# Capital Markets and Financial Institutions How to Survive Them

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## Capital Markets and Financial Institutions How to Survive Them

## Offered By ”Moscow Institute of Physics and Technology”

**Week- 1**

**1 – Moral hazard, adverse selection, and the adventures of the greedy monopolist bank**

1.

Question 1

In choosing investment projects, unobservability is likely to result in:

1 point

- a. High risk projects get driven out of the market
- b. Low NPV projects get driven out of the market
- Both “a” and “b”
**Neither “a” nor “b”**

2.

Question 2

The adverse selection problem can be alleviated by the following actions:

1 point

- Raising the minimum requirements for the project owner’s financing
- Pledging the project owner’s personal property as collateral
**Hiring an independent auditor**- All of the above

3.

Question 3

The presence of moral hazard in insurance leads to the following:

1 point

- In some cases the complete insurance becomes unrealistic
- The insurance with a deductible is much cheaper than the complete insurance
**All of the above**- The cost of complete insurance increases

4.

Question 4

Hiring an outside specialist for monitoring in order to alleviate the adverse selection problem leads to the following:

1 point

- Potential collusion between the borrower and the lender
**The increase in the effective cost of financing**- Creation of adverse incentives for the borrowers’ irresponsible behavior
- Sending incredible signals to the borrower

5.

Question 5

Suppose that in our analysis of adverse selection in credit markets (Lecture 1.9, Handout 1.2) the greedy monopolist bank may distinguish the borrowers by the type. What interest rate would the bank charge for the loans to the Type 2 borrowers?

1 point

**Just below 125%**- Just above 50%
- Just below 50%
- Just above 125%

6.

Question 6

Suppose that in our analysis of adverse selection in credit markets (Lecture 1.9, Handout 1.2) the greedy monopolist bank may distinguish the borrowers by the type and charges different face values for the loan of $8 million to the borrowers of each type. What would be the maximum expected cash flow to the bank per one borrower?

1 point

- Just below $10.67m
- Just below $11.33m
- Just below $10.00m
**Just below $11.00m**

7.

Question 7

Suppose the borrower has 2 projects available. The projects’ cash flows are given below (the H and L states are equally probable):

State H L

Project 1 15 15

Project 2 18 3

To finance either project the amount to be borrowed is $8 million. The bank charges the face value of the loan F > $8m (compare to the discussion in Lecture 1.11 and in Handout 1.2). At what F the borrower chooses Project 1?

1 point

- F > 18
- 15 < F < 18
- 12 < F < 15
**F < 12**

8.

Question 8

For the terms given in Question 7, at what F the borrower chooses Project 2?

1 point

- F > 18
**12 < F < 18**- 8 < F < 12
- F < 8

9.

Question 9

For the terms given in Question 7, what face value of the loan will the bank charge to maximize the bank’s expected cash flow?

1 point

- Just below 10
**Just below 12**- Just below 15
- Just below 18

10.

Question 10

For the terms given in Question 7, due to what problem raising the face value of the loan does not necessarily result in the increase of the bank’s expected cash flow?

1 point

**Moral hazard**- Adverse selection
- Both problems
- Can’t say

**Week- 2**

**2 – Debt contracts and the anatomy of bank financing**

1.

Question 1

In an equity type financing we may observe the following:

1 point

**Expected cash flows for the investor are uncertain**

Collusion between the entrepreneur and the investor occurs

The investor receives the fixed amount of money

The entrepreneur and the investor manage the project together

2.

Question 2

Debt contract with liquidation helps alleviate the moral hazard problem by means of:

1 point

Co-insurance

Restoring observability through monitoring

**The right incentives for the borrower**

All of the above

3.

Question 3

Suppose that in our analysis of financing by means of debt contracts and monitoring (Lecture 2.3, Handout 2.1) the probability of the low state has grown to 25% (expected cash flows in both high and low state have not changed). What would be the face value of the $6m loan if the cost of monitoring is $50,000?

1 point

$6.50m

$6.00m

$6.25m

**$6.40m**

4.

Question 4

Suppose that in our analysis of bank financing (Lectures 2.3 – 2.6, Handouts 2.1 – 2.2) the probability of the low state has grown to 30% (expected cash flows in both high and low state have not changed). What would be the face value for the borrowers of the $6m loan in the case of debt contract with liquidation?

1 point

**$8.57m**

$6.42m

$7.27m

$6.79m

5.

