Moral hazard occurs in bond markets by G1Z90h

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									                                                Monetary Analysis Take-Home Final 2009 Spring
                                                                                         Ball


1)

The Efficient Markets Hypothesis is a financial theory that states that all asset prices are equal to
the present value of their expected earnings. Expected earnings are assumed to be derived from
rational expectations; expectations that take into account all relevant public information
available. The implication of the efficient markets hypothesis is then that no stock is a better buy
than any other as they all have prices equal to the expected value of their future earnings. It is my
contention that the Efficient Markets Hypothesis (EMH) may not be 100% correct, but that it
is a good approximation to reality in financial markets. To prove my thesis I will first clarify
the type of evidence needed to support or contradict the Efficient Markets Hypothesis. I will then
offer theoretical and empirical evidence in support of the theory. Finally, I will address the major
arguments put forth against the Efficient Markets Hypothesis.

The Efficient Markets Hypothesis should be analyzed in two distinct parts; first independently as
a theory and then cohesively with its implication on financial markets. As a theory, the Efficient
Markets Hypothesis simply states that all assets prices reflect the present value of their expected
future earnings. The implication of this theory is then that no undervalued assets can exist in
markets by definition, as all assets are priced at a value equal to the present value of their future
streams of income. The next step can then be made to say that all asset prices must then follow a
“random walk” as their fluctuations are unpredictable. This then leads back to the implication
that no stock purchase is a better investment than any other. This fundamental understanding of
the Efficient Markets Hypothesis is crucial to being able to provide relevant evidence in support
or contradiction of the theory. As we now can see, the Efficient Markets Hypothesis is not saying
that in the future investors will not outperform each other and/or the market index. The Efficient
Markets Hypothesis is saying that no investor will able to do this consistently as his good or bad
fortunes are the products of “random walks” of stock prices and not due to any thing he has
direct control over. With this framework in place, let us evaluate the validity of the Efficient
Markets Hypothesis.

An important conceptual point to note about the Efficient Markets Hypothesis is that it is a self-
fulfilling prophecy. If you look closely at the Efficient Markets Hypothesis you will soon realize
that it relies on the very actions of investors that it would deem futile to hold true. To elucidate,
the Efficient Markets Hypothesis implies that searching for undervalued assets is a waste of time.
Yet this is only because the market is allegedly so efficient that prices adjust to new relevant
information almost instantaneously, incorporating the information into the price so quickly that
investors would not be able to profit. This efficiency however is the direct result of so many
investors, analysts, firms, and parties working actively to find undervalued assets. The Efficient
Market Hypothesis thus conveys that it is the sheer effort of investors to find under priced assets
that causes them to not exist in financial markets in the first place. This self-fulfilling nature of
the Efficient Markets Hypothesis subtly lies as one if its greatest attributes. For example, if
everyone believed the Efficient Markets Hypothesis it would no longer hold true. But more
importantly, if that were to occur then it would create a host of profit opportunities for investors.
This is because the market would become much less efficient with no one actively searching for
undervalued assets and as a result they would exist as prices would take time to adjust. Investors
seeing these profit opportunities would then act upon them until the Efficient Markets
Hypothesis again held. Logically, this is the outcome that will ultimately be reached by rational
investors and we see that today in financial markets. It is then a strength of the Efficient Markets
Hypothesis to be so entrenched in such basic economic actor incentives like wealth and profit
maximization. By working to maximize their own utilities (assuming more money equals more
utility), investors work towards an equilibrium where all investors are working against the
Efficient Market Hypothesis’s advice only to assure its validity. Though they vary in there
complexity and the assumptions they put on investors, game theoretic models can be used to
make this same point analytically by proving the existence of a convergence towards a
symmetric Nash equilibrium in financial markets where all investors would find it optimal to not
pay heed to the Efficient Markets Hypothesis.

