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Money, Banking, and Financial Institutions

Money, Banking, and Financial Institutions

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Spring 2006

Midterm Exam 2

Name____________________________________

The exam consists of 10 problems and it is worth 100 points.

Please write in the space provided. If necessary, write on the back of the page.

Please ask me if you have any questions.

To receive full credit you have to carefully explain all your answers and show all

your work.

General advice: If you get stuck in the early parts of a problem, do not stop there. You

can receive substantial partial credit by explaining how you would solve the rest of

problem if you had the necessary answers from its previous parts.

1. (20 points) Determine whether each of the statements below is True or False:

An investor with the short position in the bond futures market is hoping for

lower interest rates in the future.

A put option is said to be in the money if the price of the asset is lower than

the strike price.

Most of the options sold in the US are of the so-called European type.

beat the market average.

Indirect finance plays a more significant role in the modern financial system

than direct finance.

2. (5 points) Compute the profits of an investor who bought for a $300 premium a

call option on 100 shares with a strike price of $1000 per share, if at the

expiration date the market price of this share is $1200.

3. (5 points) Suppose that a corn futures contract specifies the delivery of 1000

bushels of corn in 5 months at the price of $5 per bushel. Suppose that the price

rises from $5 to $6 per bushel of corn. Carefully describe the transactions on the

margin accounts of a seller and a buyer of one such corn futures contract.

4. (10 points) Explain what the moral hazard of debt contracts is and name at least

two ways of dealing with this problem?

stocks next year. The price of each share of stock is $200. Assume that the growth

rate of dividends is 4% a year. The risk-free interest rate is 3%. What is the

implied risk premium?

stock market indices? Give at least one example of each?

a. A customer repays a $1000 loan to the bank.

b. Bank borrows $100,000 on the federal funds market to meet the required

reserve norms.

8. (10 points) Explain the relationship between return on assets and return on equity.

What incentives does this relationship give a bank manager? Is this the desired

outcome preferred by regulators? Why?

9. (15 points) Suppose that a bank has $350 million in assets the interest rate on

which is equal to the current rate on 1-year Treasury Bills plus 3%. The interest

rate on the remaining $800 million in assets is fixed and is equal to 7%. The bank

pays the interest rate equal to the rate on 1-year T-Bill rate plus 1% on $900

million of its liabilities. It pays a fixed rate of 4% on the remaining $250 million

of its liabilities. The current T-Bill interest rate is 4%.

a. Carefully describe the nature of the risk this bank faces because of the

mismatch of the interest rate sensitive assets and liabilities?

c. Suppose that the T-Bill interest rate rises to 5%, what is the change in

profits of this bank?

10. (15 points) Show graphically and explain the profits and losses of selling futures

relative to buying put options.

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