Chapter 2
ANSWERS TO QUESTIONS
1. Assume that a carpenter borrowed $2,000 to be paid off in a year to finance a machine that
would make him work faster. As a result, she is able to take on more projects and collect
$400 more earnings in the first year, after paying off the principal of $2,000. However, there
is a 15% rental fee (interest) on her loan, which she also has to pay off. What is the
carpenter’s net earnings for the first year? (Round your response to the nearest dollar.)
The carpenter’s net earnings for the first year can be derived using the equation: ‘additional
2. Some economists suspect that one of the reasons economies in developing countries grow so
slowly is that they do not have well-developed financial markets. Does this argument make
sense?
Yes, because the absence of financial markets means that funds cannot be channeled to
3. Give at least three examples of a situation in which financial markets allow consumers to
better time their purchases.
Examples of how financial markets allow consumers to better time their purchases include:
• The purchase of a durable good, like a car or furniture.
• Paying for tuition.
4. If you suspect that a company will go bankrupt next year, which would you rather hold,
bonds issued by the company or equities issued by the company? Why?
You would rather hold bonds, because bondholders are paid off before equity holders, who
5. Suppose that Toyota sells yen-denominated bonds in Tokyo. Is this debt instrument
considered a Eurobond? How would your answer change if the bond were sold in New York?
If the Yen denominated bond is sold in Tokyo, then it is not considered a Eurobond. If the
6. Describe who issues each of the following money market instruments:
a. Treasury bills
b. Certificates of deposit
c. Commercial paper
d. Repurchase agreement
e. Fed funds
Treasury bills are short-term debt instruments issued by the US government to cover
immediate spending obligations, i.e. finance deficit spending. Certificates of deposit (CD) are
7. What is the difference between a mortgage and a mortgage-backed security?
Mortgages are loans to households or firms to purchase housing, land, or other real structures,
where the structure or land itself serves as collateral for the loans. Mortgage-backed securities
8. The U.S. economy borrowed heavily from the British in the nineteenth century to build a
railroad system. Why did this make both countries better off?
The British gained because they were able to earn higher interest rates as a result of lending
9. A significant number of European banks held large amounts of assets as mortgage-backed
securities derived from the U.S. housing market, which crashed after 2006. How does this
demonstrate both a benefit and a cost to the internationalization of financial markets?
The international trade of mortgage-backed securities is generally beneficial in that the European
banks that held the mortgages could earn a return on those holdings, while providing needed
capital to U.S. financial markets to support borrowing for new home construction and other
10. How does risk-sharing benefit both financial intermediaries and private investors?
Financial intermediaries benefit by carrying risk at relatively low transaction costs. Since
higher risk assets on average earn a higher return, financial intermediaries can earn a profit
11. How can the adverse selection problem explain why you are more likely to make a loan to a
family member than to a stranger?
Because you know your family member better than a stranger, you know more about the
12. One of the factors contributing to the financial crisis of 2007–2009 was the widespread
issuance of subprime mortgages. How does this demonstrate adverse selection?
The issuance of subprime mortgages represents lenders loaning money to the pool of
potential homeowners who are the highest credit risk and have the lowest net wealth and
13. Why do loan sharks worry less about moral hazard in connection with their borrowers than
some other lenders do?
Loan sharks can threaten their borrowers with bodily harm if borrowers take actions that
14. If you are an employer, what kinds of moral hazard problems might you worry about with
regard to your employees?
They might not work hard enough while you are not looking or may steal or commit fraud.
15. If there were no asymmetry in the information that a borrower and a lender had, could a
moral hazard problem still exist?
Yes, because even if you know that a borrower is taking actions that might jeopardize paying
off the loan, you must still stop the borrower from doing so. Because that may be costly, you
16. “In a world without information costs and transaction costs, financial intermediaries would
not exist.” Is this statement true, false, or uncertain? Explain your answer.
