ASLANA FINAL PDF

Chapter 21 1. Explain in general terms how savings institutions differ from commercial banks with respect to their sources of funds and uses of funds. Discuss each source of funds for savings institutions. Identify and discuss the main uses of funds for savings institutions. Savings institut...

Chapter 21 1. Explain in general terms how savings institutions differ from commercial banks with respect to their sources of funds and uses of funds. Discuss each source of funds for savings institutions. Identify and discuss the main uses of funds for savings institutions. Savings institutions (SIs) focus mainly on mortgage lending, while commercial banks offer a broader range of financial services, including business loans and credit lines. Sources of Funds for Savings Institutions 1. Deposits – Primary source, including savings accounts, time deposits, and checking accounts. 2. Borrowed Funds – Can include loans from the Federal Home Loan Bank (FHLB) or other financial institutions. 3. Capital – Equity from shareholders (for stock-owned SIs) or retained earnings. Uses of Funds for Savings Institutions 1. Mortgages – Main use, primarily fixed-rate and adjustable-rate home loans. 2. Consumer and Commercial Loans – Some SIs provide personal and small business loans. 3. Investments – Bonds, government securities, and mortgage-backed securities for income and liquidity. 4. Reserves – Cash held to meet withdrawal demands and regulatory requirements. 2. What are the alternative forms of ownership of a savings institution? Stock savings institutions are owned by shareholders, and mutual savings institutions are owned by depositors 3. What criteria do regulators use when examining a savings institution? Regulators examine savings institutions based on a comprehensive set of criteria to ensure their safety, soundness, and compliance with laws and regulations. The primary criteria used in these examinations can be summarized using the CAMELS rating system: capital adequacy, asset quality, management, earnings, liquidity, sensitivity to market risk. 4. How did the creation of money market deposit accounts influence the savings institution's overall cost of funds? Money market deposit accounts (MMDAs) increased a savings institution's cost of funds, because some depositors switched their funds from savings accounts or NOW accounts to the higher yielding MMDAs. 5. Discuss the entrance of savings institutions into consumer and commercial lending. What are the potential risks and rewards of this strategy? Savings institutions that diversify their business may become less reliant on mortgage lending and therefore may be able to stabilize their earnings. However, by diversifying, they forgo their specialization in their area of expertise. 6. Describe the liquidity and credit risk of savings institutions, and discuss how each is managed. Savings institutions experience liquidity risk since they commonly use short-term liabilities to finance long-term assets. They commonly increase their liabilities rather than reduce their assets in order to increase liquidity. 7. What is an adjustable-rate mortgage (ARM)? Discuss potential advantages such mortgages offer a savings institution. An adjustable rate mortgage has an interest rate that is tied to some market-determined rate they are used as a strategy to reduce interest rate risk. They enable savings institutions to maintain a more stable margin between interest earnings and interest expenses. 8. Explain how savings institutions could use interest rate futures to reduce interest rate risk. Savings institutions can sell financial futures in order to hedge against interest rate risk. If interest rates rise, the futures position will generate a gain that can offset the likely reduction in a savings institution's spread. 9. Explain how savings institutions could use interest rate swaps to reduce interest rate risk. Will savings institutions that use swaps perform better or worse than those that were unhedged during a period of declining interest rates? Explain A savings institution can swap fixed payments in exchange for variable payments. If interest rates rise, variable inflow payments to the savings institution increase while the outflow payments remain fixed. Thus, the favorable effect of the swap will offset the unfavorable effect of higher interest rates on the savings institution's cost of funds. If interest rates declined, savings institutions that used swaps would perform worse than savings institutions that were unhedged. The favorable effect on the spread could be offset by lower swap payments received during a period of declining interest rates. 10. Explain why many savings institutions experience financial problems at the same time. many savings institutions have a similar composition of assets, such as long-term fixed rate mortgages. This causes them to have similar exposure to interest rate risk and credit risk, so they may be adversely affected at the same time if they do not use strategies to reduce their exposure. 11. If market interest rates were expected to decline over time, will a savings institution with rate- sensitive liabilities and a large amount of fixed-rate mortgages perform best by (a) using an interest rate swap, (b) selling financial futures, or (c) remaining unhedged? Explain In case of the interest rates decrease, a savings institution would perform best by not hedging. Its cost of funds would decline and its spread would increase. 12. What were some of the more obvious reasons for the savings institution crisis of the late 1980s? Fraud by managers or executives of some S&Ls; Illiquidity, resulting from withdrawals by depositors; Rising interest rates in the late 1980s, which reduced the spread between interest earned on loans and interest paid on deposits. 13. Explain how the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) reduced the perceived risk of savings institutions. The FIRREA prohibited investment by savings institutions into junk bonds. Second, it mandated an increase in capital requirements of savings institutions. Third, it helped to eliminate many of the troubled savings institutions. 14. Who are the owners of credit unions? Explain the tax status of credit unions and the reason for that status. Why are CUs typically smaller than commercial banks or savings institutions? CUs are technically owned by the depositors. CUs are not taxed because they are non-profit institutions. CUs are small because each CU is designed to accommodate a particular group or affiliation. 15. Describe the main sources of funds for credit unions. Why might the average cost of funds to CUs be relatively stable even when market interest rates are volatile? Share deposits, with no specified maturity; Share certificates, which specify a particular interest rate and maturity; The proportion of funds obtained through regular share deposits at CUs is relatively large. The rates offered on them have remained somewhat stable while rates on share certificates move with the market. This allows CUs to obtain much of their funds at a relatively low and stable cost. 16. Who regulates credit unions? What are the regulators' powers? Where do CUs obtain deposit insurance? CUs are regulated by the National Credit Union Administration (NCUA), which has the power to grant or revoke charters. It also examines the financial condition of CUs and supervises any liquidations or mergers. Most credit unions obtain insurance from the National Credit Union Share Insurance Fund. 17. Explain how credit union exposure to liquidity risk differs from that of other financial institutions. Explain why credit unions are more insulated from interest rate risk than some other financial institutions. Credit unions must rely on members for future deposits. They cannot accept deposits from nonmembers and are therefore more limited than other depository institutions. This can limit their ability to resolve any illiquidity problems. Their interest rate risk of CUs is limited because they do not provide long-term loans with fixed rates. 