Question 5

Suppose that in our analysis of bank financing (Lectures 2.3 – 2.6, Handouts 2.1 – 2.2) the probability of the low state has grown to 30% (expected cash flows in both high and low state have not changed). What would be the minimum interest that would satisfy the depositors?

1 point

**9.89%**

9.62%

7.87%

8.33%

6.

Question 6

If the bank pays the minimum interest to the depositors (see Question 5), and if the terms for the borrowers are the same as in a corresponding debt contract with liquidation, how much money would the bank make if the cost of monitoring is $20,000 for each project?

1 point

$1.96m

$2.17m

**$2.06m**

$2.43m

7.

Question 7

Suppose that in our analysis of bank financing (Lectures 2.3 – 2.6, Handouts 2.1 – 2.2) the probability of the low state has grown to 30% (expected cash flows in both high and low state have not changed). What is the maximum interest rate that the bank can afford to pay the depositors?

1 point

10.14%

11.89%

14.63%

**13.10%**

8.

Question 8

If the bank pays the maximum interest rate to the depositors (see Question 7), and if the terms for the borrowers are the same as in a corresponding debt contract with liquidation, how much money would the bank make if the cost of monitoring is $20,000 for each project?

1 point

$1.79m

**$1.71m**

$1.87m

$2.06m

9.

Question 9

If the bank pays the minimum interest to the depositors (see Question 5), how could the bank improve the terms for the borrowers – namely, what is the minimum face value for the loan of $6m that the bank could offer to the borrowers?

1 point

$9.19m

$8.00m

$8.57m

**$8.19m**

10.

Question 10

If the face value for the borrowers is reduced to the minimum (see Questions 5 and 9), how much money would the bank make if the cost of monitoring is still $20,000 for each project?

1 point

**$1.52m**

$1.19m

$1.39m

$1.32m

**Week- 3**

**3 – Asset transformation – “black boxes” and “red triangles”**

1.

Question 1

If the consumption level of an economic agent grows, his expected utility of consumption:

1 point

Can’t say

Does not change

**Increases**

Decreases

2.

Question 2

In our analysis of asset transformation (Lecture 3.2, Handout 3.1), suppose that the probability of the early withdrawal grew to 30%, while the promised amounts in the case of holding a “red triangle” have changed to $1.15 at t = 1 and $1.90 at t = 2. The parameters of the illiquid asset (“black box”) stay the same. Will rational investors prefer the “red triangle” to the “black box”?

1 point

Depositors are indifferent with respect to both assets

**Yes**

No

Can’t say

3.

Question 3

In terms of Question 2 will the bank afford to offer a “red triangle”?

1 point

**No**

Can’t say

Yes, but the bank just breaks even

Yes, the bank will also make a profit

4.

Question 4

In our model of asset transformation (Lecture 3.2, Handout 3.1), suppose that the probability of the early withdrawal is stochastically distributed from 10% to 30%. The promised amounts for a “red triangle” are $1.15 at t = 1 and $1.90 at t = 2, for the “black box” stay at $1 and $2. Will rational investors prefer the “red triangle” to the “black box”?

1 point

Depositors are indifferent with respect to both assets

No

Yes

**Can’t say**

5.

Question 5

Suppose that a “red triangle” promises the holder to pay $1.15 at t = 1 and $1.90 at t = 2, while the “black box” still pays $1 at t = 1 and $2 at t = 2 (recall Lecture 3.2, Handout 3.1). At what probability of early withdrawals will rational depositors be indifferent with respect to the “black box” and the “red triangle”?

1 point

**11.70%**

15.30%

13.87%

10.67%

6.

Question 6

In terms of Question 5 (i.e. at the minimum amount of early withdrawals at which the depositors switch from “black boxes” to “red triangles” rounded up to the proper integer number), how much money will the bank make?

1 point

$3.80

$4.40

**$5.00**

$2.75

7.

Question 7

In our analysis of asset transformation (Lectures 3.2 – 3.4, Handouts 3.1 – 3.2), suppose that the probability of the early withdrawal is now 25% while the promised amount in the case of holding a “red triangle” at t = 1 has changed to $1.30. The parameters of the illiquid asset (“black box”) are the same. What is the maximum amount that the bank can promise to pay the holders of the “red triangle” at t = 2?

1 point

$1.917

**$1.763**

$1.833

$1.793

8.

Question 8

In terms of Question 7 will rational investors prefer the “red triangle” to the “black box”?

1 point

Depositors are indifferent with respect to both assets

**Yes**

No

Can’t say

9.

