Money, Banking, and Financial Markets in the Concept of Money Demand - Assignment Example

Money, Banking, and Financial Markets Answer In the Keynesian theory of money demand, Keynes d that demand for money depends on interest and income. Money is held by an individual to facilitate normal transactions and to serve as a precaution for unexpected contingencies that may take place in the future. But for the fulfillment of both of these motives, demand for money depends on income. People also prefer to hold money as an asset for speculative purposes. The speculation depends on the interest rates and income since they are volatile in nature. For example, people hold more money when they expect a fall in bond price which will result in negative income, so as to meet the contingencies that would be arising at that point of time. Since demand for money varies with interest rates, velocity also changes with changes in interest rates. Demand for money also depends upon the expectations about future interest rates. In an article published in The Globe and Mail on July 31, 2013, the author, Linda Stern, suggested to ignore advice such as “Don’t take a mortgage with you in retirement”, and “Older Folks should invest more conservatively” (Stern). In support to the view “Don’t take a mortgage with you in retirement”, it is stated in the article that carrying forward mortgages over a long period of time not only increases the risk of investment but also involves a greater expenditure on the side of the loan taker. Carrying a mortgage over a long period increases its value and interest, so it is advisable not to use a large amount when paying mortgages and instead to invest that extra amount in some other investment plans which may be beneficial in the long run. Earlier payment of mortgages is related to the emotions of the loan-taker, reduces the risk and leads to savings due to lower interest payments. Ignoring the advice may be risky, but it may bring greater potential and stronger chance of capitalization since no one is aware of the opportunities that may come in the future. The situation will be more understandable from the following example. A person has $100,000 in cash and a 15-year mortgage with a balance of $100,000 at 4% interest. Case 1: The person decides to pay off his mortgage with the available cash and to invest the mortgage payment that would have to be paid per month (i.e. $739) for 15years at 7%. By paying the mortgage, the person saves %33,143, and at the end of 15 years investment amounts to $237,706. Case 2: The person decides not to pay the mortgage and invest cash of $100,000 for 15 years at 7% interest. After 15 years, the investment amounts to $284,894, and $33,143 are paid as interest for the mortgage. Subtracting the payment, a net gain of $251,751 is made by the person, if he/she decides to pay off the mortgage later. On deciding to pay off the mortgage, the person has received an emotional satisfaction, less risk and higher liquidity, but he/she has also suffered an opportunity loss of $14,045. Thus, every financial investment and debt is added to a price and risk, but decision is to be taken wisely. In support to the view “Older Folks should invest more conservatively”, it is stated in the article that when a person moves towards old age, he/she should either invest less in stocks or withdraw all money from stocks and invest in instruments which will guarantee returns with less amount of risk involved. They may choose to invest in certificate of deposits or bonds. Investment on guaranteed returns for short term may hold a support to the person at the time of retirement since it would assure a return at the end of the period. But ignoring the advice, it can be said that investment in bonds too can be a risky investment to the investor since future can only be assumed and not ascertained. If the interest rate rises in future, the bond holders may lose value, and investment will become riskier. Even with the rise in the expected rate of inflation the investor may face the same risk. Thus, the person may face the same risk with investment in guaranteed returns that he/she may face on investment in stocks. Therefore, every financial investment bears risks, so decision depends on the investor. Some persons at old age support long-term investment and some support short-term investment. This too depends on the availability of wealth, liquidity of investment, and the motive behind the investment by the investor. Answer 2 The financial crisis that took place in 2007-2009 was also known as the Global Financial Crisis and is considered by economists to be the most terrible financial crisis since the Great Depression of 1930. Prior to the crisis, the United States and other advanced countries of the world experienced an upward trend in the prices of real estates, which was particularly well felt in the residential property markets. This boom was worsened by the financial institutions (FIs) which exploited the loopholes in the capital regulation by allowing the banks to increase leverage while maintaining the capital requirements. The FIs did it by moving assets off-balance sheet to special purpose vehicles (SPVs) with weak capital standards and by funding themselves with short-term and in wholesale markets in spite of traditional deposits. These SPVs were used to invest in illiquid and risky assets and were funded in wholesale markets without the