Question

1. Explain the difference between herding and limits to arbitrage.

1. Show in a precise way how can a bank make so much more with leverage. Then show how they can lose so much more with leverage.

2. Explain (in a precise way) the vicious and virtuous circles that take place using mark to market accounting in banking.

Answer 1

Ans 1) Herding: It is behavior of the people where people follow the other market participants action like if market participants are buying some asset then people with herding behavior also start buying without any analysis and vice versa.

Limit to arbitrage: It is the restriction imposed on the securities prices which may be utilized for the arbitrage profit by rational investors or traders, but this price inefficiency protected for a certain amount of time.

Ans 2) Leverage is a double edge sword where one can be make huge profit when the trade or investment in his direction but it can increase the loss in adverse situation. It is used by almost all financial participants as well as bank.

Let take a bank A has 4 Million of debt at 4% and 6 Million in equity if bank make 1 Million in profit then the return on equity will be equal to (1 Million - 160,000)/6 Million = 14% which will be 10% in case all 10 Million will be in equity. Thus performance is better using leverage. Similarly if bank make no profit in the the certain year then in that year net income will be -160,000 due to interest paid on the debt. It shows that when banks are facing financial challenges leverage worse the situation .

Ans 3) Mark to market used by the banks lead to virtuous cycle if there is gain through it which will lead to credit loosening which lead to more spending which lead to increase in prices which further increase the profit of bank through mark to market. Similarly it is vicious cycle if there is any loss due to the mark to market which lead to credit tightening which further lead to less spending which lead to reduction in prices that will further increase the losses through mark to market.