Question 9

Suspension of convertibility is not a very effective tool for the prevention of bank runs if:

1 point

Depositor preferences with respect to liquidity are likely to change over time

Suspension of convertibility is announced post factum

The percentage of early withdrawals is stochastic

**All of the above is observed**

10.

Question 10

Deposit insurance has the following drawbacks:

1 point

It works poorly if the percentage of early withdrawals is uncertain

It provokes the unexpected moves of depositors

**It provides incentives for the irresponsible behavior of the bank**

None of the above

**week- 4**

**4 – From the Great Depression to Bank 3.0**

1.

Question 1

Deposit insurance is not effective in preventing bank runs if:

1 point

Banks use suspension of convertibility

A special agency is created to manage the claims of insured depositors

Both small and large deposits are insured completely

**Deposits below a certain level are insured partially**

2.

Question 2

The depth and protraction of the Great Depression were, in part, due to:

1 point

The excessive activity of the Federal Reserve

The entrepreneurs’ apathy

**The growth in cost of credit intermediation**

All of the above factors

3.

Question 3

In order to solve the problems of the S&L industry it was necessary to:

1 point

Allow to clean up the balance sheets of the problem S&L’s within 3 years

**Determine the S&L’s equity level on the basis of market value of assets**

Broaden the participation of the local authorities in the S&L supervision

Close down S&L’s when their capital would become negative

4.

Question 4

The deposit insurance premia go down if:

1 point

Capital requirements are relaxed

Capital requirements become tighter

The bank’s asset risk grows

**Interest rates on bank loans increase**

5.

Question 5

The level of the bank’s risk increases if:

1 point

Interest rates on bank loans decrease

Interest rates on bank deposits decrease

**The share of financial derivatives as percentage of assets goes up**

The bank shareholders put up additional capital

6.

Question 6

The partial insurance of the bank liabilities:

1 point

Solves the problem of bank runs

Provides for efficient monitoring from the bank borrowers

Enhances the government’s willingness to allow massive bankruptcies

**Provokes the free rider problem in the case of many creditors**

7.

Question 7

One of the main causes of the huge scale of the S&L crash was:

1 point

The existence of S&L’s in all states of the US

Massive fraud on the side of top managers of S&L’s

Too weak regulation

**The absence of incentives to close down “zombie” S&L’s**

8.

Question 8

The Bank 3.0 concept states that in a modern bank:

1 point

The role of bank employees in the sale of bank products increases

The bank’s office stops offering banking services

**The interaction with clients is implemented when it is convenient to clients**

Deposit insurance becomes irrelevant

9.

Question 9

In providing mortgage loans at Bank 3.0 the process of monitoring is implemented by:

1 point

The bank’s specialists

**Becomes irrelevant**

Is not implemented at all

The bank’s clients through the social media

10.

Question 10

The obstacle on the path of a bank becoming Bank 3.0 is:

1 point

A week IT-platform that does not provide for the efficient digestion of the big data

The excessively conservative policy of the top management

Inadequate regulatory environment

**All the above problems**

**Week- 5**

**5 – Investment banking practices**

1.

Question 1

The invention of new financial instruments and active market making in them by investment banks leads to:

1 point

The greater deregulation in the area of investment banking

**Fast “copying” of the instrument by competitor banks**

Decrease in overall speculative appetite due to the improved market efficiency

A monopoly of the bank-inventor for the instrument

2.

Question 2

In arranging underwriting, investment banks often invite their international colleagues as partners in underwriting syndicates, sharing with them the commission and other corresponding income. The main goal of this arrangement usually is:

1 point

**The enhancement of the pool of potential investors**

High ethical standards of the investment banking business

The inability to attract international investors without international partners

The opportunity to circumvent prohibitive regulation rules and procedures

3.

Question 3

A research department at an investment bank provides for:

1 point

The development of the new financial instruments

The constant monitoring of the issuers

Investment recommendations for the bank’s clients

**All of the above**

4.

Question 4

Consider the following “winner’s curse” situation (see Lecture 5.4 and Handout 5.2). Suppose that the placement price is $100; also, with probability 40%, the value of the issue is $120, and in other cases – just $70. Suppose further that in the case of high value each investor will receive only 80% of the shares bid for. At what price would uninformed investors buy the shares?

1 point

$90.2

**$87.4**

$89.3

$85.7

5.

Question 5

A company plans the shelf registration of securities. It is most likely that:

1 point

The company plans to issue convertible bonds

The company plans to issue bonds

This is an industrial company

**The company plans to issue common stock**

6.

