About the dangers of leverage in the banking system

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Imagine an investment bank which has quite of 10 and operates in an economy where risk is 0.15, the policy rate is 0, the rate of return o financial assets is 0.05 and the price of financial assets is 1. a) How many financial assets does the investment bank hold in period 0? What is their leverage? b) In period 1, risk falls to 0.04 and price of financial assets rises to 1.03. What happens to the IB's leverage and holdings of financial assets? c) In period 2, the IB marks to market its financial assets. How much does this increase their equity? How many financial assets do they hold at the end of this period? In the next period risk rises back towards its initial level. Calculate how much asset prices need to fall to bankrupt the IB. What does this tell us about the dangers of leverage in the banking system?

Reference no: EM131338023

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