What Factors Caused the Global Financial Crisis - Assignment Example

Student’s Name: Institution: Date: FIN2000 ASSIGNMENT Q1. What factors caused the Global Financial Crisis? Describe three factors in detail. Most expert in finance matters blame government’s policy on housing regulation for Global Financial Crisis (Chwieroth, 2011). Through its agencies, the government came up with an idea of increasing home-ownership by advancing affordable loans. Prospective homeowners applied for mortgages in large number. Note that high number of people who applied for mortgages at that period could afford to service the loan. After a merely one year, almost thirty million housing loans were outstanding. The government and its agencies owed almost twenty of these loans. Half of these mortgages were high-risk and significant number of them appears in government financial records. Since most mortgage holders were unable to service the loans, default rate became extremely high (Martin, 2011). It became impossible to collect the whole amount advance as credit and as a result, banks and other credit institutions suffered a great blow. Borrowers were not in position to repay the housing loans. When the banks lost their money, they were unable to advance further credit to deserving customers. Institutional lending became a major problem (Martin, 2011). In addition, inter-banks risk premium rose from insignificant rate to almost five percent hence making lending among banks expensive. This crippled operations of many institutions in all sectors of economy (Eichengreen, Mody, Nedeljkovic, & Sarno, 2012). This made the situation worse because most operations, both internal and external dealings paralyzed. This was because borrowing had actually stopped thus most businesses especially the ones that rely on credit could not operate. This affected economic activities in the whole world leading to public outcry. Q2. Describe two consequences of the Global Financial Crisis in details. When the borrower fails to adhere to the loan repayment terms, it is obvious they property is ceased to recover the money. During the Global financial crisis, most of borrowers who had applied for mortgages lost their properties including deposits they had initially made to the bank. On the other hand, the banks could not recover the whole amount (Rose, & Spiegel, 2012). This is because the property ceased from the borrower had less value at that time than the principal amount advanced and incurred expenses. In this case, both the bank and the borrowers suffered financial loss. As mentioned earlier, the banks could not continue lending money due to huge loss that had led to liquidity crisis. This situation is known as a credit crunch. Besides liquidity crisis in banking industry, the situation also led to collapse of housing sector and stock market. Note that many institutions were under struggle especially trying to fund their operations. This affected their revenue generating hence influencing their worth in stock market (Schwert, 2011). Most of them went below par, which led to partial suspension. This implied that they could not continue trading in stock exchange. This was the case with most giant institutions thus collapse of this crucial market. In addition, the housing sector, which relies mainly on bank credit stopped since there, no single bank could either afford or agree to engage in huge lending (Kamin, & DeMarco, 2012). Since real estate requires huge capital, most investors depend on bank loans and such was not available by then. Q3.Briefly describe how the Global Financial Crisis affected the banking sector in the U.S and Australia. Banking sector in the U.S was worst hit by the Global Financial Crisis than any other developed country. This is attributed to the role of banking sector in any development especially where financial commitment is needed. When most mortgage holders could not service their home loans, it was the banks that suffered (Martin, 2011). The loss scared away most investors and they started withdrawing their deposits. In addition, banks became less willing to lend among themselves since the risk and interest was virtually high. As a result, several major banking institutions were either acquired under duress or faced take-over from the government (Acharya, & Schnabl, 2010). Unlike the US and other developed economies, Australian banking sector was resilient enough to withstand negative effects of the Global Financial Crisis. Banking operations continued as usually and have recorded profits. As a matter of fact, there was no need for capital injection from the government thus demonstrating the strength of Australian economy (Beltratti, & Stulz, 2012). However, there was a slight depreciation of Australian dollar which affected the foreign exchange market. The government through Reserve Bank of Australia stepped in to salvage the situation by restoring the market liquidity. Q4. The Commonwealth Bank issues