Interest Rate Changes & Financial Markets Analysis: Treasury Yields, Bonds & Institution A, Exams of Capital Markets Regulation

Download Interest Rate Changes & Financial Markets Analysis: Treasury Yields, Bonds & Institution A and more Exams Capital Markets Regulation in PDF only on Docsity! FBE 524 Take-Home Midterm Examination -- October 17, 2000 Due October 26, 2000, 6:15pm MBA.PM Office Write your name in a bluebook or on lined 8.5x11” paper (staple all sheets in upper left-hand corner when examination is completed) and answer four of the following questions or type your answers but limit their length to approximately two-thirds to one page of double-spaced type (with normal margins and font size.). I will grade the first four questions you provide so do not answer more than four questions! The questions are equally weighted (25 points each) and cover the material discussed in class through October 17, 2000. While there is no way to enforce a time limit but the examination is intended to be an ninety-minute examination. I will not reward longer answers and value good organization and clear writing much more than many pages of words. Think about the question before answering and address each of the points raised using the analytical structure and concepts covered in class. The exam is due at either the FBE office in Hoffman Hall (HOH700) before 5:00pm or at the EMBA.PM office in Popovich Hall before 6:30 pm October 24, 2000. Use the following data in the next two questions.: Yield is in percent per annum Dec. 23, Dec 9, Oct. 6, U. S. Government Securities 1998 1999 2000 Secondary market 3-month 4.58 5.10 6.25 1-year 4.69 5.35 6.06 5-year 4.65 5.67 5.92 10-year 4.81 6.14 5.87 30-year 5.20 6.22 5.91 Corporate bonds Moody’s seasoned Aaa 6.33 7.43 7.67 Baa 7.32 8.09 8.39 Source: Federal Reserve Board, Release H15, various issues 1. How would you describe changes in the term structure of default risk-free interest rates over the last two years? What could have produced these changes? What were the forward rates for 4-year Treasury in 1998 and 1999 and how do they compare to five-year spot rates one year later? Discuss the accuracy of forecasts of the expected future spot rate from these forward rates and analyze these results in terms of possible sources of bias and/or the efficiency or inefficiency of the Treasury securities market. Given the expectations hypothesis, what do the latest spot rates imply will happen to short-term rates in the future? Be explicit. The short end of the term structure shifted up over the last two years (52 basis points 98-99 and another 115 basis points 99-00). The long-end shifted up the first year (102 basis points for the 30- year between 98-99) and the term structure steepened, but then the long end fell (31 basis points) in the second period and the term structure was downward sloping by October, 2000. The increases in the short rate may have been a response to increased inflation fears, which apparently motivated the Federal Reserve to increase the Fed funds rate over the last two years. The upward shift in the term structure the first year (98-99) may have reflected some combination of increased inflation fears, expectations of increasing real rates with an overheating economy, increases in liquidity premiums for long-term funds, and possible shifts in the demand and supply for short-term and long-term funds. The downward sloping term structure currently may reflect expectations of a slowdown in the economy with falling real rates, a reduction in term premiums for long-term rates, or an increase in the demand for long-term default-risk-free bonds relative to supplies, which are decreasing with the Federal budget surplus. The forward rate for a four-year security in one year in December, 1998, is: 10469.1/()0465.1(4 5  = 4.64%, and similarly for December, 1999: 10535.1/()0567.1(4 5  = 5.75%. These forward rates can be compared to the actual spot 4- year (almost the same as a five-year maturity) one year later. Specifically, 4.64% compares to 5.67%, which is 103 basis points higher, while the 5.75% compared to the actual 4-year spot rate of 5.92%, or 17 basis points higher. In 1998, using the pure expectations hypothesis, the term structure predicted that rates would be roughly the same in one year (4.64% for a 4-year versus 4.65 for the then current 5-year) and in 1999 it predicted that rates would rise slightly (from 5.67 on a then current 5-year to 5.75 for a 4-year). Predictions for both years are wrong, which could simply because of changes in expectations due to new information, biases in forward rates induced by liquidity premiums in the term structure, or to changes shifts in supplies and demands for funds of different maturities. However, market efficiency does not require that predictions are correct, but only that they do not have a predictable bias in errors which could be used to improved predictions. The term structure now suggests that rates will fall in the future, possibly because of falling inflation or falling real rates. Expectations of falling rates could be indicative of expectations concerning a slowdown or recession in the economy. 2. Aaa and Baa corporate rates have increased over the last two years. Discuss all the sources of these changes between each year, noting carefully differences between the two time periods. What factors in the economy could account for these changes? Between 1998 and 1999, default-risk free yields on 10-year (a maturity assumed to be in line with corporate bond yields in the table), Treasuries increased 133 basis points. The default premiums on AAA bonds relative to 10-year Treasuries fell 23 basis points and on BAA relative to AAAs another 33 basis points. In other words, in the earlier period, the increase in bond yields was due to an upward shift in the default-risk free term structure of interest rates, and default premium fell but not enough to offset the increase in risk-free rates. In the later period, in contrast, long-term Treasury yields fell and risk premiums relative to 10-year Treasuries increased: the AAA risk-premum increased 51 basis points and the BAA-AAA premium six basis points. Therefore, while long-term Treasury yields fell in the later period, default risky bond yields increased. The hot economy in the earlier period could explain reduced concerns about default risk, while an anticipated slowdown in the economy with falling future rates of return could be associated with increased fears of defaults. 3. Using the Federal Reserve Board’s Flow of Funds Accounts handed out in class, discuss the relative size and changes in market shares of household assets and liabilities of different types of deposit-taking institutions and the share of deposit-taking institutions relative to other major financial institutions interacting with households. How can you explain these changes and what, if any, relevance do these developments have to deposit-taking institutions around the world? Total financial assets of households increased 115% (from $16,442 billion in 1991 to $35,343.1 billion in 1999), whereas deposit increased only 30% (from $3,251.1 to $4,231.5 billion), meaning that households keep a smaller share of their financial assets in deposit-taking institutions. The growth in household assets over the period has been in corporate equities (up 234%), mutual funds (up 429%), and in pension fund reserves (up 159%). Commercial banking total assets increased 74% over the period (from $3,442.2 to $5,991.9 billion) but small time and savings deposits only increased 45.4% (from $1,386.5 to $2,016.2 billion) and checkable accounts (total) actually declined over the period. However, commercial banks’ share of deposit-taking institutions’ assets increased as savings institutions’ assets and liabilities were essentially flat and deposits actually declined. On the liability side, commercial banks’ mortgage total increased 69.6% but savings institutions’ mortgage total declined. The largest growth in mortgages, however, has been in Federally related mortgage pools, up 97.6% (from $1,130.4 to $2,234.* billion, as shown in Table L.218). Banks and savings institutions are thus losing market share of both household saving and household borrowing. These changes may anticipate changes in other countries where banks dominate household savings, as in China, Japan, and Europe.