Though the Efficient Market Hypothesis has an overwhelming amount of theoretical validity it
can also be confirmed empirically. Some of the most compelling data comes when one studies
the returns on two different kinds of funds, actively managed funds and index funds. Actively
managed funds employ analysts who research companies in an effort to pick the “good stocks.”
In contrast, an index fund simply buys all the stocks in a broad market index, such as the S&P
500. These index funds do not hire analysts to study companies and instead just hold all an
index’s stocks. Consequently, index funds hold onto their stocks and do not trade as often as
actively managed funds. Actively managed funds thus have higher fees than index funds as they
need to pay analysts and traders within the fund. On average, actively managed funds charge
shareholders 1 percent of their assets each year, while index funds charge around a quarter of a
percent each year. After these fees are accounted for, returns are likely to be higher for index
funds. The returns on mutual funds have also been studied by economists exclusively. These
results have also shown a strong trend of returns of index funds being higher than those of
actively managed mutual funds. To take a specific example, about 1300 actively managed stock
funds operated over within 1995 and 2005. If you were to average all these funds together you
would obtain a rate of return of 8.2%. In the same timeframe the return of the S&P 500 was 10%.
Of the individual mutual funds, only 15% had a higher return than the S& P 500 index, while
85% had a lower return. Taking this result and alluding back to the analysis presented in my
clarification of the Efficient Market Hypothesis (second paragraph) we can then see that even the
fact that 15% of the funds beat the S&P 500 does not contradict the Efficient Markets
Hypothesis. Again, this is because somebody always has to beat the market. New information
will always arise and some stocks will outperform others. Individuals or funds owning those
stocks will consequently have above average returns. But the key insight here is that this is
nothing more than good fortune as it is impossible to predict which mutual funds will beat the
market index. Research supporting this insight is also not hard to find. Various studies have
analyzed mutual funds that have had above-average returns for 1 to 5 years. These studies have
also overwhelmingly indicated that these mutual funds were not able to beat the index in
subsequent years. All in all, the Efficient Markets Hypothesis is confirmed empirically through a
host of different data sets and types of studies. The evidence has accrued so lob-sided to a point
where many academics in the field are saying that empirically there is a consensus that the
Efficient Markets Hypothesis is great approximation of how financial markets operate.
Up until this point I have presented hard empirical and theoretical evidence in support of the
Efficient Markets Hypothesis. However taking all that into account, it is also important to keep
in mind that the theory should not be taken as an absolute law. No market is perfect and
inefficiencies can exist. That said, these inefficiencies are rare and do not affect the Efficient
Markets Hypothesis’s ability to be a good approximation of reality in financial markets.
Dissenters of the Efficient Markets Hypothesis argue that some of these inefficiencies are
enough to invalidate the Efficient Markets Hypothesis. I will now address and refute some of
these popular arguments.

An often cited rebuttal to the Efficient Markets Hypothesis is that fast trading can beat the
market by exploiting the time lags of share prices incorporating new information. The Efficient
Markets Hypothesis assumes that asset prices adjust instantaneously to new information. In
reality, this process does take some time. Good news about a stock prompts buy orders, which in
turn raises ask prices as supply decreases and it is realized that there is a surge in demand. A lot
of times this process takes a matter of minutes or seconds. But there is a brief period of time
before the price rises where a stock may be undervalued. Investors can profit from this market
imperfection if they are able to trade fast enough. Large investment banks even have fast trading
departments that specialize in doing this. That said, the existence of a few small amount of
people profiting due to this market imperfection is not enough to invalidate the Efficient Markets
Hypothesis’s ability to approximate reality. The average investor does not have the ability to
trade in this manner and if he did the imperfection would no longer exist. This sets up a common
answer that can be applied to a lot of the nuances brought up by dissenters of the Efficient
Markets Hypothesis; a small market imperfection that only allows for a relatively small amount
of people to consistently beat the market is not enough to say that the Efficient Markets
Hypothesis is not a good approximation of reality in financial markets.

Another commonly referenced statement against the Efficient Markets Hypothesis is that a few
notorious stock pickers have proven themselves to be able to beat the market. Names that are
often referenced are Warren Buffet, Peter Lynch, and William Miller. These individuals have
been able to consistently beat the market to the point where the statistical chance of them having
beaten the market simply by luck is so low that it suggests that maybe a few exceptional
individuals are able to consistently beat the market and pick undervalued stocks. This market
imperfection is also not enough to dispute the Efficient Markets Hypothesis’s ability to serve as a
good approximation of financial markets. There are only a handful of these types of people in the
world and their collective impact does not significantly alter reality in financial markets.
Furthermore, it is important to note, that it can be argued that Buffet, Lynch, and Miller are the
anomalies. Most people cannot do what they have done in the past. A substantial amount of
evidence verifies this facet. If everyone could do what Warren Buffet has done then he would not
be Warren Buffet. His actions and those of geniuses like him are not good approximations of
reality in financial markets and thus should not be used to provide evidence against the Efficient
Market Hypothesis’s ability to approximate reality in financial markets.