18. Identify some advantages of credit unions. Identify disadvantages of credit unions that relate to their common bond requirement. 1.They offer attractive rates to members, as they are non-profit and not taxed 2. Non-interest expenses are relatively low. 3.They have a small spread between loan and share deposit rates, which benefits savers and borrowers. A disadvantage is that the common bond requirement restricts a CU from growing beyond the potential size of that particular affiliation. 19. Explain how the credit crisis in the 2008–2009 period affected some savings institutions. Compare the causes of the credit crisis to the causes of the SI crisis in the late 1980s. Several large savings institutions failed, including Countrywide Financial and Washington Mutual. 20. Explain why savings institutions may benefit when interest rates fall. The assets of savings institutions commonly have fixed rates, so interest income does not adjust to interest rate movements until those assets reach maturity or are sold. Therefore, when interest rates fall, an SI's cost of obtaining funds declines more than the decline in the interest earned on the loans and investments 21. How does high economic growth affect an SI? High economic growth results in less risk for an SI because its consumer loans, mortgage loans, and investments in debt securities are less likely to default. Critical Thinking Question The Future of Thrift Operations Write a short essay on the future of thrift operations. Should savings institutions be merged into the banking industry, or should they remain distinctly different from commercial banks? Interpreting Financial News Interpret the following comments made by Wall Street analysts and portfolio managers. While merging them into the banking industry could enhance efficiency and oversight, maintaining their distinct status allows them to focus on specialized services. The best approach may be a hybrid model that preserves their mission while ensuring regulatory alignment with commercial banks. a. “Deposit insurance can fuel a crisis because it allows weak SIs to grow.” -- Deposit insurance can encourage risky behavior, as weak SIs (savings institutions) may expand irresponsibly, increasing systemic risk. b. “Thrifts are no longer so sensitive to interest rate movements, even if their asset and liability compositions have not changed.” -- Thrifts have diversified their revenue sources and risk management, reducing their dependence on interest rate fluctuations. c. “Many SIs did not understand that higher returns from subprime mortgages must be weighed against risk.” -- Higher subprime mortgage returns come with greater default risk, which many SIs underestimated, leading to financial instability. Managing in Financial Markets Hedging Interest Rate Risk As a consultant to Boca Savings & Loan Association, you notice that a large portion of its 15-year, fixed-rate mortgages are financed with funds from short-term deposits. You believe that the yield curve is useful in indicating the market’s anticipation of future interest rates, and that the yield curve is primarily determined by interest rate expectations. At the present time, Boca has not hedged its interest rate risk. Assume that a steeply upward sloping yield curve currently exists. a. Boca asks you to assess its exposure to interest rate risk. Describe how Boca will be affected by rising interest rates and by a decline in interest rates. -- Boca faces significant interest rate risk. If rates rise, its short-term deposits will become more expensive, while fixed-rate mortgage income remains unchanged, reducing profit margins. If rates decline, Boca benefits as funding costs decrease, but its fixed-rate loans remain unchanged, maintaining profitability. b. Given the information about the yield curve, would you advise Boca to hedge its exposure to interest rate risk? Explain. -- Since the yield curve is steeply upward sloping, the market expects rising rates. Boca should hedge by using interest rate swaps or futures to lock in lower borrowing costs and protect against rising rates. c. Explain why your advice to Boca might possibly backfire. -- If rates unexpectedly decline instead of rising, Boca's hedge could result in opportunity costs, reducing its potential gains from lower funding costs. Market Participation by Savings Institutions Rimsa Savings is a savings institution that provided Carson Company with a mortgage for its office building. Rimsa recently offered to refinance the mortgage if Carson Company will change to a fixed-rate loan from an adjustable-rate loan. a. Explain the interaction between Carson Company and Rimsa Savings. -- Carson Company is the borrower, and Rimsa Savings is the lender. Rimsa originally provided an adjustable-rate mortgage and is now offering to refinance it into a fixed-rate loan. b. Why is Rimsa willing to allow Carson Company to transfer its interest rate risk to Rimsa? (Assume that there is an upward-sloping yield curve.) -- With an upward-sloping yield curve, Rimsa expects future interest rates to rise. By switching Carson to a fixed-rate mortgage, Rimsa locks in current rates, avoiding potential losses if funding costs increase. c. If Rimsa maintains the mortgage on the office building purchased by Carson Company, what is the ultimate source of the money that was provided for the office building? If Rimsa sells the mortgage in the secondary market to a pension fund, what is the source that is essentially financing the office building? Why would a pension fund be willing to purchase this mortgage in the secondary market? If Rimsa keeps the mortgage, depositors’ funds are the ultimate source of financing. If Rimsa sells the mortgage to a pension fund, the pension fund’s investors (retirees and workers) indirectly finance the building. Pension funds buy mortgages for stable, long-term returns that match their future payout obligations.  Chapter 22 1. Is the cost of funds obtained by finance companies very sensitive to market interest rate movements? Explain. The interest expenses on short-term funds obtained by issuing commercial paper and other short- term debt are sensitive to interest rate movements. The interest rate expenses on funds obtained from issuing bonds are not sensitive to interest rate movements 2. How are small and medium-sized finance companies able to issue commercial paper? Why do some well-known finance companies directly place their commercial paper? They can issue secured commercial paper, so that the debt is backed by assets. Even though they may have moderate risk, their commercial paper should be in demand if it's backed. Finance companies can avoid commercial paper dealer fees by issuing commercial paper directly; it must develop an in-house system to do this. 3. Explain why some finance companies are associated with automobile manufacturers. Why do some of these finance companies offer below-market rates on loans? some finance companies specialize in providing financing for customers of automobile manufacturers. They may offer below-market rates if they can receive some type of rebate from the manufacturers. The below-market rates can increase the sales for the manufacturers. 4. Describe the major uses of funds by finance companies. The major uses of funds are consumer loans (including credit card loans), business loans, leasing, mortgages on commercial real estate, and second mortgages on residential property. 