Tri Vi Dang Columbia University

Money and Banking Spring 2025

Exercise Set 2

Due Thursday, 3/6

This exercise set consists of four regular questions (60 points) and one AI based bonus question
(6 extra points).

Question 1 [20 points]

Consider the following bond market. It is common knowledge that the bond pays either $40 or
$100 at t=1. Both states are equally likely.

Agent S owns the bond. Since he needs cash at t=0 he is willing to sell the bond at a discount of
 = $3. It means if the true value of the bond is $40 agent S is willing to sell it for at least $37. If
the true value of the bond is $100 agent S is willing to sell it for at least $97.

Agent B is interested in buying the bond. If the true value of the bond is $40 (or $100) agent B is
willing to buy it for at most $40 (or $100).

The seller (agent S) proposes a price to sell the bond. Both agents are risk neutral and maximize
expected utility.

a) What price does the seller offer in equilibrium? Is there trade? [3 Points]

Now suppose agent B is a sophisticated buyer. After seeing the price offer of the seller, the buyer
can try to learn something about the bond. If agent B spends $8 on information acquisition, he
can find out the true value of the bond.

b) Suppose the seller offers the expected payoff of the bond and thus the price p=$70. What
is the best response of the buyer? Should the seller offer this price? [4 Points]

c) Suppose the seller offers a price p = E(x) − Δ = $67. What is the best response of the
buyer? Should the seller offer this price? [4 Points]

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d) Suppose the seller offers a price p = xH − Δ = $97 . What is the best response of the
buyer? [3 Points]

e) Is there any price at which agent S is willing to sell and agent B is willing to buy?
Provide a complete proof by analyzing different price ranges. [6 Points]

Question 2 [16 points]

Now suppose there is a rating agency in the above bond market. The rating agency evaluates the
company that issued the bond. The buyer can acquire information at cost of $8.

Suppose the rating agency announces an AA-rating, i.e. there is an 98% probability that the
payoff of the bond is $100.

a) Is there trade in equilibrium? If so, what is the price the seller is offering? [8 Points]

Suppose the rating agency announces an BB-rating, i.e. there is a 95% probability that the payoff
of the bond is $40.

b) Is there trade in equilibrium? If so, what is the price the seller is offering? [4 Points]

c) How does the rating agency create liquidity in the bond market? Provide a verbal
explanation. [4 Points]

Question 3 [12 points]

Consider the following economy with three dates (t=0, 1, 2). A firm needs to raise I=$100 to
finance a project at t=0. At t=2, the project generates $400 if it is a success or pays off nothing if
it is a failure. Both cases are equal likely. At t=1, the firm learns about the outcome of the
project.

There is an early consumer who has w=$100 at t=0 and the utility function

u E = cE 0 + 1.2  min[cE1 ,100] + max[cE1 − 100,0] + cE 2 .

There is a late consumer who has W=$320 at t=1 and the utility function u L = cL0 + cL1 + cL2 .

Suppose the firm issues equity at t=0 to raise $100. As a listed company, at t=1 the firm reports
whether the project is a failure or success. If the early consumer buys equity at t=0, he sells his
equity holding to the late consumer at t=1 after the announcement of the firm.

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a) What equity contract does the firm offer the early consumer so as to get $100? What is
the fraction of equity the firm is selling? [6 Points]

b) What is the price of the equity at t=1? What is the expected utility of the early consumer
at t=0? [4 Points]

c) What is the expected profit of the firm at t=0? [2 Points]

Question 4 [12 points]

Now suppose there is bank in the above economy. The bank provides loans to firms and keeps
information secret. Consumers do not observe whether the project is a failure or success. At t=2
the bank is liquidated and consumers who have deposits with the bank get back what the bank
owns them at t=2.

The bank offers the early consumer the following demand deposit contract. If the early consumer
deposits $100 at t=0, he can withdraw $100 at t=1.

The bank offers the late consumer the following contract. If he deposits $100 at t=1, he gets back
the loan that the firm repays to the bank since the bank is liquidated at t=2.

a) What loan contract does the firm offer the bank to get $100? Does the early consumer
deposit $100 at t=0 and does the late consumer deposit $100 at t=1? [10 Points]

b) What is the expected profit of the firm? [2 Points]

Bonus Question [6 extra points]

Formulate a true-or-false question consisting of one or two sentences in the context of lecture
notes 6 to 12 which an AI chatbot (ChatGPT, Deepseek, Gemini or Claude can be used) does not
provide a correct answer. Provide a screenshot of the question and the AI chatbot answer.

See Exercise Set 1 for information about the bonus question.