The last major argument offered against the validity of the Efficient Markets Hypothesis comes
from the field of behavioral finance. Behaviorists argue that investors, being human, deviate
from rational behavior consistently and this leads to inefficiencies in financial markets. There are
many behavioral theories. The most well-known are anchoring forecasts, irrational exuberance,
and cognitive biases. Anchoring forecasts refers to the investor behavior of being reluctant to
change your opinion. Irrational exuberance refers to the behavior ascribed to investors during
asset bubbles, in which they irrationally overvalue an asset. Cognitive biases refer to behaviors
such as overconfidence and overreaction. My first response to these behaviorists’ theories is that
they do not necessarily contradict the Efficient Markets Hypothesis. The Efficient Markets
Hypothesis says that asset prices are equal to their future expected cash flows. If enough
investors taking into account all relevant information have “irrational” future expectations about
an asset’s price then that just means the majority of investors had poor expectations. Secondly, at
the point where people start to be able to identify these irrational behaviors, investors can then
profit off these market inefficiencies caused by behavioral inadequacies and they would thus no
longer exist in financial markets. Thirdly, if these market inefficiencies caused by investor
behavior exist but are only able to be exploited by a small number of especially knowledgeable
investors then they are not of a large enough scale to invalidate the Efficient Market’s
Hypothesis’s ability to serve as agood approximation of financial markets.

In conclusion, there is overwhelming theoretical and empirical evidence indicating that the
Efficient Markets Hypothesis is a good approximation of reality in financial markets. Although
market imperfections do exist, they are not of a large enough scale to significantly alter reality
within financial markets. Thus, even though the Efficient Markets Hypothesis may not be 100%
correct it is still a accurate representation of reality within financial markets.


2)

A

Investment banks, and consequently people who work for investment banks, earn so much
money basically because of their ability to reduce the problem of adverse selection. Adverse
selection prevents brand-new companies from issuing securities as information about them is
asymmetric. To be able to go public, a firm needs a track record to help people judge the value of
its stock. Even then, potential buyers of securities are hesitant because they still know less about
the firm’s business than the firm does (asymmetric information). These investors fear that bad
companies will try to sell them securities at inflated prices. Clearly, there is a need for a mediator
in this situation to reduce this level of concern and allow for a mutually beneficial trade to occur.
Investment banks serve this function and as a result are able to earn large amount of money in
transaction commissions and through the underwriting process.

Investment banks are able to solve this problem because they research and examine the
companies whose securities they underwrite. They do their best to validate that the firms are in
good standing and that the securities are fairly priced. They then put their own reputations on the
line and convince other institutions of the securities value. Reputation is extremely important in
this sense because it is the key to being able to sell the securities. Investors have heard of
Goldman Sachs, they know they underwrite good securities, and they are willing to take their
guarantee about a company who they may never have heard of before. Thus, because reputation
is so important, investment banking is a highly concentrated industry, dominated by a small
number of players. In the 2000s, more than half of the securities underwritten in the world were
done so by 10 investment banks. Perceivably, it is extremely difficult for a lesser-known
investment bank to enter the business as it would not have the reputation investors look for when
deciding who to trust. All in all, the high earnings for investment banks and consequently those
who work for them are rewards for the firm’s reputations. To give a notorious example, in 2006
the 26,000 employees of Goldman Sachs earned an average of $600,000 per person in salaries
and bonuses, .a total of $16.5 billion.


