Financial Markets and Investments: Understanding Bond Markets and Interest Rates, Exams of Economics

Download Financial Markets and Investments: Understanding Bond Markets and Interest Rates and more Exams Economics in PDF only on Docsity! 1 Money, Banking, and Financial Markets (Econ 353) Midterm Examination II March 11, 2004 Name_______________________________________ Univ. Id #______________________ Note: Each multiple-choice question is worth 4 points. Problems 19, 20, and 21 carry 10, 8, and 10 points, respectively. 1) If the expected return on U.S. Treasury bonds falls from 10 to 5 percent and the expected return on GE stock rises from 7 to 8 percent, then the expected return of holding GE stock _____ relative to U.S. Treasury bonds and the demand for GE stock _____. A) rises; rises B) rises; falls C) falls; rises D) falls; falls 2) When the interest rate on a bond is _____ the equilibrium interest rate, in the bond market there is excess _____ and the interest rate will _____. A) below; demand; rise B) below; demand; fall C) above; supply; rise D) below; supply; rise 3) When prices in the stock market become less uncertain, the demand curve for bonds shifts to the _____ and the interest rate _____. A) right; rises B) right; falls C) left; falls D) left; rises Figure 1 4) In Figure 1, one possible explanation for the increase in the interest rate from i1 to i2 is A) an increase in the expected inflation rate. B) a decrease in the expected inflation rate. C) an increase in economic growth. D) a decrease in economic growth. 2 Figure 2 5) Figure 2 illustrates the effect of an increased rate of money supply growth. From the figure, one can conclude that the A) the liquidity effect is smaller than the expected inflation effect and interest rates adjust quickly to changes in expected inflation. B) the liquidity effect is larger than the expected inflation effect and interest rates adjust quickly to changes in expected inflation. C) the liquidity effect is larger than the expected inflation effect and interest rates adjust slowly to changes in expected inflation. D) the liquidity effect is smaller than the expected inflation effect and interest rates adjust slowly to changes in expected inflation. 6) If the expected path of one-year interest rates over the next five years is 1 percent, 2 percent, 3 percent, 4 percent, and 5 percent, the expectations theory predicts that the bond with the highest interest rate today is the one with a maturity of A) one year. B) two years. C) three years. D) four years. 7) An increase in marginal tax rates would likely have the effect of _____ the demand for municipal bonds, and _____ the demand for U.S. government bonds. A) increasing; increasing B) increasing; decreasing C) decreasing; increasing D) decreasing; decreasing 8) According to the liquidity premium theory A) a steeply rising yield curve indicates that short-term interest rates are expected to remain unchanged in the future. B) a moderately rising yield curve indicates that short-term interest rates are expected rise moderately in the future. C) a flat yield curve indicates that short-term interest rates are expected to rise moderately in the near future, then fall moderately in the distant future. D) a downward sloping yield curve indicates that short-term interest rates are expected to fall sharply in the future. 5 Q19. (a) (4 points). Suppose that in February 2003 the yen/dollar exchange rate was 120 yen/$. After one year, in February 2004, the yen is trading at 105 yen/$. Did the dollar appreciate or depreciate against yen from February 2003 to February 2004? By how much? (Show your work) (b) (4 points) Now suppose that the annual interest rate on dollar bank deposits in February 2003 was 5 %. Further, in February 2003 it was expected that the future exchange rate in February 2004 would be 105 yen/$. If the interest rate parity condition holds, what was the implied interest rate on yen deposits? (Show your work) Ans. (a)Dollar’s depreciation against yen = (E2004 – E2003)/E2003 = (105-120)/120 = -0.125 Hence, dollar depreciated by 12.5% (b) If the interest parity condition holds: Yen deposit rate = Dollar deposit rate + dollar’s expected appreciation Yen deposit rate = 0.05 + (105-120)/120 = 0.05 -0.125 = -0.075 Hence, the implied yen deposit rate is equal to -7.5%. 6 Q20. (a) (3 points) Assuming that the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years for the following path of one-year interest rates over the next five years: 5%, 6%, 6%, 7%, 6%. (b) (3 points) Now suppose that investors prefer short-term bonds. Specifically, the liquidity premiums for one- to five-year bonds are 0%, 0.2%, 0.4%, 0.6%, and 0.8%, respectively. How would your answers to part (a) change? Calculate the new values. a. Apply the expectation hypothesis of term structure i.e., the long-term interest rates are averages of short terms. Then the yields on bonds of different maturities are 1- yr 5% 2- yr (5+6)/2 = 5.5% 3- yr (5+6+6)/3 =5.67% 4 –yr (5+6+6+7)/4 = 6% 5- yr (5+6+7+6+6)/5 = 6% b. After adding corresponding liquidity premiums, the yields will be as follows: 1- yr 5 + 0 = 5% 2- yr 5.5 + 0.2 = 5.7 % 3- yr 5.67 + 0.4 = 6.07 % 4 –yr 6 + 0.6 = 6.6 % 5- yr 6 + 0.8 = 6.8 % 7 Q21. (8 points) In general, corporate bonds pay higher yields than the treasurys of the same term to maturity. This difference is termed as the risk spread. One reason for the recent widening yield difference (spread) between treasury bonds and corporate bonds is said to be investors’ ‘flight to quality’: in the wake of recent corporate accounting scandals it is said that the perceived risk on corporate bond has increased relative to the treasurys. Explain why this ‘flight to quality’ has led to an increase in the spread by using a demand and supply framework for bonds. (For getting full points you need to draw a demand-supply diagram, illustrate the shifts, and clearly indicate how interest rates are affected by those shifts) Ans. Basically, the relative risk on corporate bonds has increased. The demand for corporate bonds will shift to the left while the demand for treasurys will shift to the right. Hence, the yields on corporate bonds have increased while those on treasurys have decreased. In the result, the yield spread has widened. Here is the diagrammatic explanation. Copyright © 2001 Addison Wesley Longman TM 6- 3 Increase in Default Risk on Corporate Bonds