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Economics 350: Student Name:

Spring 2014 ID #:

Homework #3

Due: Thursday, April 3 in class

Total Pts. Available: 40

Question 1. The following question extends question 8.6 of the Mishkin textbook.

a. (2 pts.) Rich individuals often worry that people will seek to marry them only for their wealth. Is this a problem of adverse selection? Briefly explain.

b. (2 pts.) Does the concern in part (a) also involve issues of moral hazard? Briefly explain. (Hint: Are gold-digging spouses trustworthy?)

c. (2 pts.) Briefly explain how a pre-nuptial agreement can address the problems of adverse selection discussed in part (a). (Background: Pre-nuptial agreements specify how a

married couple’s assets will be divided if they divorce. The agreements usually specify

that the rich person will retain most of her/his pre-marital wealth.)

d. (2 pts.) Briefly explain how a pre-nuptial agreement can address the problems of moral hazard discussed in part (b).

Question 2. (2 pts.) Explain why internet “chat rooms” (electronic bulletin boards where

participants leave messages for others to read) should reduce the amount of fraud by

product manufacturers and vendors. (Hint: review pp.174-178 in Chapter 8.)

Question 3. Answer the following questions from Chapter 10 of the Mishkin textbook.

a. (1 point) Question 10.20: What happens to reserves at the First National Bank if one

person withdraws $ 1,000 of cash and another person deposits $500 or cash. Use T-

accounts to explain your answer.

b. (2 pts.) Question 10.6: If the bank you own has no excess reserves and a sound customer comes in asking for a loan, should you automatically turn the customer down,

explaining that you don't have any excess reserves to lend out? why or why not? What

options are available for you to provide the funds your customer needs?

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Question 4. (Adapted from questions 10.3 and 10.11 in the Mishkin textbook.) The bank

you own has the following balance sheet:

a. (2 pts.) If the bank suffers a deposit outflow of $5 million with a required reserve ratio on deposits of 10%, what actions should you take to comply with the reserve

requirement?

b. (2 pts.) What are the benefits and costs for a bank when it decides to increase the amount of bank capital?

Question 5. (2 pts.) (This question asks you to consider how long-term, repeated,

relationships can address issues of asymmetric information.) Why might it be the case that

there are more unscrupulous landlords in college towns than in towns where most of the

renters are families?

Question 6. Suppose that MegaBank has the following balance sheet:

Assets ($) Liabilities ($)

3-month Treasury Bonds $6,000 6-month CDs 12,000

Adjustable-Rate Mortgages 12,000 Money Market Deposit Accounts 2,000

Fixed-rate Mortgages 28,000 Checkable Deposits 14,000

10-year Treasury Bonds 6,000 10-year CDs 14,000

Bank Capital (Net Worth) _____

a) (1 pt.) Calculate MegaBank’s bank capital. b) (4 pts.) Calculate MegaBank’s (basic) gap(Hint: see pp. 233-34) . Is the gap positive or

negative?

c) (2 pts.) Suppose MegaBank is concerned about its interest rate risk. In the absence of a hedge, would MegaBank benefit or lose as (future) spot interest rates rose? What would

happen as spot interest rates fell?

d) (2 pts.) Suppose spot interest rates fell by 2 percentage pts. What would happen to the bank’s profits? (Assume that interest rates on variable-rate assets and liabilities change

instantly.)

e) (2 pts.) Suppose MegaBank entered into a forward contract to buy Treasury bonds at some future date. As future spot interest rates fell, would MegaBank’s profits from that

contract rise or fall?

f) (2 pts.) Suppose the bank enters into a forward contract to sell Treasury bonds at some future date. As future spot interest rates fell, would the bank’s profits from that contract

rise or fall?

Assets ($millions) Liabilities ($millions)

Reserves 9 Deposits 90

Loans 90 Borrowings 9

Securities 10 Bank Capital 10

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g) (2 pts.) Explain how MegaBank could hedge against the risk described in part (c) with a financial futures contract. In particular, would MegaBank contract to buy or sell Treasury

bonds?

h) (2 pts.) Explain how MegaBank could hedge against the risk described in part (c) with an option instead. In particular, would the bank purchase a put or call option?

i) (2 pts.) Suppose MegaBank is considering whether to purchase 3-month or 10-year Treasury Bonds. If MegaBank wants to reduce its interest rate risk, which should it

purchase?

j) (2 pts.) Suppose MegaBank is considering whether it should attract new deposits with 6- month CDs or 10-year CDs. If it wanted to reduce the positive gap described in part (b),

which sort of CD would it sell?