MONEY AND BANKING

NUMBER ONE {100 points}.  Discuss and analyse the models and concepts of asset valuation we have covered in our studies.  As you survey this vastly complex subject matter, utilize and/or address the following aspects of financial theory: (1) discounting, (2) maturity, and (3) capital (equity) gains.  Is the economic idea of “yield” sufficient to guide rational investment decision-making in the highly competitive profit-seeking enterprise of financial management and speculation?  Explain.  

Under Money and Banking, asset valuation serves to determine the value of assets held. Certain concept and terms are used such as discounting, maturity and capital or otherwise equity gains. Discounting basically involves bringing to the present any future expected economic benefits using the Present Value Interest Factor formulated from the prevailing interest rates. Maturity refers to the time period for which a certain security. Say, a bond is held before payments are issued to the holder.

For bonds, the payments include the redemption value and the expected series of coupons. Capital gains are differences depicted when the Redemption value, R, is greater than the initial price, P, of the security. Various models are used in valuation of assets such as: asset-based approach, discounted cash flow model, market approach and the arbitrage pricing theory model.

Asset-based Approach.

This model basically values the assets by estimating the loan portfolio of the firm less its outstanding debts to obtain the value of equity. In most cases, the asset-based approach is used to determine how liquid a bank or any other firm is, and especially in the event of legal proceedings. This approach is however limited in situations where a bank has a hold in multiple areas of business such as commercial banking and investment banking, making valuation less accurate.

Market or Relative Valuation Approach.

This model appraises assets by relating them to the prices at which similar assets in the market are being sold at or the prices at which these similar assets were sold some three to six months ago. This then forms the basis for valuation of the assets held by the firm.

Income Approach.

Under this model, the value of an asset is taken to be the value of its expected cash flows discounted to the present using the prevailing interest rate. This is also the discounted cash flow model. The discounted value is then taken to be the actual value of the asset at that time period. Under this model is the Dividend Discount Model in which equity is valued from the result of discounting future expected dividends.

Arbitrage Pricing Model Approach.

This is a form of asset valuation that holds the expected return of an asset as a liner function macroeconomic factors that result to market indices. Here, the expected return on assets is formulated from the degree of sensitivity of the market to variations and then use to price the asset primarily by discounting it to the present. Under arbitrage, the market value of the asset should be equal to the asset’s expected value to maturity after discounting.

Yield in the discipline of economics refers to the return expressed in percentage form that an investor expects on cash flows such as interest rates or dividends. The yield to maturity of an asset can also be understood as its Internal Rate of Return (IRR), which is the rate that satisfies the equation of value. A higher yield enables investors to recover their portfolio sooner. Generally, yield tends to be inversely proportional to the price of an asset, implying higher yields at bonds of lower prices. However, decrease in market value of an asset can also be due to increased association with risk. Higher risk implies higher returns. Yield on an asset can thus be used to formulate investment decisions as it is equal to the asset’s IRR. This implies that an investment should be taken up when the yield is greater than the prevailing cost of capital.

NUMBER TWO {100 points}.  Why are more resources not devoted to adequate prudential supervision of the financial system to limit excessive risk-taking, when it is clear that this supervision is needed to prevent financial crises?  Would a set of strict regulatory controls over: (1) minimum capital requirements, (2) international capital flows, mobility and trading, and/or (3) new instruments of financial engineering and financial innovation, solve this problem?  What is the critical weakness in relying on regulation to solve problems in the market for financial information product?  What is the alternative?  

Financial systems limit to excessive risk taking is a fundamental step in preventing financial crisis. Excessive risk taking depletes prevailing valuable economic resources and in extreme cases it can lead to financial recession. Prudent supervision generally involves government regulation and monitoring of the banking system to ensure its financial safety. Weak financial regulation systems resulting from asymmetric information undermine the ability to allocate more resources to adequate prudential supervision of risk taking.

A set of strict regulatory controls over the minimum capital requirement, international capital flows, mobility and trading, and new instruments of financial engineering and financial innovation would help in providing solutions to the problem. Under minimum capital requirement, the minimum acceptable capital to asset ratio for institutions is determined above which the ratio cannot be exceeded. This will ensure that the bank can sustain significant expected losses in values of assets while still meeting its obligations such as enabling cash withdrawals. The stricter the requirements, the better this mode of regulation is at preventing financial crisis as capital levels determine the amount of risk that can be taken.

