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Solutions to the End-of-Chapter Questions, Problems, and Data
Exercises
11.1 Investment Banking
Learning objective: Explain how investment banks operate.
Review Questions
1.1 Investment banking involves, among other activities, underwriting new security issues and providing
1.2 Repo financing is borrowing funds short term using a repurchase agreement, which is the sale of
Investment banks became more reliant on repo financing and more highly leveraged because by the
Problems and Applications
1.4 Investment banks “unlock capital markets” by knowing the ins and outs of financial markets and
Investment banks also design new securities to help corporations manage risk. Investment banks are
1.5 a. Underwriting is where investment banks guarantee (typically) a price to the issuing firm for new
b. An investment bank that buys securities with its own capital is not acting as a financial intermediary.
1.6 a. Leverage involves investing using borrowed funds rather than using capital or equity to invest. The
b. Leverage is a double-edged sword. It can increase profits, but it can also magnify losses. These
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Chapter 11 Investment Banks, Mutual Funds, Hedge Funds, and the Shadow Banking System 131
1.7 Hedge funds compete for investor funding by offering higher rates of return than alternative
1.8 The leverage ratio equals the value of assets divided by the value of equity. So, the leverage ratios
are:
a. $200,000/$200,000 1
The return on investment equals the increase in the price of the house divided by the amount
invested:
a. $20,000/$200,000 10%
1.9 If an investment bank went public, it would have more access to capital because it could sell stock to
1.10 The advantage of the “up or out” policy to investment banks and other firms is that workers have an
incentive to work very hard during their first years with the firm to demonstrate that they are worthy
11.2 Investment Institutions: Mutual Funds, Hedge Funds, and Finance
Companies
Learning objective: Distinguish between mutual funds and hedge funds and describe their roles in the
financial system.
Review Questions
2.1 Investment institutions are similar to commercial banks because they are financial intermediaries that
2.2 Mutual funds differ from hedge funds in that hedge funds are usually partnerships with a relatively
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Chapter 11 Investment Banks, Mutual Funds, Hedge Funds, and the Shadow Banking System 132
2.3 Finance companies have an advantage over commercial banks in monitoring the value of collateral,
Problems and Applications
2.4 Deposits in bank savings accounts are covered by federal deposit insurance whereas money market
2.5 a. “Lehman paper” is commercial paper that Lehman Brothers had issued to raise funds. The Lehman
b. “Breaking the buck” means that the net asset value of the money market fund had fallen below $1 to
c. A run is a rush to withdraw money before everyone else does. One money market mutual fund
b. Finance companies specialize in their specific lending area and generally have more information on
2.7. a. A hedge fund is a financial firm organized as a partnership of wealthy investors that make relatively
b. “Average investors” are not able to invest in hedge funds. To buy into a hedge fund, you must be an
c. The fees hedge funds charge are higher than the fees mutual funds charge because hedge funds
2.8. a. The cost to a firm of raising new capital falls with an increase in the firm’s stock price—because the
b. Hedge funds correct this inefficiency by selling the overhyped growth stocks, thereby putting
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Chapter 11 Investment Banks, Mutual Funds, Hedge Funds, and the Shadow Banking System 133
2.9. a. The “riskier characteristics of hedge funds” refers to the fact that hedge funds are more highly
b. It is unclear whether hedge funds provide higher returns than mutual funds because hedge funds do
11.3 Contractual Savings Institutions: Pension Funds and Insurance
Companies
Learning objective: Explain the roles that pension funds and insurance companies play in the financial
system.
Review Questions
3.1 Contractual savings institutions are similar to commercial banks because they are financial
3.2 In a defined contribution plan, the firm places contributions from employees (which some employers
match up to a certain limit) into investments chosen by the employees. The employees own the
3.3 Insurance companies are financial intermediaries in that they obtain funds by charging premiums to
Problems and Applications
3.4 In a defined benefit plan, a worker’s retirement payout is determined by a formula so that the
worker can plan on receiving a specific pension payment. However, the worker could lose some of his or
3.5 a. Traditional pension plans are defined benefit plans under which retirement payouts are fixed by a
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Chapter 11 Investment Banks, Mutual Funds, Hedge Funds, and the Shadow Banking System 134
b. 401(k) plans might be more desirable to employers because they do not face the risk of having poor
investment returns and underfunded pension plans that might require the employers to divert
3.6 Pension funds have vesting periods in order to reduce turnover among employees who are not yet
vested and to avoid making pension payments to employees who have worked for the firm only
3.7 Insurance companies are likely to respond to the law by raising premiums. Doing so will increase
adverse selection problems because businesses in areas with high rates of arson will still be willing
3.8 Insurance companies never know the exact amounts of their future payouts, but through risk pooling
3.9 a. A medical insurance policy guarantees medical services such as doctor visits, medical exams,
b. With medical services always improving and getting more expensive, companies offering medical
11.4 Risk, Regulation and the Shadow Banking System
Learning objective: Explain the connection between the shadow banking system and systemic risk.
Review Questions
4.1 The shadow banking system is a collection of nonbank financial institutions that channel money
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Chapter 11 Investment Banks, Mutual Funds, Hedge Funds, and the Shadow Banking System 135
4.2 A run on a financial firm is the attempt by investors to get their money out before the firm fails.
Problems and Applications
4.3 The money market mutual fund industry is important because these institutions hold so much
short-term debt. In particular, money market mutual funds buy large amounts of commercial paper,
b. The “run potential” in money market mutual funds refers to the possibility that real or perceived bad
news about the quality of money market mutual fund assets could cause investors to redeem their
4.5 Leverage magnifies profit, but it also magnifies loss. Relying too much on short-term borrowing
creates a large mismatch between the maturity of assets (loans) and the maturity of liabilities, and
4.6 a. A repurchase agreement is a short-term loan that pays a small amount of interest. In this sense, repos
b. If “depositors” (lenders) refuse to renew their repos, it is the equivalent of depositors making a
withdrawal from a commercial bank. The shadow bank would need to pay off the loans of the
4.7. a. An investment bank can be subject to a run when investors do not renew their repurchase
4.8 The financial crisis may have been difficult to foresee because of the complexity of some of the
financial securities that been introduced over the previous decade and because of how quickly the
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Chapter 11 Investment Banks, Mutual Funds, Hedge Funds, and the Shadow Banking System 136
Data Exercises
D11.1
a. Retail money market mutual funds are offered primarily to individuals, whereas institutional money
b. The trends in retail and institutional money market mutual funds have been similar other than the
D11.2
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Chapter 11 Investment Banks, Mutual Funds, Hedge Funds, and the Shadow Banking System 137
a. The larger values later in the period mask the changes in the smaller values earlier in the period, so
we have divided the data into two periods: 1952 to 1984 and 1985 to 2012. The value of mutual
b. The value of mutual fund shares owned by households can change due to changes in the value of the
© 2014 Pearson Education, Inc.
