Contemporary Issues in Banking and Finance

SECTION A
1. (a) Does the quantity of reserves constrain the ability of the banking system to engage in
new lending?
(9 marks)
(b) Explain how a “corridor” system was used by central banks to influence short term
money market rates in the pre-2008 period.
(9 marks)
(c) Explain how quantitative easing can increase both the volume of reserves and the
volume of retail deposits.
(8 marks)
(d) How is monetary policy enacted in the post-QE period?
(8 marks)
2. (a) Explain the main elements of the New Consensus approach to monetary
macroeconomics.
(16 marks)
(b) Identify the strengths and weakness of this approach.
(6 marks)
(c) How should central banks respond to the coronavirus crisis?
(12 marks)
3
3. A bank offers savings accounts with a rate of interest r1, of 0.5% per annum, on balances held
for one year, and a rate r2, of 1% per annum, compounded annually, for balances held for two
years.
(a) If you deposit £500 today, what will you receive:
i. after one year?
(2 marks)
ii. after two years?
(2 marks)
(b) How much do you need to deposit today to receive £500,
i. after one year?
(3 marks)
ii. after two years?
(3 marks)
(c) Consider a riskless two-year bond that pays coupons of C at the end of each year and
repays par value of F. Write down a formula for the price this bond should trade at in an
efficient market.
(4 marks)
(d) If you face a choice between the bank deposits listed above, and a bond that pays
3% of face value annually, how much should you pay for:
i. A bond that matures in one year with par value of £500?
(3 marks)
ii. A bond that matures in two years with par value of £500?
(3 marks)
(e) What are the factors that determine the shape of the yield curve on debt
instruments?
(9 marks)
(f) Under what conditions would the yield curve become inverted?
(5 marks)
4
SECTION B
4. (a) A firm has 1,000,000 shares outstanding and net income of £400 million. In the
coming year, you expect the firm to pay out half its net income as dividends. You expect to be
able to sell a share in the company for £900 at the end of the year.
(i) If you require a return on equity of 12%, how much will you be willing to pay
for a share in the company?
(5 marks)
(ii) Now assume that you expect to hold this stock for the rest of your life and
that you expect the dividends paid by the stock to grow at a rate of 4% every year. (You
continue to require a return on equity of 12%.) How much will you be willing to pay for a share
in the company?
(5 marks)
(b) Explain what the Efficient Markets Hypothesis is and how the analysis in (a) is related
to it.
(11 marks)
(c) What is Prospect Theory? Explain the theory clearly and be sure to address loss
aversion, the certainty effect, and the possibility effect.
(12 marks)
5. (a) Suppose that in 2020 the expected inflows of firm X that produces investment goods
are £100,000, X’s short-term debt is £60,000 and will accrue interest over the year at 4%, X has
£800,000 in long-term debt bearing an interest rate of 5% per annum. No long-term debt
matures this year. All the long-term debt matures in 2023. For this year, 2020, what is the
finance regime of this firm according to Minsky’s classifications? Explain your answer clearly.
(10 marks)
(b) Discuss the finance regimes defined by Minsky, and use them to explain the financial
instability hypothesis.
(10 marks)
(c) Explain clearly how the Financial Instability Hypothesis can be viewed as a critique of
the Efficient Markets Hypothesis.
(13 marks)
5
6. (a) Explain the distinction between gross and net cross-border financial flows.
(6 marks)
(b) Explain the relationship between a country’s current account position and the
financial flows in and out of that country.
(8 marks)
(c) What role did cross-border financial flows play in generating the 2008 financial crisis?
(13 marks)
(d) What issues do cross-border financial flows currently pose for policy-makers?
(6 marks)
7. (a) Assume that a loan with a value of £200,000 is used as collateral for a repo. The
haircut on the repo is 15% and the interest rate is 10%. How much money is borrowed by the
repo borrower? When the repo is paid back, how much money is paid back?
(7 marks)
(b) Discuss how loans are packaged together and sold as securities. Explain the process
in detail.
(10 marks)
(c) What is the “shadow banking” system?
(7 marks)
(d) What is the Bagehot Rule?
(4 marks)
(e) How should the Bagehot Rule be adjusted to account for the widespread use of
securitised lending

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