The International Capital flows criteria involves placing capital control measures to regulate flows from the capital markets into and out of the country’s capital account. The measures involved in this regulatory method include: placing exchange controls that hinder the trading of currencies at the prevailing market rate, adjusting transaction taxes such as the Tobin tax or even setting the minimum amount that an individual is allowed to remove from the country. This way, capital is kept in check thus risk taking.

Financial engineering and innovation involved the creation of derivatives for leveraging credit and managing financial risk as a measure to increase profitability. In some cases, this creation and innovation of financial instruments attains complexity in that regulators find it difficult to determine the risk involved. Increased use of financial engineering techniques to increase profitability may lead to recession in the long run, thus the need to place regulatory measures on such.

Capital control methods have been used by most countries for the longest time ever until today to shield against financial instability. However, there are demerits associated with this regulation, for example, capital regulation methods are costly and fail to form a distinction between desirable capital and current transactions, and the less desirable transactions. They also tend to impose administration costs on a country. Liberalisation accompanied by strict fiscal policies can serve as an alternative to capital regulation methods as it allows monetary policies to efficiently target inflation.

NUMBER THREE {100 points}.  What caused the severe equity market contraction which began about the late summer of 2008?  Why did the financial crisis precipitate a recession in the real-side macro economy?  Did the TARP program and other bailouts advocated and engineered by the US Treasury and the Federal Reserve in October 2008 prevent a massive macroeconomic collapse, or, did they make the problem worse?   Detail some convincing elements on each side of the arguments and use economic logic to defend your final conclusion

Otherwise termed as the Great Recession, the severe equity market contraction which began about the late summer of 2008 was as a result of bursting of an eight trillion dollar ($8 Trillion) housing bubble. This was as a result of high peaks in housing market activities resulting from residential construction. In 2007, the resulting losses on mortgage related financial assets began to cause financial strains in the global financial market causing the economy to enter into a recession of all times in 2008. The consequential loss of wealth then lead to crude cutbacks in consumer expenditures, which, coupled with the prevailing financial chaos, lead to severe drawbacks in investment.

Severe unemployment then followed, with millions of people losing their jobs. Statistics show that the United States Labour market lost a whopping 8.4 million jobs which is equivalent to 6.1 % of all payroll employment. This nightmare was double as intense as the 1981 recession whose job loss was only 3.1%. The United States economy recovering from the recession really slowly given the sluggish recovery patterns of the previous recessions. The economy still has 5.4% fewer jobs than it had prior to the enormous recession period. Low economic activity associated with the recession period yielded low Gross Domestic Product values, household incomes and overall investment spending. The country’s GDP feel by 4.3% and unemployment rates doubled to 10%.

TARP (Troubled Asset Relief Programme) and other bail outs advocated by the US treasury may have not solved the problem permanently, but they sure did improve the situation. TARP, in particular, gave the Treasury a $700 billion purchasing power to buy illiquid mortgage-backed securities in effort to restore liquidity to the deprived money markets. Rules of TARP required that the companies involved in the crisis e.g. the Lehman Brothers that suffered bankruptcy to forego tax benefits and executive compensations and bonuses to help save the crisis.

Funds were then distributed to various sectors such as the automotive industry and the government also. As if December 2013, funds used in the government yielded $ 11 billion for tax payers. Also, funds distributed to the automotive industry in particular, General Motors and Chrysler Groups recovered more than 1 million jobs, stabilized banks and also restored credit availability to individuals and firms. Although the bailout programs did not fully solve the situation, the funds availed sure did make the crisis a little bit bearable.

NUMBER FOUR {100 points}.  Is inflation good or bad for the economy? For the average investor?  For the government?  Explain.  Is it possible that there is a best/optimal rate of inflation that is on the whole good for all parties in macroeconomic-society?  What is that inflation rate and how will society decide upon that and then implement it into the monetary policy of the central bank?

Inflation is the persistent rise in the general price levels of goods and services in an economy over a period of time, mostly annually. This implies that inflation causes a loss in purchasing power in every unit of currency, say a dollar, yen, shilling held. Several theories are used to explain the causes of inflation: the demand-pull inflation and the cost-push inflation.

Demand-pull inflation theory describes persistent increase in general price levels as a consequence of stronger demand forces. Demand happens to be greater than supply, therefore causing some sort of shortage which sparks an increase in prices. Cost-push theory relates inflation to the increase in costs. It shows that inflation may have been as a result of increase in essential costs such as production costs or even taxes. Prices thus tend to increase in effort to sustain profitability.

