1. Private equity markets have grown rapidly. Provide an overview of theprivate equity market, including a discussion of the advantages and disadvantages. There is a paper “The Economics of the Private Equity Market” by Stephen D. Prowse at the Federal Reserve Bank of Dallas that provides
a nice overview. You are also welcome to look at other web sites, including Wikipedia. Answer the following questions: what is the private equity
market and how does it different from the standard equity market? What types of firms raise funds through the private equity market? Is it cheaper
to raise funds through a standard equity market or the private equity market? What kind of borrowers does this market attract? How does asymmetric information enter into the story? Which firms are the main participants in the private equity market?
You should write about a page (typed) on this topic.
2. Contingent convertible bonds (COCOS) have recently been in the news. Describe a COCO. I recommend going to the Investopedia website.
3. The Treasury has started to issue Treasury Inflation Protected bonds (TIPS). Go to the Investopedia web site or else CNN (look in the business section) to find a primer on TIPS. Provide a summary of what TIPS are, how they are structured (such as what price index is used), and other
basic information about the bond.
4. The “Shadow Banking System” is defined as hedge funds, conduits, SIV, money funds, monoline insurers, and investment banks. One explanation
for why the financial crisis of the past year was so dramatic is that there was a “bank run” on the shadow banking system. Provide a two paragraph
description of what a bank run means for the institutions in this list of “shadow banks.”
5. There is been tremendous innovation in financial instruments that make it easier to trade credit risk. The issuance of asset backed securities
(ABS), collateralized debt obligations (CDO), collateralized loan obligations
(CLO) and credit default swaps (CDS) have expanded on a dramatic scale between 2005 to 2007. The composition of the underlying assets shifted to higher credit risk mortgages and loans issued by non-investment grade companies. Briefly describe each category of credit risk instrument
(ABS,CDO, CLO, CDS). The Investopedia website, or the Federal Reserve
Bank of New York website, or www.bloomberg.com will be useful.
6. There has been a huge number of recent articles about negative interest
rates and monetary policy. Find an article on a reputable website (if you are uncertain please ask me) describing what negative interest rates mean
and how they might impact monetary policy. There is no right or wrong answer because we don’t really know.
Answer
Economics Homework Assignment
Question 1
Private equity market is a capital investment source raised by individuals and institutions aiming to acquire and invest in companies’ equity ownership (Dumon, 2016). Partners in private equity firm are responsible for raising funds and managing to return favorable returns from their shareholder clients, which normally has investment span of four to seven years. Private equity ownership has advantages that allow it to generate value and profits (Prowse, 1998). The number of possible company investment for private equity is large, and they can invest in unlisted companies. Private equity firms are very cautious and spend enormous resources in assessing potential companies to understand and mitigate risks involved. Besides, the private equity firm has the advantage of increased value in a company over a period before sale, which appreciates the already created value. Restricted access, barriers to entry, liquidity, and high cost are some of the disadvantages of private equity investment. Private equity cannot be accessed by many investors and require an investment of substantial amounts. Private companies need to invest large amounts for many years without returns, which make the liquid in nature.
Private equity refers to funds provision in return for equity in high-value companies. Funds are raised from institutional investors such as pension funds and insurance companies (Dumon, 2016). Standard equity contains all stocks admitted to listing on official markets regulated markets. Private equity firms, venture capital firm and angel investor raise through private equity markets by investing in credit unions insurance companies, investment banks among others.
It is cheaper to raise funds through private equity because private equity security is exempted from registration from Securities and Exchange Commission. This investment fuels massive growth in private equity firms and is hence preferable and easy.
Borrowers in equity are from privately and publicly held companies. Exit process of private equity is characterized by asymmetric information between purchasers of the portfolio company and the private equity investor. Asymmetric information affects the price of selling off the private equity investor fund’s interest. According to Prowse (1998), the primary participants in private equity markets are pension funds, insurance companies, credit unions, prime brokers trusts and people of high net worth.
Question 2
A contingent convertible bond is a fixed mechanism that is changeable into equity if predicted trigger events occur (Anonymous, 2016a). Cocos’ has been discussed in crisis management and alternative method of ensuring banks and insurance industries remain solvent. Cocos’ is related to traditional convertible bond in that there is a strike price But, differ in that there is another higher price, called “upside contingency” which the company’s stock price must attain before the makes the conversion.
Question 3
Treasury Inflation Protected bonds (TIPS) are bonds issued to protect investors against inflationary concerns. Petroff (2016) explains that TIPS offer an effective and simple way of eliminating inflation risk while providing real rate of returns. Protection against TIPS is unique from other bonds because rather than having a fixed face value, the returns at maturity fluctuate according to consumer prices. TIPS provide an additional diversification level on nominal fixed income through eliminating inflation risk of portfolios.