support of adequate capital. The growing significance of the shadow banking system, which was highly dependent on short-term finance, was a key contributor to the asset price bubble. Increase in the prices of assets led to a leverage cycle, which led to increase in debt. The household sector was affected in a similar way and led to the increase in household wealth due to rise in home values, which further led to increase in leverage. The rise in the asset was also due to the sub-prime mortgage credits in US which started in 2002 and reached its peak in 2006. The financial crisis triggered in the first quarter of 2006, when the housing market turned. A number of sub-prime mortgages were designed with balloon interest payments with an implication that within a short period the mortgage will be refinanced so as to avoid a change in its rate. During mortgage refinancing, it was assumed that home prices would continue to increase in the future. This led to the collapse of the housing market, which also affected the subprime area. The first signs of financial distress were noticed in 2007, when US faced losses from subprime loan originators and institutions that were holding derivatives of securitized subprime mortgages. Later in 2007, these signs turned into global financial distress. The causes led by weak financial regulation and supervision, which played a major role in contributing to the credit and financial crunch in the financial crisis of 2007-2009, are as follows: Encouragement of home ownership by the US government and political interference. Providing an easier access to loans to sub-prime borrowers. The bundled sub-prime mortgages were overvalued with an expectation that housing prices would continue to increase. Questionable and unregulated trading practices both on the part of buyers and sellers. Compensating structures that hold the significance of short-term value creation with long-term value creation. Banks and insurance companies lacking in the adequate amount of capital holdings that they should hold so as to support the financial commitments that they were entering into. Answer 3 (a) The Assets and Liabilities position of First Bank is: The bank decides to sell $10million of its fixed assets and replace it with $10million rate sensitive assets. Now the assets and liabilities position of the bank will be: Therefore, GAP= Rate Sensitive assets - Rate Sensitive Liabilities Or, GAP= 30-50= -20 ?Income = GAP * ?i Or, ?Income = -20*0.10= $-2m If interest rates fall by 3-percentage points in the next year, then, by using the formula ?Income = GAP * ?i, ?Income will be: ?Income = =-20*-0.03 = $0.6m Therefore, as rate sensitive assets are less than rate sensitive liabilities, so with decrease in interest rates the income will improve and be positive, which will also lead to improvement in the profits next year. Answer 3 (b) If a financial institution or a bank has greater rate-sensitive liabilities than its rate-sensitive assets, then, on rise in the interest rates, the net margin interest and income would decrease. On the other hand, if a financial institution or a bank has greater rate-sensitive assets than rate-sensitive liabilities, then, on rise in interest rates, the net margin interest and income would rise. Rate-sensitive assets of First Bank are $20million, which is less than its rate-sensitive liabilities, i.e. $50million. Thus the bank will be subject to reduced interest rate margin and income with rise in interest rates, as the gap arising due to difference in rate-sensitive assets and rate-sensitive liabilities would be negative. This will also expose the bank to interest rate risk since the bank has to pay more than it receives from its assets. At any point of time, if the bank suffers liquidity problem because of rise in interest rates, the bank will be exposed to interest rate risks. The bank decides to convert $5million of its fixed rate assets into rate sensitive assets. This would lead to decrease in gap as rate-sensitive assets will increase. With increase in the rate-sensitive assets by $5million, the bank will be able to reduce the interest rate risk to some extent as income, but not fully because even under this situation rate sensitive liabilities will be more than rate-sensitive assets. With this decision of the bank, there will be a possibility of increase in income as compared to the earlier situation with increase in interest rates. Answer 3 (c) As the value of rate-sensitive assets is more than the rate sensitive liabilities, so with increase in interest rates by 2%, the net interest margin and income will fall. The value of fixed rate assets will not be highly affected by the increase in interest rate by 2%, but rate sensitive assets will be highly affected as the change in their value is very sensitive to change in the interest rate. The percentage change in the market value of the assets can be calculated as follows: %?P = - DUR x [?i / (1+i)] Where, P = the market value %?P = the percentage change in market value, that can be depicted by (Pt+1 – Pt)/P. DUR= Duration i= interest rate Or, %?P= -2*(0.02/ (1+0.1)) Or, %?P= -3.6364 Therefore, from the above it can be said that if the interest rate increases by 2 percentage points, the market value of bank assets will decrease by 3.64%. Answer 4) It is often seen that at the time of expiry date of a futures contract, the price of contract almost approximately equals the