B

The current recession may last longer than most previous recessions because of the extent to
which it is entrenched within so many aspects of our economy. In our current recession we are
experiencing a tightening of credit throughout our financial system. This tightening of credit, or
liquidity trap, impedes profitable investments from occurring in our economy. Businesses and
projects that should be being funded are not being funded by banks and credit companies. This
then could cause our current recession to last longer than most because the investment needed to
get us out of our current recession is not being allowed to be made because of a market failure.
Our current recession is also entrenched within a housing crisis where the prices of homes have
dramatically fallen after the collapse of a bubble. This collapse has caused many people to walk
away from their mortgages because the equity of their house has now become lower than the
payments they owe to the bank. The end result is that all parties invested in these mortgages are
experiencing negative consequences as a result. Since mortgages were securitized, sold through
the financial system, and insured by third party companies there are many parties involved and
this is not a problem that can be easily solved. The magnitude of this loss is so large that it could
play a major role in lengthening the time we spend in the recession. The simple idea is that at
some point in time, someone has to take the loss in value. Whether that loss is taken by the
American taxpayer or buy the private sector can be decided. As of now the government is trying
to relieve the impact this mortgage crises will have on the economy by granting federal aid to the
banking sector and buying some of these “toxic securities”. This strategy may be necessary to
prevent an economic collapse but it will also lengthen the duration of the recession because again
at some point in time, someone needs to endure the loss in value that has occurred within the
housing industry. Our current recession may also be prolonged due to the fact that it is currently
an international recession and many economies are getting hit hard around the world. This facet
takes away the possibility of our recession being relieved by an expansion in a neighboring
economy. Finally our recession may simply last longer due to the fact that it is unprecedented.
Events that have occurred in our recession have not occurred in the past. This means that there
are no set governmental policies that can simply be re-applied to this current recession due to the
unique nature of our circumstances. This uncertainty then implies that whatever actions are taken
by the government could fail and we may endure some trial and error when dealing with this
recession. This then would also cause our recession to last longer than those in the past where the
governmental response was simply lower the interest rate. Again, these old methods cannot be
applied to our current situation; case in point, the Fed cannot lower the interest rate any further.
Unemployment may then take longer to return to its level before the recession because of the
unique nature of our current recession. As aforementioned, our current recession encompasses a
liquidity trap that prevents profitable firms from funding their projects. This then indirectly
prevents jobs from being created. This is because only prospering firms would be making
enough money to want to expand and hire more people. So the current liquidity trap may extend
the time it takes before unemployment returns to its natural level. This current recession has also
had unprecedented burdens upon the American taxpayer. This then would cause future wealth to
be lower in the economy and may prevent jobs from being created as fast as possible. This then
would also lengthen the time it takes for unemployment to return to its level before the recession.
Furthermore, the current mortgage fiasco may have caused many Americans to lose faith in our
financial system and even the safety of their wealth in general. This then could then cause a
decrease in consumer confidence which would not only prolong the recession but also prevent
jobs from being created as fast as if there was no fall in consumer confidence. This is because
when consumption is high, output rises, which in turn causes companies to hire and creates jobs.
Lastly, the unprecedented nature of our current circumstances (mortgage fiasco, international
nature, etc) could, as explained in my first paragraph, prolong the recession. All these factors
would then also play a role in causing unemployment to take longer in returning to its level
before the recession. This is because output and unemployment have a negative relationship,
when output is below its natural level unemployment is above its natural level.


C

Dollarization is the use of foreign currency (often US dollars) as money instead of your own
national currency in a country. If deciding between dollarization and a currency board, there
would be several distinct advantages to dollarization. First, dollarization would allow for you to
have a currency that is not affected by local inflation. With a currency board you would still have
your own currency and high inflation could lead to a rapid loss in value of your currency in the
future. Dollarization would eliminate this possibility significantly as now a strong foreign
currency would be used that is unaffected by local inflation. Second, often times when
considering between a currency board and dollarization a country is already in a slight dilemma
with their own currency (high inflation). Dollarizing may be a better option than a currency
board because local citizens may have more faith in this already well-established foreign
currency since the local currency seems to be having problems already. Dollarizing could then
arguably lead to a currency that would serve as a better unit of account and medium of exchange.
This would be because the local population may be more willing to accept a foreign currency
they know is well-established and adopt prices in that currency also, especially if they have had
prior bad experiences with local currency in the past.

A currency board is an institution that issues money backed by a foreign currency. Creating a
currency board rather than dollarizing would have its own distinct set of advantages. First,
having a currency board would allow for a country to retain its own currency. This would give
the government the ability to print money and alter the money supply as needed through a central
bank. This would leave the home government better positioned to handle recessions and even
expansions in their country in the future as they would be able to alter the interest rate by
increasing/decreasing the money supply. A currency board would also be a better choice for
national pride. Local citizens may prefer to have their own currency and just re-establish its
value through a currency board rather than adopt a foreign currency all together. A currency
board may also be better than dollarization because abolishing the local currency may decrease a
country’s international legitimacy and/or leave the country in a position where they would have
to endure the decisions of the foreign government’s central bank regardless of whether they are
conducive to the local economy.