Question 4
Bank run is a situation where very many customers of banks or other financial institution withdraw their deposits concurrently due to uncertainties of the banks or financial institution solvency (Wikipedia, 2016). Excessive withdrawal of deposits by customers increases the likelihood that the financial institution will experience a default. Such default prompts more customers to withdraw their deposits leading to failure of the financial institution to cover withdrawals.
Shadow banks such as investment banks offer services similar to those of banks but outside normal financial regulation since they do not take deposits. Shadow banks benefit from bank run situation because they act as financial intermediaries. When bank run situation arises, shadow banks benefit by linking lenders such as pension fund to banks or financial institutions experiencing bank ran (Wikipedia, 2016). Shadow banking institutions direct funds from investors to corporations enabling these banks to make profits through either fees or difference in interest rates. Shadow banking system will thrive in situations of the bank run.
Question 5
Asset-backed securities is aleases, loan, credit card debt, company receivables or royalties backed financial security (Anonymous, 2016b). However, mortgage-backed securities and real estate cannot be used as security.
Collateralized debt obligation is a controlled financial product that combines assets generating cash flow and repackages this resource into distinct tranches that are sold to investors. The pooled assets may include bonds, mortgages, and loans (Wikipedia, 2016b). Tranches vary significantly in their risk profile.
Collateralized loan obligations are a security backed by a debt pool, which in most cases is a corporate loan on a low-rate. The Wikipedia (2016c) states that the investor in a CLO receives scheduled debt payment from underlying loans and takes the risk in case the borrower defaults. This security will offer the investor higher returns. Banks trade CLOs to various tranches.
Credit default swap is a financial swap agreement whose seller pays off the buyer in case of loan default or any other financial credit event. This definition implies that the seller of CDS insurers they buyer against loan defaulting (Pinsent, 2016). The CDS buyer remits payments to the seller and receives a payoff if the defaulting occurs. The seller of the CDS also takes charge of the defaulted loan. Credit default swaps permit investors to speculate on transformations in CDS spreads of market indices or single names. Besides, an investor might speculate particular entity’s credit quality because CDS spread increases as credit value decreases.
Question 6
A negative interest rate is an unusual monetary policy where target interest rates are set to a negative value. Negative interest rates can be perceived as an instance when lenders pay borrowers interests. Often, negative interest rates aim to improve consumer spending and has been advocated to be an effective mechanism of recovery from the global recession. Kimball’s article in 2015, highlighted various areas that negative interest rates impacts monetary policy. Kimball accounts for debt issues that negative interest rates mat prone a country into due to the paying of borrowers. Moreover, negative interest rates affect policies on financial stability by promoting financial and fiscal dominance and also the dominance of the exchange rate. Therefore, negative interest rates promote financial markets while masking monetary policies.
Reference
Anonymous (2016a). Convertible Bond. Investopedia. Retrieved from http://www.investopedia.com/terms/c/convertiblebond.asp?o=40186&l=dir&qsrc=1&qo=serpSearchTopBox&ap=investopedia.com
Anonymous (2016b). Asset-Backed Security-ABS. Investopedia. Retrieved from http://www.investopedia.com/terms/a/asset-backedsecurity.asp?o=40186&l=dir&qsrc=1&qo=serpSearchTopBox&ap=investopedia.com
Dumon, M. (2016). What is Private Equity? Investopedia. Retrived from http://www.investopedia.com/articles/financial-careers/09/private-equity.asp?o=40186&l=dir&qsrc=999&qo=investopediaSiteSearch
Kimball, M. S. (2015). Negative Interest Rate Policy as Conventional Monetary Policy. National Institute Economic Review, 234(1), R5-R14.
Petroff, E. (2016). Introduction to Treasury Inflation-Protected Securities (TIPS). Investopedia. Retrieved from http://www.investopedia.com/articles/bonds/07/tips.asp?o=40186&l=dir&qsrc=1&qo=serpSearchTopBox&ap=investopedia.com
Pinsent, W. (2016) Credit Default Swaps: An Introduction. Investopedia. Retrieved from http://www.investopedia.com/articles/optioninvestor/08/cds.asp?o=40186&l=dir&qsrc=1&qo=serpSearchTopBox&ap=investopedia.com
Prowse, S. D. (1998). The economics of the private equity market. Economic Review-Federal Reserve Bank of Dallas, 21.
Wikipedia (2016a). Bank Run. Retrieved from https://en.wikipedia.org/wiki/Bank_run
Wikipedia (2016b). Collateralized debt obligation. Retrieved from https://en.wikipedia.org/wiki/Collateralized_debt_obligation
Wikipedia (2016c). Collateralized loan obligation. Retrieved from https://en.wikipedia.org/wiki/Collateralized_loan_obligation
