Mock Midterm
Autor: Jannisthomas • June 11, 2018 • 1,032 Words (5 Pages) • 553 Views
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[pic 1],
where DF(0.5) represents the discount factor for cash flows in six months (half-a-year) and DF(1) represents the discount factor for cash flows in one year.
The market-based discount factor DF(0.5) is 0.98361. Now plug-in and solve for DF(1):
[pic 2]
So the 52-week T-bill should trade at $96.554. It might not trade at exactly this value, due to bid-ask spreads, etc., but it should trade very close to this value.
- (10 POINTS) Briefly explain what is meant by “too big to fail” with respect to the financial system. Discuss the associated problem of moral hazard and strategies to mitigate this problem.
The term “too big to fail” refers to large financial institutions deemed to pose a systemic risk to the financial system and broader economy. There are negative externalities associated with the failure of such institutions. Because financial intermediaries facilitate the flow of funds from savers to borrowers, the failure of a large institution can curtail the amount of credit available to firms and consumers. The resulting contraction in credit can lead to a reduction in aggregate demand and an economic recession. Additionally, large institutions are often counterparties to many financial contracts. When such an institution fails, other intermediaries become more likely to also fail.
When an institution is “too big to fail,” the government implicitly pledges to bail-out or support the institution if necessary. This creates a moral hazard in which the institution is incentivized to take on large risks. (The institution benefits if things go well, while government pays if they don’t.) To mitigate this problem, “too big to fail” institutions are subject to various forms of monitoring (e.g., bank examinations, stress testing), restrictions on activities (e.g., proprietary trading limits), and capital requirements.
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General bond pricing formula:[pic 3]
Special case of annual coupons in which dj = 1/(1+r)j[pic 4]
Bond price / yield relation (m is coupon freq., i is annualized yield, T is maturity in years)[pic 5]
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