D

(i)
Three month treasury bills would have the largest relative upward shift in their nominal interest
rates because their nominal rates carry the least of their own risk premiums. The federal funds
rate provides a greater relative contribution to the nominal interest rate of 3 month treasury bills
than to the other bonds listed. Thus, when the Federal Reserve surprises everyone by sharply
raising the federal funds rates through adjustment of the money supply, three month treasury
bills would have their nominal interest rates rise also, to a greater extent than the other types of
bills and bonds listed.

(ii)
Ten Year treasury bonds would also have their nominal interest rates rise to a certain degree after
this surprise announcement. This is because though it is not as strong as the relative correlation
between 3 month treasury bills and the federal funds rate, ten year treasury bonds do have some
correlation with the federal funds rate. When the federal fund rate rises, the component of the 10
year Treasury bond that is comprised of the federal funds rate would rise and cause the nominal
interest rate of 10 year US treasury bonds to rise also, just not nearly as much as 3 month bills.

(iii)
Ten year AAA corporate bonds would then also experience an extremely slight increase in their
nominal interest rates after this surprise announcement. This increase would be lower than that of
ten year treasury bonds because the correlation between AAA corporate bonds and the federal
funds rate is not has high as that of Treasury bonds and the federal funds rate. Thus, nominal
interest rates of AAA corporate bonds would rise on a really small level though this rise may be
so small that it does not play a role in distorting economic behavior in markets.

(iv)
Ten Year Junk bonds would experience so negligible of an increase in their nominal interest
rates after this announcement though technically they would on an extremely microscopic level
have to rise. The reason for this is that Ten Year Junk bonds have rates that almost entirely
reflect their risk premiums. The federal funds rate then plays such a small part in determining
their nominal interest rates that this announcement would not affect the market for long term 10
year junk bonds at all.
3)


A.
i)     Symmetric Information

If P = 1 then the In-Between firm is guaranteed $150 next year
The In-Between Firm will thus be able to sell a bond that pays at least $110 in a year because
that is the expected payment that Savers require. They would thus promise a payment of $110.
The In-Between Firm will earn Profits of $150-$110 = $40
In-Between Firm will be able to issue bonds

P = 1 for the safe firm so guaranteed $125 next year
The Safe Firm will thus be able to sell a bond that pays at least $110 in a year because that is the
expected payment that Savers require. They would thus promise a payment of $110.
The Safe Firm will earn Profits of $125-$110 = $15
The Safe Firm will be able to issue bonds.

P = 2/3 for the Risky firm
The Risky Firm would have to promise a payment of $165;              2/3x= 110, solve for x
150-165 = -15 --- so doing this would lead to negative profits, so the firm abandons project
The Risky Firm will not be able to issue bonds.


ii)    Asymmetric Information

If Asymmetric Information then average probability of payment would be [1+2/3+1]/3 = 8/9
Savers would require $123.75 promised payment; solve 8/9x =110 for x

The In-Between Firm will be able to issue bonds promising a payment of $123.75
This is because they would be able to make a profit of 150-123.75 = $26.25

The Safe Firm will be able to issue bonds promising a payment of $123.75
This is because they would be able to make a profit of 125-123.75 = $1.25

The Risky Firm will be able to issue bonds promising a payment of $123.75
This is because they would have a 2/3 chance of making a profit of 150-123.75 = $26.25
B.
i)     Symmetric Information

If P = 5/6 then savers would require a promised payment of $132; solve 5/6x=110 for x
With 5/6 chance the In-Between firm will earn profits of 150-132 = $18
In-Between Firm will thus be able to issue bonds, promising a payment $132

P = 1 for the safe firm so guaranteed $125 next year
The Safe Firm will thus be able to sell a bond that pays at least $110 in a year because that is the
expected payment that Savers require. They would thus promise a payment of $110.
The Safe Firm will earn Profits of $125-$110 = $15
The Safe Firm will be able to issue bonds.