5. Explain how finance companies benefit from offering consumers a credit card. Finance companies finance the purchase by the consumer, charging an interest rate that compensates them for the loan provided. The offering of a credit card essentially creates several periodic loans to consumers. 6. Explain how finance companies provide financing through leasing. Finance companies purchase machinery or equipment for the purpose of leasing it to businesses that prefer to avoid the additional debt on their balance sheet. Thus, the finance companies are essentially financing the utilization of assets by a company. 7. Describe the kinds of regulations that are imposed on finance companies. Finance companies regulated by the state are subject to ceiling loan rates and maturities. They are also subject to state regulations on intrastate business. 8. Explain how the liquidity position of finance companies differs from that of depository institutions such as commercial banks. Reliance on deposits by depository institutions can cause liquidity problems, because the timing of deposit withdrawals is often uncertain. Finance companies obtain funds by issuing bonds and commercial paper, and therefore can anticipate from the security maturities when they will need additional funds. In addition, they have quick access to funds because they are familiar with issuing securities. 9. Explain how the interest rate risk of finance companies differs from that of savings institutions. Finance companies assets and liabilities share similar interest rate-sensitivity, while many savings institutions assets and liabilities share different interest rate-sensitivity. Consequently, finance companies are less exposed to interest rate movements than savings institutions. 10. Explain how the credit risk of finance companies differs from that of other lending financial institutions. Finance companies focus on consumer loans and on commercial loans that have moderate risk. Their concentrated loan portfolio exposes them to a relatively high degree of credit risk. Critical Thinking Question The Future of Finance Company Operations Write a short essay on the future of finance company operations. Should finance companies be merged into the banking industry, or should they remain distinctly different from commercial banks? Finance companies provide loans without taking deposits, unlike banks. Merging them with banks could improve regulation, but keeping them separate allows flexibility. A hybrid model with stricter oversight may be best. Interpreting Financial News Interpret the following comments made by Wall Street analysts and portfolio managers. a. “During a credit crunch, finance companies tend to generate a large amount of business.” -- When banks tighten lending, finance companies step in to provide loans, increasing their business. b. “Some finance companies took a huge hit as a result of the last recession because they opened their wallets too wide before the recession occurred.” -- Some finance companies lent too aggressively before the recession, leading to major losses when borrowers defaulted. c. “During periods of strong economic growth, finance companies generate unusually high returns without any hint of excessive risk, but their returns are at the mercy of the economy. -- In a strong economy, finance companies profit with low risk, but downturns can sharply reduce returns. Managing in Financial Markets Managing a Finance Company As a manager of a finance company, you are attempting to increase the spread between the rate earned on your assets and the rate paid on your liabilities. a. Assume that you expect interest rates to decline over time. Should you issue bonds or commercial paper to obtain funds? -- Issue long-term bonds to lock in current higher rates before they decline. b. If you expect interest rates to decline, will you benefit more from providing medium-term, fixed rate loans to consumers or floating-rate loans to businesses? -- Medium-term, fixed-rate loans are better, as their returns remain stable while funding costs drop. c. Why would you still maintain some balance between medium-term, fixed-rate loans and floating rate loans to businesses even if you anticipate that one type of loan will be more profitable under a cycle of declining interest rates? -- Diversification reduces risk if interest rate expectations are wrong or market conditions change. How Finance Companies Facilitate the Flow of Funds Carson Company has sometimes relied on debt financing from Fente Finance Company. Fente has been willing to lend money even when most commercial banks have not. Fente obtains funding by issuing commercial paper and focuses mostly on channeling those funds to borrowers. a. Explain how finance companies are unique by comparing Fente’s net interest income, noninterest income, noninterest expenses, and loan losses to those of commercial banks. -- Net Interest Income – Higher, as finance companies charge higher loan rates. Noninterest Income – Lower, as they focus on lending rather than fees. Noninterest Expenses – Lower, due to fewer branches and services. Loan Losses – Higher, as they take riskier borrowers. b. Explain why Fente performs better than commercial banks in some periods. -- Finance companies lend when banks tighten credit, allowing them to charge higher rates and gain more business. c. Describe the flow of funds channeled through finance companies to firms such as Carson Company. What is the original source of the money that is channeled to firms or households that borrow from finance companies? -- Finance companies raise money by issuing commercial paper or bonds. Investors (institutions, funds) buy these securities, and the money is lent to firms like Carson Company.  Chapter 23 1. Explain why mutual funds are attractive to small investors. How can mutual funds generate returns to their shareholders? Mutual funds enable small investors to benefit from a portfolio manager's expertise, and from diversification capabilities due to a large portfolio. Mutual funds can provide dividends or capital gain distributions to investors. In addition, investors also benefit from share price appreciation; they may be able to sell the shares at a higher price than they paid. 2. How do open-end mutual funds differ from closed-end funds? Shares of open-end mutual funds can be sold back to the sponsoring investment company, whereas shares of closed-end mutual funds cannot. 3. Explain the difference between load and no-load mutual funds. Load mutual funds require a fee to help pay for marketing commissions. No-load mutual funds do not require such a fee. 4. Like mutual funds, commercial banks and stock-owned savings institutions sell shares; yet, proceeds received by mutual funds are used in a different way. Explain. Shares issued by commercial banks and savings institutions are used to obtain capital, which may be used to finance their fixed assets such as land and buildings. Shares issued by mutual funds are used to obtain funds, which are invested in the mutual fund portfolio. 5. Support or refute the following statement: Investors can avoid all types of risk by purchasing a mutual fund that contains only Treasury bonds. Sensitive A mutual fund containing Treasury bonds is susceptible to interest rate risk. If interest rates rise, the market value of the Treasury bonds contained in the mutual fund will decline. 