Inflation is not necessarily bad for the economy as is the general perception. Whether inflation is good or bad is dependent on the impact it produces on people as well as whether it was expected or not. In the case of anticipated inflation, adjustments can be made earlier to minimize severity such as variation in bank rates or yield expected from financial assets. Investors will require higher rates of return on their investment to compensate for inflation risks associated with holding the asset in an uncertain future. The government issuing bonds in this case tends to suffer.

In the case of unanticipated inflation, investors tend to suffer more. The creditors lose and the debtors, in this case, the government gain should the lender estimate the inflation rate incorrectly. For debtors, the gain would be equal to enjoying an interest-free loan. The Government may have introduced Indexed linked bonds to deal with such uncertainties.

In cases of deflation, the Government uses deflationary fiscal policies e.g. increased tax rates and deflationary monetary policies such as increasing the borrowing rates to bring the economy back to equilibrium. These measures are effective for demand-pull inflation. For the cost-pull inflation, the Government increases its currency exchange rate.

Inflation is a sign of economic growth. Zero inflation implies a weaker economy. This implies an optimal rate of inflation that operates for the common good of the parties involved in the macroeconomic society. Most countries prefer to maintain an inflation rate of 2%. The Keynesian Philips Curve in the long run shows a negative relationship between employment and inflation, implying that unemployment can be slightly reduced at the expense of a slight degree of inflation.

Society can set the optimal inflation rate on the basis of Friedman’s rule. This monetary policy advocates zero nominal rate so that the opportunity cost for holding cash by private agents is equal to the social cost of creating additional money. The Central Bank therefore needs to formulate a rate of deflation equal to the real interest rates on Government bonds and other assets so as to equate the nominal rate to zero.

NUMBER FIVE {100 points}.  Discuss and analyse the shape of the yield curve.  What important principles from finance form the core for understanding the behaviour of changes in the yield curve?  How does the Expectations Theory apply to interpretation of the shape and movement of the yield curve?  How does the preferred habitat theory apply to the interpretation of the shape and movement of the yield curve?  

The yield curve relates the variations in yield to the different time period of investment. It explains the relationship between the rate of interest and the term to maturity. Variations of interest rates relative to the period of investment is what defines the term structure of interest rates. The Normal yield curve is upward sloping, eventually flattening in the long run, and there are two explanations to its normal shape.

Consider an anticipated future increase in the risk-free rate of investment. Investors are likely to enjoy better rates should they invest in future. Under the Arbitrage Pricing Model, investors currently putting their funds in businesses will require compensation for the expected increase in future risk free rates. Thus, longer term investments will have higher yield. The second explanation is that long-term bonds are generally associated with higher risk compared to the short-term bonds. The longer the time to maturity, the higher the expected yield. This is because investors will require a higher return for bonds held into the long-term due to uncertainties and risk that yield the Time Value of Money (TVM) concept.

The yield Curve can take many shapes as it is dependent on the demand for and supply of securities. The eventual flattening of the yield curve in the long run is as a result of diminishing marginal increases in the yield. Some fundamental financial theories have been used to form core understanding of the concept of behavioural changes associated with the yield curve. They include: Expectations Theory, Liquidity Preference Theory, Market Segmentation Theory and the Preferred Habit Theory.

Under the Expectation Theory, the demand for short term and long term investments will vary according to the anticipated future adjustment in interest rates. If investors expect a future fall in interest rates, then the short term investments will be less attractive than the long term investments. This is due to the perception that investors holding long term securities will keep on enjoying high rates after the expected fall in interest rates. The result will be an increased yield on the short term bonds resulting to a downward sloping yield curve. If an increase in interest rates is expected, short term investments will be in higher demand than long term investments. The effect will be an upward sloping yield curve.

The Preferred Habit Theory simply states that investors have a preferred length in which they are willing to hold bonds to maturity and they will tend to go against these preferences only if they can associate an increase in risk with a higher return. Longer bonds tend to be more sensitive to changes in interest rates thus higher risk. Under this theory, investors will always prefer the short term bonds and will only take up long term bonds if they are optimistic about the return. The behaviour of the yield curve will thus be similar as in the case of an expected rise in future rates, that is, an upward sloping yield curve.

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