P = 2/3 for the Risky firm
The Risky Firm will thus have to promise a payment of $165; 2/3x= 110, solve for x
150-165 = -15 --- so doing this would lead to negative profits, so the firm abandons project
The Risky Firm will not be able to issue bonds.


ii)    Asymmetric Information

If Asymmetric Information then average probability of payment would be [1+2/3+5/6]/3 = 5/6
Savers would require $132 promised payment; solve 5/6x =110 for x

$132 exceeds earnings of $125 for Safe firm so Safe Firm would abandon project and not be
able to issue bonds

Savers know this and thus the average probability of payment would then be [2/3+5/6]/2 = 3/4
Savers would then require promised payment of $146.666; solve 3/4x=110 for x

$150 exceeds $146.66 so In-Between Firm would be able to issue bonds, promising a
payment of $146.66
5/6 chance of 150-146.66 = 3.34 profits

$150 exceeds $146.66 so Risky Firm would be able to issue bonds, promising a payment of
$146.66
2/3 chance of 150-146.66 = 3.34 profits
C.
i)     Symmetric Information

If P = 2/3 then savers would require a promised payment of $165; solve 2/3x=110 for x
150-165 = -15 --- so doing this would lead to negative profits, so the firm abandons project
In-Between Firm will not be able to issue bonds

P = 1 for the safe firm so guaranteed $125 next year
The Safe Firm will thus be able to sell a bond that pays at least $110 in a year because that is the
expected payment that Savers require. They would thus promise a payment of $110.
The Safe Firm will earn Profits of $125-$110 = $15
The Safe Firm will be able to issue bonds.

P = 2/3 for the Risky firm
The Risky Firm will thus have to promise a payment of $165; 2/3x= 110, solve for x
150-165 = -15 --- so doing this would lead to negative profits, so the firm abandons project
The Risky Firm will not be able to issue bonds.


ii)    Asymmetric Information

If Asymmetric Information then average probability of payment would be [1+2/3+2/3]/3 = 7/9
Savers would require $141.42 promised payment; solve 7/9x =110 for x

$141.42 exceeds earnings of $125 for Safe firm so Safe Firm would abandon project and not
be able to issue bonds

Knowing this the average probability of payment would then be [2/3+2/3]/2 = 2/3
Savers would then require promised payment of $165; solve 2/3x=110 for x

$165 exceeds earnings of $150 so In-Between Firm would be not able to issue bonds

$165 exceeds earnings of $150 so Risky Firm would be not able to issue bonds
4)

Dear Professor Ball,


Since “Money, Banking, and Financial Markets” was published in June 2008 a lot has occurred
that may require you to update some of the information contained within your textbook. Below
you will find update suggestions that could be implemented in the next edition separated by
paragraph.


Quick Changes

On Page 51 of the textbook, Problem number 2, Chapter 2, references the 1964 movie
Goldfinger. The question states that the title character has “his operation…financed by North
Korea, which hopes to make the dollar worthless…” This statement is not accurate. Though
Goldfinger’s servant Oddjob is Korean, the plan (Operation Grand Slam) to blow up Fort Knox
is financed by the Chinese Government. Though this may not be the most important update, I
think it is worth changing as I presume many students and professors, especially James Bond
fans, would notice this mistake.

Page 261, Chapter 9 of the textbook, contains a case study about Commerce Bank. The case
study is used as a tool to show how a bank was able to raise funds from the ground up through a
customer-oriented business strategy. Commerce Bank has since been bought out buy TD Bank
for 8.5 billion dollars. Though I do not think that the case study should be removed I think it
should be updated to include this fact and maybe make the point that though the business
strategy can work it may have its drawbacks during a recession.