6. Describe the ideal mutual fund for investors who wish to generate tax-free income and also maintain a low degree of interest rate risk. A short-term municipal bond fund can avoid taxes and has a low degree of interest rate risk. 7. Explain how changing foreign currency values can affect the performance of international mutual funds. As foreign currencies depreciate (appreciate) against the dollar, the prices of foreign stocks as measured in dollars decline (rise). Thus, depreciation (appreciations) of foreign currencies tends to decrease (increase) the net asset value of international mutual funds that are held by U.S. investors. 8. explain how the financial reform act of 2010 applies to hedge funds Separates “proprietary trading” from the business of banking: The “Volcker Rule” will ensure that banks are no longer allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers. 9. Explain how the income generated by a mutual fund is taxed when it distributes at least 90 percent of its taxable income to shareholders The mutual fund is not taxed if it distributes at least 90 percent of taxable income to shareholders. 10. According to research, have mutual funds outperformed the market? Explain. Would mutual funds be attractive to some investors even if they are not expected to outperform the market? Explain. Mutual funds have not outperformed the market, based on a risk-return comparison with the market. Mutual funds provide diversification benefits that investors could not afford to achieve on their own. Mutual funds allow investors to rely on someone else's investment decisions rather than on their own judgment. 11. How do money market funds differ from other types of mutual funds in terms of how they use the money invested by shareholders? Which security do money market funds invest in most often? How can a money market fund accommodate shareholders who wish to sell their shares when the amount of proceeds received from selling new shares is less than the amount needed? Money market funds are composed of money market securities, such as Treasury bills, commercial paper, Eurodollar deposits, banker's acceptances, repurchase agreements, or CDs. Conversely, mutual funds are composed of stocks and bonds. Money market funds invest more money in commercial paper than in any other type of security. Money market funds could sell some of their security holdings in order to generate sufficient funds to cover the redemptions. 12. Explain the relative risk of the various types of securities in which a money market fund may invest. Most money market securities exhibit some default risk since the issuers of securities could go bankrupt. Eurodollar deposits, CDs, and commercial paper are exposed to default risk. U.S. Treasury bills are free from default risk. 13. Is the value of a money market fund or a bond fund more susceptible to increasing interest rates? Explain. A bond fund is more susceptible to increasing interest rates because the securities contained in a bond fund have longer maturities than securities contained in a money market fund. 14. Explain why diversification across different types of mutual funds is highly recommended. The performance of each type of mutual fund is influenced by a particular economic factor. Thus, diversifying within one specific type of mutual fund creates significant exposure to that factor. The stock market movements influence stock fund performance, interest rate movements influence bond fund performance, and exchange rates and foreign market movements influence international funds. Diversifications across stock funds, bond funds, and international funds limits the exposure to any single economic factor. 15. Explain why some hedge funds failed as a result of the credit crisis Some hedge funds failed because they invested heavily in mortgages during the credit crisis, and their investments were highly levered. 16. Explain the difference between equity REITs and mortgage REITs. Which type would likely be a better hedge against high inflation? Why? Equity REITs invest directly in properties, while mortgage REITs invest in mortgage and construction loans. Equity REITs would likely be a better hedge against inflation because rents and property (the sources of income for equity REITs) tend to rise with inflation. 17. Compare the management of a closed-end fund with that of an open-end fund. Given the differences in the funds' characteristics, explain why the management of liquidity is different in the open-end fund as compared with the closed-end fund. Assume that the funds are the same size and have the same goal to invest in stocks and to earn a very high return. Which portfolio manager do you think will achieve a larger increase in the fund's net asset value? Explain. The closed-end fund manager does not need to worry about redemptions, whereas the open-end fund manager must worry about accommodating redemptions and therefore must always maintain some liquidity for this purpose. Therefore, the closed-end fund manager has more flexibility to invest. 18. Selecting a Type of Mutual Fund Consider the prevailing conditions that could affect the demand for stocks, including inflation, the economy, the budget deficit, the Fed’s monetary policy, political conditions, and the general mood of investors. Based on current conditions, recommend a specific  type of stock mutual fund that you think would perform well. Offer some logic to support your recommendation. If the economy is stable and growth is strong, a growth stock mutual fund is a good choice. For uncertain or slowing economies, a value stock mutual fund offers more stability. If inflation is high, a sector-specific fund focused on energy or materials could perform well. 19. Explain why hedge funds may be able to achieve higher returns for their investors than mutual funds. Explain why hedge funds and mutual funds may have different risks. When the market is overvalued, why might hedge funds be better able to capitalize on the excessive market optimism than mutual funds? The hedge funds are subject to fewer restrictions on what they can invest in than mutual funds. The hedge funds can invest in a wide variety of investments to achieve high returns and they can engage in short selling while many mutual funds are not allowed to take such positions. Hedge funds typically have a high degree of risk because they are not subject to restrictions on their investment strategy. When hedge funds engage in short selling, there is downward pressure on the stock's price. Because hedge funds can engage in short selling while mutual funds cannot. 20. Money that individual and institutional investors previously invested in stocks is now being invested in private equity funds. Explain why this should result in improved business conditions. The shift from stock investments to private equity funds can lead to improved business conditions by providing capital, expertise, and a long-term focus that public markets often lack. These benefits contribute to more efficient and innovative companies, job creation, and overall economic growth. Private equity’s ability to turn around underperforming businesses and invest in long-term projects ensures a more resilient and dynamic business environment, fostering sustained economic prosperity. 21. Which type of fund do you think would be better able to capitalize on a weak, publicly traded firm that has ignored all forms of shareholder activism? The private equity fund may be more capable of capitalizing on a weak publicly-traded firm that ignores shareholder activism because it could attempt to acquire the firm and restructure it. Equity mutual funds are not in the business of acquiring firms. 