common stock, and preferred stocks. Some money market assets are included for liquidity purposes. The growth in these funds in the 1990s and 2000s reflected the dramatic increase in equity returns, 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 mutual fund activity. At the end of 2008, total assets fell to $9,601.1 billion and the number of accounts to 264,499. 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 in 2009, so did assets invested in mutual funds, growing to $11,126.4 billion by the end of the year. 4) Hedge funds are a type of investment pool in that they solicit funds from (wealthy) individuals and other investors (e.g., commercial banks) and invest these funds on their behalf. Hedge funds are similar to mutual funds in that they both are pooled investment vehicles that accept investors money and generally invest these funds on a collective basis. Hedge funds, however, are not technically mutual funds in that they are not required to register with the SEC. Thus, they are subject to virtually no regulator oversight and generally take significant risk. Hedge funds are also 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 assure 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, offer a high degree of privacy for their investors. Hedge funds offered in the U.S. avoid regulations by limiting the number of 6

7 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). These stiff financial requirements allow 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. 5) 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. Figure 5-4 shows the general categories of hedge funds by risk classification. More risk 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 form 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 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 form events such as IPOs, sudden price changes resulting from a disappointing earnings announcement, and hostile takeover bids. These funds 7

8 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, reoganizations, 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 an the final purchase price of the company. 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: 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. 6) 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, fund managers are able to hold well-diversified portfolios of assets. In addition, managers can obtain lower transaction costs because of the volume of transactions, both in dollars and numbers, and they benefit from research, information, and monitoring activities at reduced 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. Chapter 6: 8

9 1) The primary function of finance companies is to make loans to individuals and corporations. Finance companies do not accept deposits, but borrow short- and long-term debt, such as commercial paper and bonds, to finance the loans. The heavy reliance on borrowed money has caused finance companies to generally hold more equity than commercial banks for the purpose of signaling solvency to potential creditors. Finally, finance companies are less regulated than commercial banks, in part because they do not rely on deposits as a source of funds. 9

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