Consider an investment bank whose demand for financial assets F is described by the following: , where e is equity (net

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Consider an investment bank whose demand for financial assets F
is described by the following: , where e is equity (net worth) of
the investment bank, z is a measure of the risk level in the
economy, r is the rate of return on financial assets, is the policy
interest rate and P is the price of financial assets. With this
set-up answer the following questions.
a) Explain the effect of the rate of return, r, on financial
assets on the investment bank’s leverage. (2 marks)
b) Now suppose z = 0.20, r = 0.1, = 0, P = 1 in the economy, and
the investment bank’s equity is e = 15 currently (period 0).
I. What is the leverage and the financial asset holdings of the
investment bank in period 0? (3 marks)
II. In period 1, risk measure falls to z = 0.10, and the price
of financial assets rises to P = 1.05. What will happen to the
investment bank’s leverage? How about holdings of financial assets?
(5 marks)
III. In period 2, the investment bank marks to market its
financial assets. How much does this increase their equity? What
will be the investment bank’s holdings of financial assets at the
end of this period? (5 marks)
IV. In period 3, the price of financial assets falls to P =
0.90. Does the investment bank remain solvent? Explain. (5
marks)
V. Suppose that a regulator sets the maximum allowed leverage to
be 15. Do your answers change to parts II – IV? Explain. (5
marks)