What are the three causes for the emergence of the shadow banking system?

ECON 2411: Principles of Money and Banking

ECON 2411: Principles of Money and Banking

Question
ECON 2411: Principles of Money and Banking

Instructor: Hoonsik Yang

Problem Set 2 – Fall 2015Instructions

• Partial credit will be given provided you show intermediate steps and are solving parts of the problem

correctly
.

• Due: 10/30 Friday at 3:30PM; Please refer to the syllabus for the late penalty
.

• Double check if you have written your name
.

Questions

1
. (10 points)

(a) The current price of a stock is $70
. If dividends are expected to be $1 per share for the next four

years, and the required return is 20%, then what should be the price of the stock be in 4 years

when you plan to sell it?

(b) Next day, you heard a commentary from ECONOMICS channel saying that due to the unexpected

success of the firm’s investment, the dividends are expected to be $2 per share for the next four

years (and it did not change the expected dividends after that four years)
. What will be the price

of this stock now if rational expectation theory is right?

2
. (10 points) What specific procedures do financial intermediaries use to reduce asymmetric information

problems in lending? Explain three of them
.

3
. (10 points) The profits from your asset portfolio depends on how your fund manager works
.

Lazy

Hard working

Profit Probabilities

Profit = $20,000

80%

40%

Profit = $70,000

20%

60%

Your manager views being lazy as a "leisure" valued at $5000
. If you offer 10% of the profit from your

portfolio to the manager, will he/she work hard? What if it is 50% of the profit?

4
. (15 points) Bank of Storrs has the following balance sheet
.

Assets

Reserves $ 50 mil
.

Loans $ 450 mil
.

Liabilities

Deposits $ 300 mil
.

Bank Capital $ ? mil
.

(a) How much bank capital does Bank of Storrs have?

(b) Suppose that a required reserve ratio is 10%
. How much excess reserves does the bank have?

(c) How much reserves Bank of Storrs will have if the bank suffers a deposit outflow of $30 million?

Will it be more or less than what is required? If less, what should they do to have enough reserves?

List four options
.

5
. (10 points) Using the t-accounts of Bank of Storrs and Columbia bank, describe what happens when

Hoonsik writes a $100 check on his account at Bank of Storrs to pay his friend Frederic, who in turn

deposits the check in his account at Columbia bank
.

1

6
. (10 points) Bank of Storrs has the following balance sheet
.

Assets

Reserves $ 50 mil
.

Loans $ 450 mil
.

Liabilities

Deposits $ 400 mil
.

Bank Capital $ 100 mil
.

Suppose that the bankers in Bank of Storrs find that $50 million of their loans have become worthless
.

How the bank balance sheet will look like as a result?

7
. (10 points) How can a bursting of an asset-price bubble in the stock market help trigger a financial

crisis?

8
. (10 points) What is debt-deflation? Why the net worth of borrowers decline? (Use the definition in

the textbook
. It can mean slightly different things depending on the context
.)

9
. (15 points) Read "The run on shadow banking and a framework for reform" in HuskyCT (reading

materials) and answer the following questions
.

(a) What are the three causes for the emergence of the shadow banking system?

(b) Suppose that I lend you $200 for a day, and you give me a set of bonds with a market value of

$202 as collateral
. How much is the haircut in this case? If I find out that you are more likely to

default than I originally expected, will the haircut increase or decrease?

2

ECON 2411: Principles of Money and Banking

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