price of the underlying asset which is to be delivered after the maturity of the contract. This phenomenon can be understood after discussing the significance of ‘basis’ in futures contract, and the same can be explained with the concept of cost-of-carry model and arbitrage. The ‘basis’ of futures is defined as the difference between the future price and the spot price of an asset. The value of basis will be different for each delivery month for the contract. In normal market conditions, the futures price exceeds the spot price, and hence the basis will be positive. As the maturity approaches, the difference between future and spot price gradually diminishes. This can be explained from the cost-of-carry model. The cost-of-carry model clearly defines the relationship between the related spot price and the futures price. As a futures contract nears expiration, the basis reduces to zero. This means that there is a convergence of the futures price to the price of the underlying asset. This happens because if the futures price is above the spot price during the delivery period, it provides clear arbitrage opportunity. In case of such arbitrage, the trader can shorten his futures contract, buy the asset from the spot market, and make the delivery. This will lead to a profit equal to the difference between the futures price and spot price. As traders starts taking advantage of this opportunity for arbitrage, the demand for the contract raise leading to fall of futures prices and gradual convergence of the spot price with future price (Fig. 1). Fig. 1. Convergence of price of contract and price of underlying If the futures price is below the spot price during the delivery period, all the parties interested in buying the asset will take a long position. The trader would buy the contract and sell the asset in the spot market making a profit equal to the difference between the future price and the spot price. As more traders take a long position, the demand for the particular asset would increase and the futures price would rise nullifying the arbitrage opportunity. As the date of expiry comes near, the basis value declines, and there is a convergence of the spot price towards futures price. On the expiry date, the value of basis is zero. If it is not so, then there will be an arbitrage opportunity, as explained earlier. Arbitrage opportunities can also arise when the spreads (difference between two future prices of contracts) or the basis (difference between futures and spot price) during the tenure of a contract are not same. Answer 5 (a) The overnight rates are, basically, the rate at which large banks lend and borrow from one another in overnight market. The central bank also plays a key role in overnight transactions by lending and borrowing money with a group of banks. Such strategy of the central bank to participate in overnight transactions helps it to manage monetary policy. The bank rate is often an upper limit for overnight rate because it indicates the central bank’s eagerness to let commercial banks determine the amount of borrowing from it and, hence, influence the demand for money in the economy by changing the monetary base. The bank’s discount rate is also the target for overnight rate for maintaining reserves. This target rate or the upper limit determines the rate at which banks can borrow from each other. Any announced alterations to these rates will indicate the economy’s future course of monetary policy. The overnight rate is a very important indicator and a measure for economy’s prevailing liquidity condition. If the bank rate somehow exceeds the upper limit of overnight rates, there will be liquidity crunch in the economy due to lack of confidence among banks to lend money to each other. Such conditions will result into a similar scenario as the one experienced from the 2008 liquidity crunch. Hence, from the above discussion, it can be said that in order to avoid tightness of liquidity in the economy, the bank rate is set as the upper limit for overnight rate (Handa, p.349). Answer 5 (b) Overnight rates are the rates at which participants lend and borrow overnight funds in the money markets. It is also treated as reference rate that signals monetary policy stance by announcement of target overnight interest rate (Fig. 2). Fig. 2. Operating band of overnight rates The objective of the bank is to maintain the overnight rate within the band of 50 basis points. The bank rate minus 50 basis points is chosen as the lower limit of overnight rate so as to influence indirectly other short-term interest rates. The decision to keep operating band was primarily in response to subprime financial crisis. The operating bank of upper limit as bank rate and lower limit of bank rate minus 50 basis points help the central bank to influence the movement of market securities that depends on overnight funds. Other factors like exchange rates, changing expectations, market demand, liquidity, etc., influence economic and monetary policy of the system. A lower limit ensures control over liquidity in the market, and at the end of every working day, the LVTS participants’ settlement balance with bank approximately equals to zero. Works Cited Stern, Linda. “Popular financial advice that might be best to ignore.” The Globe and Mail. The Globe and Mail Inc., 31 July 2013. Web. 9 Aug. 2013. . Handa, Jagdish. Monetary Economics. New York: Routledge, 2008. Print. Read More