bonds on the capital markets to raise financing for its loans. a) How much financing will the Commonwealth Bank raise if it issues 500, 5 year bonds that pay an annual coupon of 6% and have a face value of $1000 if yields of bonds of similar risk and maturity are 7%? Answer: a) The general formula applicable in bond valuation is Where: B0 = current value of the bond (at time zero). I = annual interest paid in dollars (coupon interest x face value) n = number of years to maturity M = par value (face value) in shillings = required return on a bond I = par value x coupon rate = 1000*6% = $60 M = 1000 kd = 7% n = 5 years B0 = 60 x (PVIFA7%, 5yrs) + 1000x (PVIF7%, 5yrs) 60 x 3.145 + 1000 x 0.256 444.7 x 500 = $222,350 b) What will happen to the price of bonds in a) if in one year the credit rating of the Commonwealth Bank is increased from AA to AAA? Why? The price of bonds will not be affected by the increase in credit rates hence will remain constant. Any change in rates does not influence current prices although it affects future transactions. The changes in credit rating do not have retrogressive effect especially when the amount invested in high. This is done to avoid unnecessary risk on the part of the investor. In addition, the period of five years to maturity is short and in most cases, any foreseeable change is easily detected and considered during the transaction. 5. Apple Inc. (APPL share code) issues bank bills on the money market to raise Short-term financing for its operations a) How much financing would Apple raise if it issued a bank bill that has a maturity of 180 days, a face value of $50 million and was issued at a rate of 5%? The acceptance fee is 50 basis points. Solution: B0 = 1000/ (1.05)180/366 = 1000 (PVIF5%, 180/366yrs) = 1000 x 0.065 = $65. The company raises 65 dollars for financing its operations in this transaction. b) Do you think Apple Inc. should have issued a commercial paper rather than a bank bill? Explain why or why not. Apple Inc. should have issued a commercial paper rather than a bank bill. Issuance of commercial paper is among the most flexible methods of seeking short-term finance for the company. The process involved in issuing a bank bill is complicated and has higher cost in terms of interest rates and other operational costs. In this case, commercial paper could be better for such a short period of 180 days. The amount of financing needed could still be raised at lower cost than issuing a bank bill. 6. The ANZ Bank (Share code: ANZ.AX) expects to pay a dividend of $0.91 today and dividends are expected to grow at 6% forever. The required return on Commonwealth Bank shares is 9%. Based on this information would you buy the share today? (Base your answer on current market data for Commonwealth Bank shares) Solution: Where: D1 is the dividend for coming financial year Ks is the required return on the stock g is the growth rate in dividend 0.06 x 0.91 = 0.546 Dividend for coming financial year is 0.91 + 0.546 = $1.45 Dividend growth rate of 6% is good enough to push the value of the stock in the market. Constant growth in dividend implies that the stock will always improve in terms of trading price in the market floor. Any wise investor considers such aspect when buying the stocks. In this case, I would buy this stock today just to wait and earn attractive returns in future. In practice, any increase in dividends always influences the value of shares in stock market thus increasing the value of stock. This means that an investor is able to sell the same stock at a good profit coming years when the dividends are declared. References: Acharya, V. V., & Schnabl, P. (2010). Do Global Banks Spread Global Imbalances? Asset-Backed Commercial Paper during the Financial Crisis of 2007–09. IMF Economic Review, 58(1), 37-73. Beltratti, A., & Stulz, R. M. (2012). The credit crisis around the globe: Why did some banks perform better? Journal of Financial Economics, 105(1), 1-17. Chwieroth, J. (2011). The crisis in global finance: political economy perspectives on international financial regulatory change (No. 424). Academy of Korean Studies Press. Eichengreen, B., Mody, A., Nedeljkovic, M., & Sarno, L. (2012). How the subprime crisis went global: Evidence from bank credit default swap spreads. Journal of International Money and Finance, 31(5), 1299-1318. Kamin, S. B., & DeMarco, L. P. (2012). How did a domestic housing slump turn into a global financial crisis?. Journal of International Money and Finance, 31(1), 10-41. Martin, R. (2011). The local geographies of the financial crisis: from the housing bubble to economic recession and beyond. Journal of Economic Geography, 11(4), 587-618. Rose, A. K., & Spiegel, M. M. (2012). Cross-country causes and consequences of the 2008 crisis: early warning. Japan and the World Economy, 24(1), 1-16. Schwert, G. W. (2011). Stock volatility during the recent financial crisis. European Financial Management, 17(5), 789-805. Read More