Role of Government Chapter

Since June 2008 there has been increased involvement by the United States government within
the private sector, specifically financial markets. The United States Government has directly
aided some of the largest investment banks, bank holding companies, and insurance companies
in the world. The increased active presence of this additional actor in the financial market has
important implications for some of the most important concepts addressed in your book. I think it
would be worthwhile to apply ideas such as moral hazard, asymmetric information, and adverse
selection between governments and the companies they choose to aid. It would also be
interesting to dually contrast the government’s motives with those of traditional economic actors
in the market. Finally, a parallel should be drawn addressing the methods by which governments
can best reduce the problems of things like moral hazard and adverse selection. In Chapter 18 of
your textbook you do discuss some of the government’s options about bailouts and offer some
insight on the matter but that is not what I am suggesting. I am suggesting a chapter that would
analyze a government’s role, power, and presence in financial markets in relation to some of the
most powerful concepts related to markets.
Moral hazard occurs after contracts have been made where the risks that one party takes through
their actions has direct consequences that harm the other party. Moral hazard occurs in bond
markets, deposit insurance, stock markets, and many situations within financial markets. The
government now endures this same hazard when it lends funds to private companies. After the
money is given to these companies there is a risk that they will misuse the funds and these
actions would negatively impact the government and consequently taxpayers. Just as moral
hazard is reduced in markets through covenants, deductibles, and other means, the government
should implement similar paradigms to reduce its own risk to the moral hazard. These ideas
should be discussed in relation to past deals struck between governments and companies in this
chapter to offer additional insight to moral hazard.

The idea of asymmetric information and adverse selection then also arises between firms and
governments when the government is taking an active policy to aid firms that would be able to
innovate and use funds productively. Firms know the true extent to which they would be able to
do this. For example, if General Motors says they need 45 billion dollars to develop a new fuel
efficient car that would be able to compete on competitive markets, the true chance of the
project’s success is better known by General Motors than the United States government.
Furthermore, the feasibility and the amount of resources needed to do the project is also better
known by General Motors. It is not hard to see how adverse selection could rear its ugly head.
Companies that have good projects that would be in line with the government’s goals of re-
shaping industries in a manner that does not harm the American taxpayer do not get funded
because there is no way to discern these projects from those that are simply a waste of money.
The chapter should discuss this concept along with guidelines by which this problem could be
solved. Investment Banks solve the problem of adverse selection in security markets, should
independent companies be hired to evaluate projects and relay information back to the
government? Or should the government conduct its own analysis? The introduction of the
government as an active economic actor in financial markets brings many new insights and
questions to the way in which the system operates.

Finally this chapter should also discuss the difference between the end goals of the government
as an economic actor in financial markets. Firms and investors work towards profits. They thus
can make optimal choices definitively as they are working towards a well known goal. Knowing
this also allows for third parties to better analyze, understand, and interpret firm and investor
behavior. But what is exactly a government’s end goal or exit strategy when it plays an active
role in financial markets? Do governments treat their aid to companies as profitable investments
or necessary evils? Answers to these questions are at times lacking in the real world. As we see,
it is the absence of these definitive goals that makes all taxpayers somewhat uneasy regardless of
their personal beliefs on federal aid to the private sector.

All in all, this chapter would exclusively analyze questions about a government when it takes an
active role in financial markets. The chapter would address the many concerns that the
government as an economic actor would endure (moral hazard, asymmetric information, etc)
while also contrasting these similar obstacles with the government’s possible motivations for
acting within the market. Finally, the chapter would be able to offer some interesting history
about governments around the world and how they approached similar situations. To give a
quick example, Northern Rock was nationalized while Bear Sterns was handled much
differently.



Investment Bank Chapter

I think investment banks have become such a major part of the modern financial system that it
would be worthwhile to exclusively dedicate a chapter to them in the book. This chapter would
discuss their direct disparities to traditional banks, their operational activities, and their histories
from past to present. Currently, they are discussed in the textbook briefly as agents that make a
lot of money underwriting securities because of their ability to solve the adverse selection
problem through the uses of their reputation in transactions. But how did they come to earn this
reputation and how did this system transform into what it is today? I feel there are a lot of
questions about investment banks left unanswered in your textbook. It would be interesting and
worthwhile for you to specifically analyze investment banks and tell us what it is they exactly do
step by step. For example, what is the process of underwriting a security? How are investment
banks structured internally? The possibilities are endless.

All in all, I personally felt that I wanted to learn more about investment banking after reading
your textbook. You mention them earning astronomical amounts of money but only real give a
brief and broad reason for why that occurs. I think it would benefit students taking a course in
money, banking, and financial markets to better understand the process by which this occurs and
I think it would make for excellent material as it would be relevant academically to all and
pragmatically to some.



In conclusion, these are the additions and changes I believe would improve your textbook,
“Money, Banking, and Financial Markets”. Please feel free to contact me should you wish to
discuss any of my suggestions. Thank you for teaching this course this year and have a great
summer.

								
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