Question 6

In arranging an IPO, the US companies usually prefer:

1 point

**Fully underwritten offers**

The choice depends on the issue volume

Rights issues

Shelf registration of the issue

7.

Question 7

In choosing an investment bank for an IPO, the US companies usually prefer:

1 point

Running a tender to save on the cost of the issue

**Direct negotiations with the investment bank on the terms of the issue**

The choice of the contract depends on characteristics of the stock issued

None of the above

8.

Question 8

A group of companies А engaged in firm commitment IPO’s while a group of companies B organized IPO’s using a best efforts method. The weighted average underpricing for the group A amounted to 30%, whereas for the group B – 45%. We know that in case of firm commitment the risk incurred by the investment bank is higher; therefore, the bank should require a greater discount. How does that correspond to the above data?

1 point

The mentioned groups are just exceptions form the general rule

**If the companies from group B engaged in firm commitment IPO’s, the weighted average underpricing would exceed 45% (in the absolute value)**

If the companies from group A engaged in best efforts IPO’s, the weighted average underpricing would exceed 45% (in the absolute value)

The group А companies would not succeed in arranging IPO’s using best efforts

9.

Question 9

As a rule, the following agents are not the clients of investment banks:

1 point

Investors buying the issues of newly placed securities

**Investors engaged in high frequency trading (HFT)**

The companies – issuers of securities

The government

10.

Question 10

The active trading in the newly introduced derivative financial instrument by the investment bank usually does not contribute to:

1 point

The liquidity of other derivative financial instruments in the market

**The long-term monopoly of the bank-inventor for the instrument**

A potential conflict of interest among the divisions of the investment bank

The growth in the volume of trading in the instrument by other investors

**Week- 6**

**Final Test**

1.

Question 1

Suppose that the risk-free rate is zero, and all agents are risk-neutral.

There are two mutually exclusive equally probable outcomes – high (H) and low (L). There are two mutually exclusive projects – Project 1 и Project 2. Each project requires the initial investment of $15m. The projects’ cash flows are as follows:

Outcome H L

Project 1 $30m 0

Project 2 $22m $22m

There are also two kinds of borrowers – conservative and risk-taking. Conservative investors may choose between Projects 1 and 2, while risk-taking borrowers have only Project 1. The borrowers cannot be distinguished when they come to a bank for a loan.

A. Find the face value of the loan that the bank will charge. Which project will the borrower choose?

Let the face value of the loan F = 12. Which project will the conservative borrower take? Will the bank recover its investment?

2 points

Project 2, the bank will not recover its investment

**Project 1, the bank will recover its investment**

Project 2, the bank will recover its investment

Project 1, the bank will not recover its investment

2.

Question 2

In terms of Question 1,

A. Find the face value of the loan that the bank will charge. Which project will the borrower choose?

Let the face value of the loan now 12 < F < 22. What will the face value be?

2 points

**$16m**

$15m

$14m

$13m

3.

Question 3

In terms of Question 1,

A. Find the face value of the loan that the bank will charge. Which project will the borrower choose?

Which project will the conservative borrower now take?

2 points

Project 2

The conservative borrower is indifferent with respect to the projects

**Project 1**

Can’t say

4.

Question 4

In terms of Question 1,

A. Find the face value of the loan that the bank will charge. Which project will the borrower choose?

If both types of borrowers choose Project 1, what face value will the bank charge?

2 points

$28m

**$24m**

$16m

$20m

5.

Question 5

In terms of Question 1,

B. Repeat your calculation supposing that the borrower’s equity is $9m, and he needs to borrow just $6m.

Let the face value of the loan F = 6. Which project will the conservative borrower take? Will the bank recover its investment?

2 points

**Project 2, the bank will not recover its investment**

Project 1, the bank will not recover its investment

Project 2, the bank will recover its investment

Project 1, the bank will recover its investment

6.

Question 6

In terms of Question 1,

B. Repeat your calculation supposing that the borrower’s equity is $9m, and he needs to borrow just $6m.

Let the face value of the loan now 6 < F < 22. What will the face value be?

2 points

$10m

$7m

$9m

**$8m**

7.

Question 7

In terms of Question 1,

C. Can you relate the intuition behind your answers to the role of bank capital requirements in bank regulation?

With the growth of equity portion in project financing the following occurs:

2 points

The risk of the low outcome is pushed to the bank

**The risk of the low outcome stays with the borrower**

Can’t say

The risk of the low outcome is the same for the borrower and the bank

8.

