Transcript Multiple Choice Tutorial Chapter 33 International Trade

Tutorial
Chapter 12
The Financial Crises
2007-2008
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1. A derivative is
a. the type of stock that pays dividends.
b. a bond that has value derived from the profits
of a government or a corporation.
c. a financial instrument whose value is derived
from tax revenues.
d. a financial product whose value is derived
from the price of something else.
D. The word derivative comes from the word derived,
the value is derived from some other event. For
example, you and I make a bet on the weather next
Monday, if I am correct you owe me $100, if you are
correct I owe you $100. So this contract has value
because of an event that will take place next Monday.
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2. A derivative is simply an agreement between two
parties betting on some outcome that will occur in
the future, the agreement is binding and cannot
be transferred to a third party.
False
Derivative contracts can be bought and sold
multiple times before the strike date, the
date the agreement becomes binding.
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3. Because no one can accurately predict the
future and with so many uncertainties, the
buyers and sellers of derivatives would often
rely on some complicated mathematical
model to determine future value.
True
Because the value of derivative contracts
depend on some future event, and because no
one can for certain predict the future,
participants in this market often relied on
some formula derived by mathematical
wizards called Quants, like the Black Scholes
Formula, to base their predictions on.
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4. In 1996, Bankers Trust settled with Proctor
and Gamble, forgiving most of the $200
billion lost in the derivatives market.
True
In 1994 the Federal Reserve raised interest rates,
an invent that caused Proctor and Gamble to
lose on a derivative bet. Proctor and Gambles
losses mounted as the Fed raised interest rates
several more times. To avoid a legal lawsuit
and bad publicity, Bankers Trust decided to
take the loss instead of Proctor and Gamble.
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5. An over-the-counter derivatives market is a
market where
a. only the two parties are privy to the facts of
the contract.
b. the participants have to divulge extensive
financial data to that the investors know what
they are investing their money.
c. both stocks and bonds are bought and sold.
d. only the very wealthy can participate.
A. An over the counter market is a market void
of an exchange whereby participants divulge
financial information so that investors can
make informed decisions. With an over-thecounter market there is no way of knowing the
facts except what the seller wishes to divulge.
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6. Congress passed the Commodity Futures
Modernization Act of 2000, which stripped the
Commodity Futures Trading Commission of all
responsibility over the derivatives market and
forbade the SEC from interfering with over-thecounter derivatives.
True
The Commodity Futures Modernization Act of
2000 closed the door to any government
oversight of the derivatives market.
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7. A subprime mortgage is a mortgage made to
persons with poor credit histories.
True
A prime loan is a loan made to credit worthy individuals.
Subprime loans are more risky due to the poor credit
histories of the people the loans are given to.
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8. Fannie Mae and Freddie Mac are two government
agencies who make mortgage loans.
False
Fan and Fred do not make loans, they purchase
mortgage loans from banks. The purpose is to
increase the flow of funds in the mortgage market.
Instead of a bank receiving monthly payments over
a long time period, they could get their money right
away and thus have more cash to relend.
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9. Prior to 1992, the government required Fannie
Mae and Freddie Mac to buy only prime
mortgages. After 1992, Congress required Fan
and Fred to purchase subprime loans as well.
True
Congress was eager to make almost everyone in
American a home owner. Thus they pressured Fan
and Fred to make more subprime loans to qualify
more people for mortgage loans. In turn, banks
came up with ingenious, and sometimes fraudulent,
ways to convince people to borrow money.
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10. The practice of hedging one’s exposure to
risk goes back hundreds, if not thousands of
years, whereby farmers would hedge against
possible future losses.
True
The practice of hedging is a sound business practice
and has a lot more to do with stability than it does
with gambling. Farmers will enter into a futures
contract with someone by agreeing to sell their
produce at a certain price (called the strike price)
in the future regardless of what happens in the
market. In this fashion the farmer is protected
from the vagaries of the market. At times the
strike price is lower than the market price and at
other times it can be higher than the market price.
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11. A hedge is a position established in one
market in an attempt to offset exposure in
price fluctuations in another market.
True
Just as farmers use hedging to stabilize events, hedge
funds (investment companies) will play off one
possible scenario against another to protect
themselves from any sudden market changes. Just
like with the farmer, the main objective is stability.
A key element in successful investing to avoid
losses. Goldman Sachs Group, Inc. makes
investments in things where profit is a certainty.
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12. When Brooksley Born was investigating the
derivatives market as head of the Commodities
Futures Trading Commission
a. there were some spectacular failures by entities
that were speculating with little restraint.
b. almost no one in government were familiar
with derivatives.
c. all the biggest banks were dealers in the
derivatives market.
d. all of the above.
D. Despite the enormity of the derivatives problem all
the big players in government and banks vilified her
for her attempt to rein in the excess of this market.
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13. Basically Allen Greenspan, the Chairman of the
Federal Reserve before the financial crises of 2007
– 2008, believed that
a. greed is so strong in human nature that it is
necessary to regulate markets.
b. the market can solve all problems.
c. a centrally controlled economy would be the
most efficient economic system.
d. big business is at the root of most of our
economic problems.
B. He believed in totally free markets void of
any government restrictions or regulation.
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14. Let’s suppose you are a farmer and you want to
protect yourself from the uncertainties of the market.
To add an element of certainty to your business you
enter into a ______ _______ with a bank.
a. futures contract
b. balloon payment
c. vertical contract
A. A futures contract is a way to hedge your bets on
some future event. In this case the farmer would
agree to sell his crop for a set price on some date
in the future. If the market price is greater than
the agreed upon price the farmer makes less
money than without the contract, and vice versa.
