Problem set #4

# Problem set #4 - Problem Set 4 Ec 136 Fall 2009 This...

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Problem Set 4 Ec 136, Fall 2009 This problem set is due on October 13, in class. Sorry, no late problem sets are accepted! All students must submit problem sets individually. Please write your name, section time and GSI on the front page of your solution. Note on rounding: please round all prices and (percentage) returns to two digits after the decimal point: e.g., 5.45% or 1.0545. 1. Bank runs Toxic Limited is an investment bank with the following balance sheet. Assets Liabilities illiquid CMOs equity \$20 cash \$200 short term debt The CMOs can be sold at t = 1 for a price of P 1 = 160 , but if held until t = 2 , their value rises to P 2 = 210 . Short term debt is in the form of demand deposits, and is held by 200 investors, each of whom has \$1 . At t = 1 , Toxic promises a 5% net return to each of these investors if they keep their money in the bank until t = 2 . Assume that 5% is high enough that if an investor is con°dent that the bank will remain solvent, then it is optimal to keep the money in the bank. a) Suppose that all investors keep their money in the bank until t = 2 . Will they get the promised 5% return? If you are one of the 200 investors, and know that the other 199

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