STUDENT NAME : LINDIWE L MPUNZI

STUDENT NUMBER : L0212489S

MODE OF STUDY : CONVENTIONAL

A. Illustrate and thoroughly explain how a business cycle expansion
(accompanied by expansionary fiscal policy) would affect interest rates
on short term government bonds. Assuming a constant expected return
on the overall stock market (and constant β), predict the impact on the
required return on a risky stock or portfolio based on the CAPM. (8 marks)
Fiscal policy affects the exchange rate and the trade balance in an economy. In the
case of a fiscal expansion, the rise in interest rates attracts foreign capital. Thos is due
to government borrowing. Foreigners bid up the price of the dollar, causing an
exchange-rate appreciation in the short run just to get more dollars. This appreciation
makes imported goods cheaper in the United States and exports more expensive
abroad, leading to a decline of the merchandise trade balance. When the government
runs a deficit, it meets some of its expenses by issuing bonds.

B. While inflation has been declining over the past year, as the economy
begins to accelerate out of the business cycle trough, bond traders will
expect rising inflation over the next few years. Using your answer to the
question above, and a model of the term structure of interest rates,
explain how the business cycle expansion accompanied by expectations
of rising inflation will affect interest rates on intermediate and longer
term government bonds (9 marks)
In their attempt to get more dollars to invest, foreigners bid up the price of the dollar,
causing an exchange-rate appreciation in the short run. Expansionary fiscal policy will
lead to higher output today, but will lower the natural rate of output below what it
would have been in the future. Similarly, contractionary fiscal policy, though dampening
the output level in the short run, will lead to higher output in the future.
Given your answers to questions 1 and 2 above, explain the interest rate risk
faced by a bank. How would you hedge against such interest rate risk using
financial futures? How would you hedge against this risk using options?
Which method would you recommend? Why? (8 marks) Interest rate risks is
when interest rates rise above the rate locked in at the time of purchase, the bond’s
price falls. Banks are more exposed if they are heavily involved in investing in capital
markets or sales and trading. If interest rates fall, futures prices will rise, so buy futures
contracts now (at the relatively low price) and sell later (at the higher price). The gain
on futures can be used to offset the lower interest earned. For example, a business that
has borrowed funds can hedge against rising interest rates by selling a bond futures
contract. Then, if interest rates do in fact rise, the resulting gain on the contract will
offset the higher interest rate that the borrower is paying. Options trading offers a
convenient way to hedge their portfolio against sudden price declines. By investing in
long-term put options, a trader can reduce their risk exposure and ensure that they can
still sell their assets at a satisfactory price, even if the market moves against them
Using futures is the best because futures have several advantages over options in the
sense that they are often easier to understand and value, have greater margin use, and
are often more liquid.

QUESTION 2
Over the past year and a half, banks, hedge funds, and investment bank have written
off billions or trillions in bad loans. Like many other financial crises, the current crisis
started with a significant increase in lending using a relatively new lending channel
securitized mortgage loans made by non-banks with little or no regulatory oversight.
The Federal Reserve has attempted to calm markets by increasing liquidity and serving
as a lender of last resort. And the U.S. government has “rescued” Fannie Mae and
Freddie Mac along with AIG and numerous investment banks, commercial banks, and
now possibly the big three automakers. Provide a detailed explanation of the causes
and consequences of the current US financial crisis. Be sure to address at least the
following topics and to use equations, graphs and models where necessary:
i. The role of asymmetric information and regulation in the current crisis.
(5marks)
Asymmetric information is a term that refers to when one party in a transaction is in
possession of more information than the other. For example accountants and bankers.
In certain transactions, sellers can take advantage of buyers because asymmetric
information exists whereby the seller has more knowledge of the good being sold than
the buyer It results in increasing knowledge between experts in specialized field. Lastly
it is healthy for an economy since it helps in increasing the efficiency of the economy.
C.

ii. Why did a credit crunch emerge? (7marks)

A credit crunch is an economic condition in which investment capital is hard to secure.
Banks and other traditional financial institutions become wary of lending funds to
individuals and corporations as they are afraid that the borrowers will default. This
causes interest rates to rise as a way to compensate the lender for taking on the
additional risk.

Sometimes called a credit squeeze or credit crisis, a credit crunch tends to occur
independently of a sudden change in interest rates. Individuals and businesses that
could formerly obtain loans to finance major purchases or expand operations suddenly
find themselves unable to acquire such funds. The ensuing ripple effect can be felt
throughout the entire economy, as home-ownership rates drop and businesses are
forced to cut back due to a dearth of capital.
A credit crunch often follows a period in which lenders are overly lenient in offering
credit. Loans are advanced to borrowers with questionable ability to repay, and, as a
result, the default rate and presence of bad debt begin to rise. In extreme cases, such
as the 2008 financial crisis, the rate of bad debt becomes so high that many banks
become insolvent and must shut their doors or rely on a government bailout to
continue.
The fallout from such a crisis can cause the pendulum to swing in the opposite
direction. Fearful of getting burned again by defaults, banks curtail lending activity and
seek out only borrowers with pristine credit who present the lowest possible risk. Such
behavior by lenders is known as a flight to quality. The usual consequence of a credit
crunch is a prolonged recession, or slower recovery, which occurs as a result of the
shrinking credit supply.

In addition to tightening credit standards, lenders may increase interest rates during a
credit crunch to earn greater revenues from the reduced number of customers who are
able to borrow. Increased borrowing costs hinder an individual's ability to spend money
in the economy, and it eats into business capital that could otherwise be used to grow
operations and hire workers.

For some businesses and consumers, the effects of a credit crunch are worse than an
increase in the cost of capital. Businesses unable to borrow funds at all face trouble
growing or expanding and, for some, remaining in business becomes a challenge. As
businesses scale back operations and trim their workforce, productivity declines and
unemployment rises, two leading indicators of a worsening recession.

iii. A well-designed bailout plan is wise policy and can improve welfare not only after a
financial shock happens but before it does. Bailouts “alleviate the under capitalization of
firms during a financial crisis” and speed economic recovery. Thus, “bailouts constitute
a powerful stabilizing force ex post, yet generate modest moral hazard effects when
appropriately designed.

iv. What steps should be taken to prevent the next financial crisis?
To prevent a future financial crisis, there must be increases in collateral requirements
for globally traded financial products, irrespective of the financial institutions making the
trades .employing asset managers to buy toxic real estate securities and making bank
equity purchases.

To establish an agreed European supervisory approach that not only focuses on

individual institutions, but also takes a macro-prudential view, by considering the
financial system as a whole.
References
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 EBRD Working Paper No. 169. J. Bos, R. De Haas and M. Millone (2015) “Sharing
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 Evans, Michael. Practical Business Forecasting. Hoboken, NJ: John Wiley and
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 https://www.accountingtools.com/articles/interest-rate-futures
 https://www.econlib.org/library/Enc/FiscalPolicy.html