True. If there are no informational or transactions costs, people could make loans to each
17. Suppose a few investors are looking for an investment opportunity that will yield high returns.
They are willing to invest in private securities instead of government bonds. However, their
analyst found that currently most companies listed on the market and are actively trading in
securities are in trouble, which would make them risky investments. What can you conclude
from this situation? How would you advise the investors?
Based on the situation, one might agree with the analyst’s assessment; however, the adverse
selection problem can also explain such a situation. Adverse selection is created because of
asymmetric information before a financial transaction occurs. In such a situation, potential
18. How do conflicts of interest make the asymmetric information problem worse?
Potentially competing interests may lead an individual or firm to conceal information or
disseminate misleading information. A substantial reduction in the quality of information in
19. How can the provision of several types of financial services by one firm be both beneficial
and problematic?
Financial firms that provide multiple types of financial services can be more efficient through
economies of scope, that is, by lowering the cost of information production. However, this
20. If you were going to get a loan to purchase a new car, which financial intermediary would
you use: a credit union, a pension fund, or an investment bank?
You would likely use a credit union if you were a member, since their primary business is
21. Why would a life insurance company be concerned about the financial stability of major
corporations or the health of the housing market?
Most life insurance companies hold large amounts of corporate bonds and mortgage assets;
22. In 2008, as a financial crisis began to unfold in the United States, the FDIC raised the limit
on insured losses to bank depositors from $100,000 per account to $250,000 per account.
How would this help stabilize the financial system?
During the financial panic, regulators were concerned that depositors worried their banks
would fail, and that depositors (especially with accounts over $100,000) would pull money
23. Financial regulation is similar, but not exactly the same, in industrialized countries. Discuss
why it might be desirable—or undesirable—to have the same financial regulation across
industrialized countries.
This is a topic for which there is no clear answer. On one side, it would be beneficial to have
financial regulations that are identical in all countries to avoid financial markets participants
ANSWERS TO APPLIED PROBLEMS
24. Suppose you have just inherited $10,400 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 3%. The FDIC
insures the account against bank failure.
Option 2: Invest the money in a corporate bond with a stated return of 6%, although there
is a 10% chance the company could go bankrupt.
repaying you.
Option 4: Hold the money in cash and earn zero return.
a. If you are risk-neutral (that is, 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 and then add them up.)
b. Assume that Option 3 and Option 4 are your only choices. If you could pay your friend
$50 to find out extra information about Ayesha that would indicate with certainty
whether she will leave town without paying, would you pay the $50? 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 $10,400 × 1.03 = $10,712. With Option 2, a
bond return of 6% implies a potential payoff of $10,400 × 1.06 = $11,024, and there
b. Option 3 implies the very real possibility of either receiving nothing (if she actually
leaves town), or $11,128 (if she indeed pays as promised). If you don’t pay Ayesha,
you have an expected return of $10,349 as shown above. If you paid your friend the
$50 and learned that Ayesha would leave without paying, then obviously you
ANSWERS TO DATA ANALYSIS PROBLEMS
1. Go to the St. Louis Federal Reserve FRED database and find data on federal debt held by the
Federal Reserve (FDHBFRBN), by private investors (FDHBPIN), and by international and
foreign investors (FDHBFIN). Using these series, calculate the total amount held and the
percentage held in each of the three categories for the most recent quarter available. Repeat
for the first quarter of 2000, and compare the results.
2017:Q1
2000:Q1
Held ($bil.)
% Share
% Share
Fed
2859.1
13.7
10.5
Private Investors
57.1
3182.8
66.7
Foreign Investors
6079.3
29.2
1085.0
22.7
4769.5
2. Go to the St. Louis Federal Reserve FRED database and find data on the total assets of all
commercial banks (TLAACBM027SBOG) and the total assets of money market mutual funds
(MMMFFAQ027S). Transform the commercial bank assets series to quarterly by adjusting
the Frequency setting to “Quarterly.” Calculate the percent increase in growth of assets for
each series, from January 2000 to the most recent quarter available. Which of the two
financial intermediaries has experienced the most growth?
Commercial Banks
Money Market Mutual Funds