22. In recent years, private equity funds have grown substantially. Will the creation of private equity funds increase the semistrong form of market efficiency in the stock market? Explain. Private equity funds commonly acquire private companies so they will not necessarily affect stock market efficiency, but also they could acquire some public companies that could remove some stock market inefficiencies. 23. explain hedge funds' motivation to rely on expert networks in recent years hedge funds rely on expert networks to gain access to specialized knowledge, obtain unique market insights, generate investment ideas, conduct due diligence, mitigate risks, ensure regulatory compliance, and maintain a competitive advantage in today’s dynamic financial markets. Expert networks play a pivotal role in helping hedge funds make informed investment decisions, optimize portfolio performance, and achieve superior risk-adjusted returns for their investors. Critical Thinking Question Hedge Fund Strategy A critic recently claimed that hedge funds increase market volatility when they publicize that a public corporation exaggerated its earnings. The critic argued that hedge funds should not be allowed to make such public statements and should not be allowed to take short positions that bet against the firm that is being criticized. Support or refute this opinion. Hedge funds play a vital role in market efficiency by exposing overvalued stocks and promoting transparency. Publicizing corporate exaggerations and taking short positions helps correct market mispricing, benefiting investors. Banning these actions would protect companies from necessary scrutiny, leading to inefficiencies and instability. Therefore, hedge funds should be allowed to continue their role in maintaining market accountability. Interpreting Financial News a. “Just because a mutual fund earned a 20 percent return in one year, that does not mean that investors should rush into it. The fund’s performance must be market adjusted.” -- A 20% return doesn’t guarantee future success. The fund’s performance should be compared to market benchmarks to see if it outperforms relative to risk b. “An international mutual fund’s performance is subject to conditions beyond the fund manager’s control.” -- Global funds are influenced by external factors like foreign policies, exchange rates, and geopolitical events, which the manager can’t control. c. “Small mutual funds will need to merge to compete with the major players in terms of efficiency.”-- Smaller mutual funds may struggle to compete with larger funds in terms of cost efficiency and resources, making mergers necessary for survival. Investing in Mutual Funds. As an individual investor, you are attempting to invest in a well-diversified portfolio of mutual funds, so that you will be somewhat insulated from any type of economic shock that may occur. a. An investment adviser recommends that you buy four different U.S. growth stock funds. Since these funds contain over 400 different U.S. stocks, the adviser says that you will be well insulated from any economic shocks. Do you agree? Explain. This entire portfolio is subject to adverse U.S. stock market effects, and therefore is not a well- diversified portfolio. b. A second investment adviser recommends that you invest in four different mutual funds that are focused on different countries in Europe. The adviser says that you will be completely insulated from U.S. economic conditions, and that your portfolio will therefore have low risk. Do you agree? Explain. This portfolio may not be exposed to U.S. economic conditions, but it is highly exposed to European economic conditions. Even though the portfolio contains stocks of different European countries, all four mutual funds are subject to general economic conditions throughout Europe. c. A third investment adviser recommends that you avoid exposure to the stock markets by investing your money in four different U.S. bond funds. The adviser says that because bonds make fixed payments, these bond funds have very low risk. Do you agree? Explain. If U.S. interest rates increase, all of these bond funds will perform poorly. Even though the bond payments are fixed, the values of the bonds (and therefore the values of the bond mutual funds) will decline if U.S. interest rates rise. Therefore, this portfolio of mutual funds has a high degree of risk. How Mutual Funds Facilitate the Flow of Funds Carson Company is considering a private placement of bonds with Venus Mutual Fund. a. Explain the interaction between Carson and Venus Mutual Fund. How would Venus serve Carson’s needs, and how would Carson serve Venus’s needs Venus Mutual Fund helps Carson by providing capital through a private bond placement. In return, Carson serves Venus by offering a fixed-income investment, which provides potential returns to Venus and its investors. b. Why does Carson interact with Venus Mutual Fund instead of trying to obtain the funds directly from individuals who invested in Venus Mutual Fund? Carson interacts with Venus Mutual Fund because it is an institutional investor with the resources and expertise to manage large investments. Directly obtaining funds from individuals would be more complex and less efficient for Carson. c. Would Venus Mutual Fund serve as a better monitor of Carson Company than the individuals who provided money to the mutual fund? Yes, Venus Mutual Fund would serve as a better monitor than individual investors because the fund has the expertise, resources, and incentive to carefully analyze Carson’s financials and operations, ensuring a better return on investment. Chapter 24 1. Explain the role of the SEC, FINRA and the stock exchanges in regulating the securities industry **SEC (Securities and Exchange Commission):** Enforces federal securities laws, oversees securities markets, and protects investors. - **FINRA (Financial Industry Regulatory Authority):** Regulates brokerage firms and exchange markets, ensuring fair practices and investor protection. - **Stock Exchanges:** Provide a platform for trading securities, establish listing rules, ensure fair trading, and monitor market activities. 2. What is the purpose of the SIPC? The Securities Investor Protection Corporation (SIPC) protects customers of bankrupt brokerage firms, covering up to $500,000, including a $250,000 limit for cash. 3. How do securities firms facilitate leveraged buyouts? Why are securities firms that are better able to raise funds in the capital markets preffered by corporations that need advice on proposed acquisitions? **Leveraged Buyouts:** Securities firms facilitate LBOs by providing advisory services, arranging financing, and securing debt needed for acquisitions. - **Capital Raising:** Firms with better fundraising capabilities are preferred because they can offer more favorable financing terms and access a larger pool of capital. 4. Describe the origination process for corporations that are about to issue new stock The origination process involves structuring and issuing new stocks, including preparing regulatory filings, marketing the issuance, and setting the price. 5. Describe the underwriting function of securities firm The underwriting function of a securities firm involves assessing the risk of new securities, buying them from the issuer, and selling them to investors, ensuring the issuer raises the needed capital. 6. What is a best-efforts agreement?  A best-efforts agreement is a type of underwriting arrangement where the underwriter agrees to do their best to sell as much of the securities offering as possible but does not guarantee the entire amount will be sold. The issuer bears the risk of any unsold portion. 