Question 8

In terms of Question 1,

C. Can you relate the intuition behind your answers to the role of bank capital requirements in bank regulation?

If the bank capital is small, then:

2 points

**The risk of low outcomes is pushed to the government**

Can’t say

The risk of low outcomes stays with the bank

The risk of low outcomes is pushed to the depositors

9.

Question 9

Suppose that the risk-free rate is zero, and all agents are risk-neutral.

There are two mutually exclusive equally probable outcomes – high (H) and low (L). The firm has two mutually exclusive projects – Project 1 и Project 2. Each project requires the initial investment of $15m. The projects’ cash flows are as follows:

Outcome H L

Project 1 $36m 0

Project 2 $22m $22m

Suppose the borrower has $3m in equity, and needs to borrow $12m. The competitive bank that can lend this amount does not observe the choice of the project by the borrower at the point of granting a loan but does obtain the true information on the cash realization (i.e., which outcome did take place).

A. Find the face value of the loan that the bank will charge. Which project will the borrower choose?

Let the face value of the loan F = 12. Which project will the borrower choose?

2 points

**Project 1**

Can’t say

The borrower is indifferent with respect to the projects

Project 2

10.

Question 10

In terms of Question 9,

A. Find the face value of the loan that the bank will charge. Which project will the borrower choose?

For the project chosen in 2.1, what will be the face value of the loan?

2 points

$16m

$28m

**$24m**

$20m

11.

Question 11

In terms of Question 9,

B. Now suppose that the bank can convert its loan into a 50% share of the borrower’s realized cash flow. Determine the face value of the loan. Which project will the borrower choose? Will the bank exercise its option?

Let the face value of the convertible bond is F = 12. At what borrower’s cash flow CF will the bank convert its bond?

2 points

$18m < СF < $24m

СF < $12m

**СF > $24m**

$12m < СF < $18m

12.

Question 12

In terms of Question 9,

B. Now suppose that the bank can convert its loan into a 50% share of the borrower’s realized cash flow. Determine the face value of the loan. Which project will the borrower choose? Will the bank exercise its option?

What will be the bank cash flows from Projects 1 and 2 in the high outcome?

2 points

$12m and $12m

**$18m and $12m**

$16m and $12m

$24m and $18m

13.

Question 13

In terms of Question 9,

B. Now suppose that the bank can convert its loan into a 50% share of the borrower’s realized cash flow. Determine the face value of the loan. Which project will the borrower choose? Will the bank exercise its option?

Which project will the borrower choose?

2 points

**Project 2**

Project 1

The borrower is indifferent with respect to the projects

Can’t say

14.

Question 14

In terms of Question 9,

B. Now suppose that the bank can convert its loan into a 50% share of the borrower’s realized cash flow. Determine the face value of the loan. Which project will the borrower choose? Will the bank exercise its option?

Will the bank exercise its option?

2 points

Can’t say

**No**

Yes

The bank is indifferent

15.

Question 15

After interest rates rose sharply in the late 1970’s, it would not have been difficult even for the outside investors in the market to conclude that the net worth of some of the S&L’s was negative. However, the stocks of these “zombie” S&L’s with negative net worth were still trading at positive prices. Can you provide an explanation for this phenomenon?

Why did the market participants believe that “zombie” S&L’s had some time to go?

2 points

**The decisions whether to close down “zombie” S&L’s were made on the basis of the book value of its assets**

The market participants were wrong

The decisions whether to close down “zombie” S&L’s were made on the basis of the market value of its assets

Regional regulators lobbied the close-down of “zombie” S&L’s

16.

Question 16

In terms of Question 15,

There existed a positive probability that during this remaining “time to go” the mentioned “zombie” S&L’s would be able to solve their problems by taking:

2 points

Low risk, but not very profitable projects

**High risk, but very profitable projects**

Low risk, but very profitable projects

High risk, but not very profitable projects

17.

Question 17

In terms of Question 15,

How can answers to Questions 3.1 and 3.2 help explain the positive prices for the stocks of “zombie” S&L’s?

3 points

The lack of massive investigations of fraud in the industry contributed to the overall speculative sentiment

A shift for market value reporting would improve their financial perspectives

There is no sensible explanation to this phenomenon

**Successful realization of profitable projects could bring “zombie” S&L’s back in the black**

**Peer-graded Assignment: Analysis of liquidity creation by a bank**