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P2.T7.509. Collateral markets (Malz)

Nicole Seaman

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Learning outcomes: Explain specific liquidity issues faced by money market mutual funds. Describe the economics of the collateral market and explain the mechanics of the following transactions using collateral: margin lending, repos, securities lending, and total return swaps. Calculate a firm's leverage ratio, describe the formula for the leverage effect, and explain the relationship between leverage and a firm's return on equity.


509.1. What is the phenomenon called "breaking the buck"?

a. When the net asset value (NAV) of a money market mutual fund falls below one dollar ($1.00)
b. When a money market mutual fund cannot borrow dollars at a cost less than its return on assets
c. When so many money market mutual funds borrow for the central bank that interest rates on the dollar rise quickly
d. When a high proportion of shareholders attempt to redeem their shares simultaneously under adverse market conditions

509.2. In regard to markets for collateral, each of the following is true EXCEPT which definition or statement is false?

a. Margin lending is lending for the purpose of financing a security transaction in which the loan is collateralized by the security
b. Total return swaps (TRS) are matched pairs of the spot sale and forward repurchase of a security. Both the spot and forward price are agreed now, and the difference between them implies an interest rate
c. In a securities lending transaction, one party lends a security to another in exchange for a fee, generally called a rebate. The security lender, rather than the borrower, continues to receive dividend and interest cash flows from the security. A common type of securities lending is stock lending, in which shares of stock are borrowed.
d. A haircut ensures that the full value of the collateral is not lent. A haircut of 10.0%, for example, means that if the borrower of cash wants to buy $100.00 of a security, he can borrow only $90.0 from the broker and must put $10.0 of his own funds in the margin account by the time the trade is settled. Similarly, the lender of cash will be prepared to lend $90 against $100 of collateral.

509.3. Suppose a firm with a simple capital structure has assets of $20.0 million and debt of $10.0 million. Return on assets (ROA) is 9.0% and cost of debt is 4.0%, such that the firm's leverage is 2.0 and its return on equity (ROE) is 14.0%. If the firm borrows an additional $6.0 million at the same cost of 4.0%, and asset returns are fixed, what is the firm's new leverage and return on equity (ROE)?

a. Leverage = 1.7 and ROE = 13.3%
b. Leverage = 2.0 and ROE = 15.7%
c. Leverage = 2.3 and ROE = 23.5%
d. Leverage = 2.6 and ROE = 17.0%

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