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
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.)
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.
Germany Stock Index 650 1825
CPI 622 760
Italy Stock Index
CPI 998 3200
Canada Stock Index
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.
Coupon Rate FV
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.
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)