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Question: Explain what is meant by the moral hazard problem in finance.

08 Oct 2022,2:03 AM

 

Question 1 (Total of 50 points)
One of the reasons why financial intermediaries emerge as one of the key institutions in an economy is the high possibility of more prevalent moral hazard problems in equity finance.
a. Explain what is meant by the moral hazard problem in finance. (10 points)
b. Explain how moral hazard emerges in equity finance.(15 points)
c. Do you think financial intermediaries can fully mitigate the moral hazard problem? Why or why not? (15 points).
d. Discuss two policies that can be used by governments to limit the extent of the moral hazard problem in equity finance. Explain how these policies can address this problem. (10 points)

 

Question 2 (Total of 50 points)
The term structure of interest rates gives us the relationship between interest rates and different maturities. It can provide us important information about the current state of the economy and the expectations about the near future.
a. Using theoretical frameworks and examples from data, explain whether the yield on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations should be same or not. (20 points)
b. Explain what a yield curve is and discuss how it is linked to the concept of term structure of interest rates. (15 points)
c. Suppose you are an economist working in a central bank. You observe that yield curves for the government securities in your country have a negative slope. Why and how would you use this observation to make a policy proposal
to the decision making bodies, such as the monetary policy committee, at the central bank? (15 points)

 

Section B
Word limit: 1000
Question 3 (Total of 50 points)
Banks are often asked to increase their capital requirements, such as their tier-one ratio, following stress tests, or in times of distress.
a. Explain what is meant by a bank’s tier-one capital ratio. (10 points)
b. Explain how banks can respond to increased capital requirements and increase their tier one ratio. (15 points)
c. Discuss empirical evidence which examines how increasing banks’ capital requirements may or may not be detrimental to the real economy (25 points)

Question 4 (Total of 50 points)
Banks have long been involved in the process of securitization of financial products.
a. Explain the process of securitization (12.5 Points)
b. Explain what is meant by a collateralized debt obligation (CDO) (12.5 Points)

c. Are markets for securitized products safer today than they were pre-global financial crisis? (25 Points)

 

 

Expert answer

 

Moral hazard is when someone takes a risk because they know they won't have to suffer the consequences if things go wrong. In finance, this can happen when people don't have to worry about losing money on bad investments since the government will bail them out. This can lead to excessively risky behavior since the people involved know that they won't have to face any consequences if things go wrong.

 

Moral hazard is a problem because it can lead to excessive risk-taking. This can ultimately lead to financial crises, as we saw during the subprime mortgage crisis. Moral hazard also creates an uneven playing field, since some people are able to take more risks than others. This can lead to unfairness and resentment.

 

There are a few ways to address moral hazard. One is to make sure that people who take risks are held accountable for their actions. This can be done through regulation or by making sure that there are financial penalties for taking excessively risky actions. Another way to address moral hazard is to provide incentives for people to take less risk. For example, insurance companies may charge higher premiums to people who are more likely to take risks.

 

Moral hazard is a complex issue, and there is no easy solution. However, it is important to be aware of the problem and to try to address it in a way that is fair and effective.

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