For maximum credit: write legibly in full sentences, label
all numbers with appropriate units, show all work. Essays and T-F-U/Explain
questions should be answered with at least one full paragraph.
Points are indicated in parentheses.
ESSAY QUESTIONS (10 Points each)
1. The Treasury yield curve is now inverted, or “humped” shape, and 30 year bond yields are about .5% lower than ten year bond yields. Offer several explanations for this phenomenon, citing theories of the term structure to support your answer.
2. Assume that the Federal Reserve implements expansionary
monetary policy.
a. What action would it take to carry out this policy?
(two points)
b. Using the Supply and Demand for Bonds model and the
Liquidity Preference model (S & D for money), show graphically the
Fed’s action and explain what happens to bond prices and interest rates
in the short run? (four points)
c. explain what happens to interest rates in the long
run under the most likely scenario, explaining the various effects on interest
rates in the long run. Use a graph to support your answer (with interest
rates on the vertical axis and time on the horizontal axis).
3. Savings and Loans started to fail in large numbers
in the early 1980s, largely because a) actual inflation was consistently
greater than expected inflation in the mid and late 1970s, and b) there
was a downward sloping yield curve in the early 1980s. Explain why
these two events caused such huge problems for S&Ls.
T-F-UNCERTAIN - State your answer (True, False or Uncertain) and then explain your answer in a short essay of at least one full paragraph. One sentence essays will not qualify for full credit. (10 points each)
4. A carefully diversified portfolio with 50 or more stocks in many different industries eliminates risk.
5. Interest rates are procyclical (rise during expansions,
fall during contractions). (Use either the S & D for Bonds or
the S & D for Credit model to explain your answer.)
PROBLEMS
6. (20 points total, 4 points for each part ) Given the
data below:
a. Calculate the annualized, compounded nominal
rate of return for each country’s stock index. (4)
b. Calculate the annualized, compounded rate of inflation
in each country.
c. Calculate the real rate of return for each stock market.
d. Which country had the highest nominal return?
e. Which country had the highest real return? Explain
your answer in words.
YEAR
1990 1996
Germany Stock Index 650
1825
CPI 622
760
Italy Stock Index
2000 9725
CPI 998
3200
Canada Stock Index
550 1800
CPI 125
200
7. (30 points total, as indicated) You are given the following information on bonds in the year 2000 when the CPI is 170.
Type
Coupon Rate FV
Term
Price
Zero Coupon
-
$1000 5 years
$700
Regular T-note
6.5%
$1000 5 years
$950
Indexed T-note
3.5%
$1040 5 years
$975
Muni-bond
4.75%
$1000 5 years
$955
a. calculate the yield to maturity (YTM) for each bond.
(10 points)
b. using the information above, calculate the expected
rate of inflation over the next five years. Explain in a short essay
specifically how expected inflation can be calculated from treasury bond
yields. . (5 points)
c. Using our answer from part b, and assuming the CPI
in 2005 is 187, calculate the actual rate of inflation. Would a person
who bought the regular T-note in 2000 and held it until maturity be helped
or harmed by the actual rate of inflation? Explain in a short essay.
(5 points)
d. assuming that Regular T-notes are fully taxable, would
a person in the 28% tax bracket prefer the muni-bond (tax-free) or the
Regular T-note? Explain your answer. (Assume that there is
no difference in risk) (5 points)
e. Explain in a short essay of three or more sentences
why the Regular T-note, the Indexed T-note and the Muni-bond are all selling
at a discount. (5 points)