7. Why did Lehman brothers experience financial problems during the credit crisis? Lehman Brothers experienced financial problems during the credit crisis due to its high exposure to subprime mortgages and leveraged investments. The firm had substantial holdings in mortgage- backed securities, which lost significant value as the housing market collapsed. Additionally, Lehman's reliance on short-term funding and inability to secure a bailout led to its bankruptcy. 8. Describe a direct placement of bonds. What is an advantage of a private placement? What is a disadvantage? **Definition:** A direct placement, also known as a private placement, is the sale of securities directly to a limited number of institutional investors without a public offering. - **Advantage:** Lower costs due to the absence of underwriting fees and regulatory requirements, and a faster process since it avoids the lengthy registration process with the SEC. - **Disadvantage:** Limited access to a smaller pool of investors, which can result in lower liquidity and potentially higher interest rates or lower prices for the securities issued. 9. Explain why securities firms from the United States have expanded into foreign markets Securities firms from the United States expand into foreign markets to access new opportunities for growth, diversify their revenue streams, and take advantage of economic expansion in other regions. International presence also helps firms serve multinational clients better and reduces their dependence on the domestic market 10. Explain the process of proprietary trading by securities firms. How was it affected by the Volcker Rule? Proprietary trading involves securities firms trading stocks, bonds, currencies, commodities, or other financial instruments with their own capital to generate profits for the firm, rather than for clients. - **Volcker Rule Impact:** The Volcker Rule, part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, restricts banks from conducting certain types of proprietary trading and limits their investments in hedge funds and private equity, to reduce risk and prevent another financial crisis. 11. What is asset stripping? Asset stripping is the practice of buying a company and then selling off its assets individually for a profit. This often occurs when a company is undervalued or when its parts are worth more separately than as a whole. This strategy is sometimes used by private equity firms and corporate raiders. 12. Explain why securities firms have used high level of financial leverage in the past. How does such leverage affect their expected return and their risk? Securities firms use leverage to amplify their investment returns by borrowing funds to invest in securities. While leverage can enhance returns when investments perform well, it also increases the risk of significant losses if the investments decline in value. High leverage can lead to financial instability and increased risk of bankruptcy during market downturns. 13. Why was the Federal Reserve concerned about systemic risk due to the financial problems of other firms? The Federal Reserve was concerned about systemic risk due to the financial problems of Bear Stearns because its failure could trigger a domino effect, affecting other financial institutions and the broader economy. Bear Stearns' interconnectedness with other banks and its significant role in the financial markets meant that its collapse posed a threat to the stability of the financial system. 14. Why do securities firms typically have some inside information that could affect future stock prices of other firms? Securities firms often have access to inside information because they are involved in various aspects of financial markets, such as underwriting, trading, and advisory services. This exposure provides them with insights into upcoming mergers and acquisitions, financial performance, and other material events that can affect stock prices. 15. Most securities firms experience poor profit performance during periods in which the stock market performs poorly. Given what you know about securities firms, offer some possible reasons for these reduced profits. During market downturns, securities firms face reduced trading volumes, lower asset values, and diminished investment banking activities such as initial public offerings (IPOs) and mergers and acquisitions (M&A). Additionally, market volatility can increase risk and lead to trading losses. 16. Explain how the credit crisis of 2008-2009 encouraged some securities firms to convert to a bank holding company structure. Why might the expected return on equity be lower for securities firms that convert to this structure? Reason for Conversion:** The credit crisis of 2008-2009 led some securities firms to convert to a bank holding company (BHC) structure to gain access to federal funding and improve their stability. As BHCs, these firms could access the Federal Reserve's discount window and participate in government bailout programs. - **Lower Return on Equity:** The expected return on equity might be lower for BHCs due to increased regulatory scrutiny, higher capital requirements, and restrictions on certain high-risk activities, which can limit profitability. 17. How did the Financial Services Modernization Act affect securities firms? The Financial Services Modernization Act, also known as the Gramm-Leach-Bliley Act of 1999, allowed commercial banks, investment banks, securities firms, and insurance companies to consolidate. This deregulation enabled securities firms to affiliate with banks and insurance companies, expanding their services and potentially increasing their competitiveness and market reach. 18. What impact has the SEC's Regulation Fair Disclosure (FD) had on securities firms? The SEC's Regulation Fair Disclosure (Regulation FD), enacted in 2000, requires that publicly traded companies disclose material information to all investors simultaneously. This regulation aimed to prevent selective disclosure and ensure a level playing field. For securities firms, this meant that they had to develop and implement procedures to ensure compliance, often leading to more formalized communication processes and enhanced transparency in their dealings with the public and investors. Critical Thinking Question Regulation of Security Firms Should large secu rities firms be allowed to be independent and insulated from bank regulation, or should they be required to register as bank holding companies and subject to bank regulations? Write a short essay that supports your opinion. Large securities firms should be subject to bank regulations to reduce systemic risk and protect the financial system. Without such oversight, they may take excessive risks that could lead to instability, as seen in past crises. Bank regulations would ensure stronger risk management, greater transparency, and consumer protection. This would help prevent conflicts of interest and create a more stable financial environment. Interpret the following comments made by Wall Street analysts and portfolio managers.  **a.** “The stock prices of most securities firms took a hit because of the recent increase in interest rates.” This statement suggests that higher interest rates negatively impacted securities firms' stock prices. Higher interest rates can increase borrowing costs, reduce trading volumes, and affect the profitability of securities firms, leading to a decrease in their stock prices. **b.** “Now that commercial banks are allowed more freedom to offer securities services, there may be a shakeout in the underwriting arena.” This comment indicates that the deregulation allowing commercial banks to offer securities services could lead to increased competition in the underwriting market. Securities firms might face pressure to lower fees and improve services to maintain their market share, potentially leading to a consolidation or exit of less competitive firms. **c.