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15. By 2007 Long Term Capital, a hedge fund, had
highly leveraged its bets. This means that Long
Term Capital
a. never took risks.
b. had deep pockets.
c. made risky bets with borrowed money.
d. was very careful with its money.
C. To be highly leveraged means that you put at risk a
huge amount of money but only have a small
amount of money on hand to back up any bad bets.
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16. What is a hedge fund?
a. An investment fund opened to a limited range
of investors, professionals and wealthy people.
b. A retirement fund like a teachers union.
c. A federal bond that protects people from
inflation.
d. A financial instrument that offers high
returns in the bond market.
A. A hedge fund attempts to establish a position on one
market to offset price fluctuations in another market.
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17. What was the purpose of the Commodity Futures
Trading Act of 2000?
a. To give the Commodity Futures Trading Commission
a free hand to regulate the derivatives market.
b. Stripped the CFTC of all responsibility over the
derivatives market.
c. Banned states from interfering with the derivatives
market.
d. Both b and c are answers.
D. The CFTA gave banks total freedom in the derivatives
market, which is today a $600 trillion market.
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18. Many events transpired between 2000 and 2010
which greatly aggravated the financial melt
down. Which of the following events transpired?
a. The government took no action to regulate
the market.
b. Wall Street firms were showering
Washington with $1.7 billion in campaign
contributions and $3.4 billion on lobbyists.
c. The practice of rent seeking was excessive.
d. all of the above.
D. Self explanatory
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19. What was the purpose of the GlassSteagall Act of 1932?
a. This act gave banks more opportunities
to invest in the derivatives market.
b. This act merged investment banks with
commercial banks.
c. This act separated commercial banks
from investment banks.
C. One of the causes of the Great Depression of the 1930s
was that banks were taking depositors money and putting
the money in highly leveraged and risky investments.
This act prevented this practice by commercial banks but
allowed investment banks a free hand.
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20. What was the Financial Services Modernization Act
of 1999? This act
a. gave more teeth to the Glass-Steagall Act of 1932.
b. made it so that banks could participate in the
derivatives market the same as investment banks.
c. Allowed commercial banks to take depositors
money and put it at great risk, similar to the way
they did leading up to the Great Depression of the
1930s.
C. Both b and c are answers. The FSMA obliterated the
safety measures of the Glass-Steagall Act of 1932.
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21. In its simplest form the credit default swap
(CDS) is a bet on a future outcome. The party that
bets correctly makes a profit and the party the
bets incorrectly suffers a loss.
True
A credit default swap is what is says, it swaps the
risk of default from one party to another. It is
like insurance. The purchaser of the CDS pays
the seller money in the event of a default on
stipulated investments. If no default occurs,
the seller keeps the money. If a default does
occur, the seller makes good on the money that
was owed to the purchaser of the CDS.
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22. With a debt to capital ratio of 40 to 1 in 2007, when
the economy went south, this excessive leverage led
to the collapse of all five investment banks.
True
A debt to capital ratio of 40 to 1 means that an
investment bank could lend out $40 with only
$1 in reserve against the $40. This excessive
leverage enabled these firms to make excessive
profits when times were good, but when the
economy slumped, losses were magnified.
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23. We experienced a big mortgage problem starting
in 2007 partly because of the abundance of
adjustable rate mortgages and the proliferation of
Alt-A, sometimes called Liar Loans.
True
When mortgage lending companies made it easy to
obtain a mortgage with very generous terms in the
early years of the loan, many people flocked to take
out mortgages. But the terms worked against them
soon after as the interest rate increased. When banks
added the feature of letting people borrow money
with no due diligence by the banks, millions of
people were trapped in loans they could not afford.
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24. A collateralized debt obligation (CDO) is a type
of structured asset backed by security whose
value and payments are derived from a portfolio
of fixed income assets.
True
A CDO is a collection of debts, like mortgages,
whereby payments are made from this income
stream to purchasers of the CDO. It is like the
CDO is a pizza and the pizza is divided into
pieces. Instead of purchasing the whole pizza,
people can purchase just a slice of the pizza.
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25. A collateralized debt obligation (CDO) is a
financial instrument that pools loans together and
divides them into different risk classes, called
tranches, whereby the senior tranches were
considered the safest and the junior tranches were
considered the most risky.
True
The senior tranches paid out less than the junior
tranches because there was less risk to the buyer. The
junior tranches paid out a higher return to
compensate the purchaser for the higher risk of loss.
However, when the CDO experienced losses due to
people not making their payments, like on a
mortgage, the investors who bought from the junior
tranches were the first who experienced losses.
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26. It was Executive Order 11,110 of President
Kennedy in the 1969’s that repealed the GlassSteagall Act.
False
The Gramm-Leach Bliley Act of 1999 repealed the GlassSteagall Act, thus eliminating the divide between
commercial banks and investment banks. Executive
Order 11,110 of 1963 gave the U.S. Treasury the
explicit order to “issue silver certificates against any
silver bullion in the Treasury,” thus replacing real
money with the fiat currency of a federal reserve note.
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27. It was Executive Order 11,110 of President
Kennedy in the 1969’s that repealed the GlassSteagall Act.
False
The Gramm-Leach Bliley Act of 1999 repealed the GlassSteagall Act, thus eliminating the divide between
commercial banks and investment banks. Executive
Order 11,110 of 1963 gave the U.S. Treasury the
explicit order to “issue silver certificates against any
silver bullion in the Treasury,” thus replacing real
money with the fiat currency of a federal reserve note.
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