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UCSC ECON 130 - Study Questions No. 1

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Study Questions No. 1 (Jan 12; Due Jan 19) Economics 130 Winter 2021 See your text for definitions of key terms. Key terms: Money Market Indirect Finance Capital market Divided Consol Diversification Perpetuity Asymmetric information Duration of bond Moral Hazard Coupon Bond Adverse Selection Coupon Rate Federal Funds rate Current Yield Investment bank Discount Bond Commercial bank Face (Par) Value Money Market Instrument Fixed Payment Loan Capital Market Instrument PDV Over the Counter Market (OTC) Rate of Return (one period) Primary market Capital Gain Secondary market Simple Loan Underwriting Yield to Maturity M1 Commodity Money M2 Fiat Money Medium of Exchange Financial intermediary Store of Value Direct Finance Unit of Account 1. Applied Problem 24 on pg. 47 in textbook (Mishkin, 12th edition). Suppose you have just inherited $10,000 and are considering the following options for investing the money to maximize your return: Option 1: Put the money in an interest-bearing checking account that earns 2%. The FDIC insures the account against bank failure. Option 2: Invest the money in a corporate bond with a stated return of 5%, although there is a 10% chance the company could go bankrupt. Option 3: Loan the money to one of your friend’s roommates, Mike, at an agreed-upon interest rate of 8%, even though you believe there is a 7% chance that Mike will leave town without repaying you. Option 4: Hold the money in cash and earn zero return. a. If you are risk-neutral (i.e., neither seek out nor shy away from risk), which of the four options should you choose to maximize your expected return? (Hint: To calculate the expected return of an outcome, multiply the probability that an event will occur by the outcome of that event.) b. Suppose Option 3 and Option 4 are your only choices. If you could pay your friend $100to find out extra information about Mike that would indicate with certainty whether he will leave town without paying, would you pay the $100? What does this say about the value of better information regarding risk? a. With Option 1, since deposits are insured it can be assumed a riskless investment. Thus, the expected total payoff would be $10,000 × 1.02 = $10,200. With Option 2, a bond return of 5% implies a potential payoff of $10,000 × 1.05 = $10,500, and there is a 90% chance that this outcome will occur, thus the expected payoff is $10,500 × 0.9 = $9450. Under Option 3, the expected payoff is $10,000 × 1.08 × 0.93 = $10,044. Option 4 is riskless, so the expected total payoff is $10,000. Given these choices and the assumption that you don’t care about risk, Option 1 is the best investment. b. Option 3 implies the very real possibility of either receiving nothing (if he actually leaves town), or $10,800 (if he indeed pays as promised). If you don’t pay Mike, you have an expected return of $10,044 as shown above. If you paid your friend the $100 and learned that Mike would leave without paying, then obviously you wouldn’t loan Mike the money, and you would be left with $9900. However, if you paid the friend $100 and learned that Mike would pay, you would have $10,700 (= $10,000 × 1.08 - $100). After paying your friend Mike, but before knowing the true outcome, your expected return would be $10,644 ($9900 × 0.07 + $10,700 × 0.93). Under Option 3, paying your friend the $100 is definitely worth it because it increases your expected return and in addition dramatically reduces the downside risk that you make a bad loan, and increases the certainty of the payoff amount. That is, with asymmetric information (not paying your roommate), you have a range of payoffs of $0 to $10,800 versus $9900 to $10,700 without asymmetric information. Thus, paying a small amount to improve risk assessment under Option 3 can be very beneficial, a task for which financial intermediaries are well suited. Option 4, is riskless, so the expected total payoff is $10,000. If you are more risk averse, Option 4 is likely the better option. However, if you are more risk neutral then paying your roommate the $100 to have a minimum $9900 payment and possibly as much as $10,700 is the better scenario. 2. Web Exercise 1 on pg. 48 in textbook (Mishkin, 12th edition) L1 page3 See Fed Financial Tables: a. What percentage of assets do commercial banks hold in loans? page 88 L.111 9570.2/15844.8 = 60.40% What percentage of assets is held in mortgage loans? 4899.9/15844.8 = 30.92% b. What percentage of assets do savings and loans hold in mortgage loans? page 88 L.111 4899.9/(10495.3+540.5) = 44.4% c. What percentage of assets do credit unions hold in mortgage loans and in consumer loans? page 90 L.144 538.7/4785.9 = 11.26% 476.1/4785.9 = 9.95% 11.26%+9.95%=21.21% 3. Question 5, page 60 in textbook. a. Brooke accepts money in exchange for performing her daily tasks at her office, sinceshe knows she can use that money to buy goods and services. This situation illustrates the medium-of-exchange function of money. We often do not think why we accept money in exchange for hours spent working, as we are so accustomed to using money. The medium-of-exchange function of money refers to its ability to facilitate trades (hours worked for money and then money for groceries) in a society. b. Tim wants to calculate the relative value of oranges and apples, and therefore checks the price per pound of each of these goods as quoted in currency units. In this case, we observe money performing its unit-of-account function. If modern societies did not use money as a unit of account, then the price of apples would have to be quoted in terms of all the other items in the market. This quickly becomes an impossible task. Suppose that a pound of apples sells for 0.80 pounds of oranges, half a gallon of milk, one-third of a pound of meat, 2 razor blades, 1.5 pound of potatoes, etc. c. Maria is currently pregnant. She expects her expenditures to increase in the future and decides to increase the balance in her savings account. Maria is contemplating the store-of-value function of money. As a medium of exchange and unit of account, measures of money known as M1 or M2 have no important rivals. With respect to the store-of-value function, however, there are many assets that can preserve value better than a checking account. Maria’s choice to preserve the

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