** “Chaos in the securities markets can be good for some securities firms.” This statement implies that market volatility or disruptions can create opportunities for certain securities firms. Firms adept at navigating turbulent markets might profit from increased trading volumes, arbitrage opportunities, or by providing advisory services during times of uncertainty. 19. Assessing the Operations of Securities Firms - **a.** This securities firm relies heavily on full-service brokerage commissions. Do you think the firm’s heavy reliance on these commissions is risky? Explain. Yes, the firm’s heavy reliance on full-service brokerage commissions is risky. The brokerage industry is increasingly facing competition from discount brokers and robo-advisors offering lower fees and automated services. A significant shift towards these alternatives could erode the firm’s commission revenue. Additionally, market downturns can lead to reduced trading activity, further impacting commission income. **b.** If this firm attempts to enter the underwriting business, would it be an easy transition? Transitioning into the underwriting business may not be easy. Underwriting requires specialized knowledge, experience, and established relationships with corporate clients. The firm would need to build a credible track record, hire experienced underwriters, and possibly invest significantly in marketing and compliance infrastructure to compete effectively with established players. **c.** In recent years, the stock market volume has increased substantially, and this securities firm has performed very well. In the future, however, many institutional and individual investors may invest in index funds or exchange-traded funds rather than in individual stocks. How would this affect the securities firm? A shift towards index funds and exchange-traded funds (ETFs) could negatively impact the firm’s revenue from trading individual stocks. The firm may see reduced demand for its stock-picking services and lower trading commissions. To mitigate this impact, the firm might need to diversify its offerings, such as providing advisory services for managing ETF portfolios or developing proprietary index funds and ETFs to attract investors. How Securities Firms Facilitate the Flow of Funds Recall that Carson Company has periodically borrowed funds but contemplates a stock or bond offering so that it can expand by acquiring some other businesses. It has contacted Kelly Investment Company, a securities firm. a. Explain how Kelly Investment Company can serve Carson, and how it will also serve other clients when it serves Carson. Also explain how Carson Company can serve Kelly Investment Company Kelly Investment Company helps Carson by facilitating its stock or bond offering, providing advice, and connecting Carson with institutional investors. In doing so, Kelly also serves other clients, including investors looking for profitable investment opportunities. Carson benefits from Kelly’s expertise in raising capital. b. In a securities offering, Kelly Investment Company would like to do a good job for its clients, which include both the issuer and institutional investors. Explain Kelly’s dilemma. Kelly’s dilemma is balancing the interests of Carson (the issuer) and institutional investors. While Carson wants a high offering price, institutional investors want a reasonable price to ensure returns. Kelly must manage both expectations. c. The issuing firm in an IPO hopes that there will be strong demand for its shares at the offer price, which will ensure that it receives a reasonable amount of proceeds from its offering. In some previous IPOs, the share price by the end of the first day was more than 80 percent higher than the offer price at the beginning of the day. This reflects a very strong demand relative to the price at the end of the day. In fact, it probably suggests that the IPO was fully subscribed at the offer price and that some institutional investors who purchased the stock at the offer price flipped their shares near the end of the first day to individual investors who were willing to pay the market price. Do you think that the issuing firm would be pleased that its stock price increased by more than 80 percent on the first day? Explain. Who really benefits from the increase in price on the first day? The issuing firm may not be pleased by the large price increase, as it indicates the stock was underpriced, meaning they could have raised more capital. The real beneficiaries are the institutional investors who purchased at the offer price and flipped shares to individual investors for a profit. d. Continuing the previous question, assume that the stock price drifts back down to near the original offer price over the next three weeks (even though the general stock market conditions were stable over this period) and then moves in tandem with the market over the next several years. Based on this information, do you think the offer price was appro priate? If so, how can you explain the unusually high one-day return on the stock? Who benefited from this stock price behavior, and who was adversely affected? If the price returns to the offer price, it suggests the offer was appropriately priced, with the initial surge likely driven by speculation or market excitement. The institutional investors who flipped shares benefitted, while individual investors who bought at the inflated price were adversely affected. 25 chapter Critical Thinking Question Investment Policy Incentives of Insurance Companies Consider a life insurance company that needs to ensure that it can make a steady stream of payments over time to beneficiaries of its policyholders. Assume that the compensation for the insurance company’s portfolio managers is tied to the return earned on the investments each year. Write a short essay that explains how the compensation plan might lead to investment strategies that do not serve the needs of the policyholders. Linking portfolio managers' compensation to annual returns may encourage them to take excessive risks for short-term gains, which could jeopardize the company’s ability to meet long-term obligations to policyholders. This misalignment of interests can lead to investment strategies that prioritize high-risk, high- reward assets instead of focusing on stable, low-risk investments needed for consistent policyholder payouts. A compensation plan tied to long-term performance would better align managers' goals with the company’s obligations. Interpreting Financial News Interpret the following comments a. “Insurance company stocks may benefit from the recent decline in interest rates.” -- Lower interest rates can increase the value of bonds in an insurance company’s portfolio, boosting the stock price of the insurer. b. “Insurance company portfolio managers may serve as shareholder activists to implicitly control a corpora tion’s actions.” -- Insurance company portfolio managers may push for changes in a company’s strategy or management to increase shareholder value, influencing corporate actions without direct involvement in operations. c. “If a life insurance company wants a portfolio manager to generate sufficient cash to meet expected payments to beneficiaries, it cannot expect the manager to achieve relatively high returns for the portfolio.” -- Generating enough cash to meet beneficiary payments requires conservative, low-risk investments, which generally offer lower returns than riskier, higher-return assets. Managing in Financial Markets Assessing Insurance Company Operations As a consultant to an insurance company, you have been asked to assess the asset composition of the company. a. The insurance company has recently sold a large amount of bonds and invested the proceeds in real estate. Its logic was that these actions would reduce the exposure of its assets to interest rate risk. Do you agree? Explain. Investing in real estate instead of bonds may reduce exposure to interest rate risk, as real estate values are less directly influenced by rate changes. However, real estate introduces other risks, like liquidity and market volatility. While bonds are sensitive to interest rate movements, the company should assess whether real estate aligns with its long-term obligations and overall risk profile. b. This insurance company currently has a small amount of stock. The company expects that it will need to liquidate some of its assets soon to make payments to beneficiaries. Should it shift its bond holdings (with short terms remaining until maturity) into stock in an effort to achieve a higher rate of return before it needs to liquidate this investment? Shifting bonds with short maturities into stocks may offer higher returns, but stocks also introduce significant volatility and risk. If the company needs to liquidate assets soon, it’s better to keep short-term, liquid assets (like bonds) to ensure the ability to meet beneficiary payments without being forced to sell in a potentially unfavorable market. c. The insurance company maintains a higher pro portion of junk bonds than most other insurance companies. In recent years, junk bonds have performed very well during a period of strong economic growth, as the yields paid by junk bonds have been well above those of high-quality corporate bonds. Very few defaults have occurred over this period. Consequently, the insurance company has proposed that it invest more heavily in junk bonds, as it believes that the concerns about junk bonds are unjustified. Do you agree? While junk bonds have performed well in a strong economy, they carry higher default risk. Relying too heavily on junk bonds could expose the insurance company to substantial losses if the economy weakens. The company should diversify its portfolio to balance high-risk, high-return investments with more stable assets to protect against potential downturns. How Insurance Companies Facilitate the Flow of Funds Carson Company is considering a private placement of equity with Secura Insurance Company. a. Explain the interaction between Carson Company and Secura. How will Secura serve Carson’s needs, and how will Carson serve Secura’s needs? Secura Insurance provides capital to Carson Company through a private equity placement, which helps Carson meet its financing needs. In return, Secura gains an ownership stake in Carson, potentially benefiting from the company’s growth and future returns. b. Why does Carson interact with Secura instead of trying to obtain the funds directly from individuals who pay premiums to Secura? Carson interacts with Secura instead of individual policyholders because Secura, as an institutional investor, has the resources, expertise, and infrastructure to manage large investments. Directly obtaining funds from individuals would be more complex and less efficient. c. If Secura’s investment performs well, who benefits? Is it worthwhile for Secura to closely monitor Carson’s management? Explain. If the investment performs well, Secura benefits through capital gains and dividends. It is worthwhile for Secura to monitor Carson’s management closely to ensure the company’s growth and protect its investment, maximizing the return on its capital. 26 chapter Critical Thinking Question Aligning Incentives of Pension Funds Consider a state pension fund that needs to generate a series of fixed payments for its retirees. Assume that the compensation of the fund’s portfolio managers is tied to the return earned on the investments each year. Write a short essay that explains how the compensation plan might lead to investment strategies that do not serve the needs of the retirees. Tying portfolio managers’ compensation to short-term returns may encourage risky investments to boost performance, which conflicts with the pension fund’s goal of providing steady, fixed payments to retirees. This can undermine long-term stability. A better approach would link compensation to long-term performance, aligning managers’ interests with the retirees’ need for reliable income. Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “The city is now broke because of its pensions.” -- The city's financial troubles are due to the growing costs of pension obligations, which it cannot afford, leading to budget deficits. b. “Defined-contribution plans would prevent politicians from buying votes in a state.” -- Shifting to defined-contribution plans would reduce politicians' ability to make unsustainable pension promises to gain votes, as the burden would shift to individual employees instead of taxpayers. c. “Public pension funds govern corporations but also need to govern themselves.” -- Public pension funds, as large investors, influence corporate decisions, but they must also ensure strong governance and accountability within their own operations to avoid mismanagement. Managing in Financial Markets Solutions to Pension Underfunding As a consultant to a state’s underfunded pension fund, you have been asked to search for solutions to prevent underfunding in the future a. One explanation for the underfunding of the defined-benefit plan is that the economy was weak recently, so financial markets were weak, and this caused the underfunding. If so, the underfunding may not be a problem in the future. Do you think this explanation is sufficient, so there is no need to search for an alternative solution? Explain. The weak economy explanation isn't enough. Relying on future market recovery without addressing structural issues could lead to recurring underfunding. b. One possible solution is to convert the state’s defined-benefit plan to a defined-contribution plan. Explain why this could be a viable solution to the problem. A defined-contribution plan shifts funding risk to employees, eliminating state liabilities and offering more control to employees over their savings. c. Some state workers prefer a defined-benefit plan because they are afraid that they will make poor investments if they are forced to manage their own funds (as they would with a defined-contribution plan). Is that a sufficient reason to force the state to remain on a defined-benefit plan? Employee concerns about investment risks are valid, but education and guidance can help. A hybrid approach, combining guaranteed benefits with individual contributions, could address both security and control. How Pension Funds Facilitate the Flow of Funds Carson Company has a defined-benefit pension plan that provides generous benefits to its employees upon retirement. a. Explain the role of the portfolio managers who manage the pension fund. What is their primary role? Portfolio managers ensure the pension fund generates enough returns to meet future retirement benefits through strategic investments. b. Explain the trade-off between investing in bonds versus in stock for the purpose of providing future retirement benefits. Bonds offer stability and predictable income for future benefits, while stocks provide higher returns with more risk. A mix of both balances risk and return. c. Explain how investment decisions on the pension fund would change if the defined-benefit plan was changed to a defined-contribution plan If switched to a defined-contribution plan, employees would control their investments, and fund managers would offer various options, focusing on individual choices rather than guaranteed benefits.