Hints for full credit: Write legibly, in full sentences.  Answer essay questions with a minimum of one full paragraph.  Label all graphs and numbers with appropriate units.
One or two sentence essays will NOT qualify for full credit.

ESSAY QUESTIONS - TEN POINTS EACH

1.  Assume that you are a U.S. hog rancher and you want to retire.  In one year you will sell off your hogs, hopefully raising about $1m from the sale.  Then you will invest $500,000 in an SP500 Index mutual fund and buy an oceanfront condominium in Acapulco, Mexico with the other $500,000.  You are extremely risk averse.  How could you use futures contracts to hedge your risk?  (Identify three risks).  Discuss the specific position you would take.

2.  What is meant by "central bank independence?"  Why is independence of the central bank important for price level stability?  Is there any empirical evidence linking central bank independence and low inflation?  Mention the concept of "political business cycles" in your answer.

3.  Compared to Canada, Europe and Japan, the banking system in the U.S. has been very fragile, and unable to withstand various "stress tests" such as severe economic recessions and periods of high inflation.  For example, thousands of U.S. banks failed during the 1930s and again during the 1980s, when very few banks failed in Canada during these periods.  Comment on this, addressing the following questions: Why have U.S. banks failed at such a high rate compared to Canada and Europe, especially during the 1930s and 1980s?  How have banking regulations contributed to the fragility of U.S. banks?

4.  How did flat-fee-based deposit insurance contribute to the problem of S&L failures?  Use moral hazard in your answer and explain what can be done about this situation.
 

PROBLEMS
1. (15 POINTS) One year zero coupon treasury securities are selling for $952.38 in the U.S. and for £930.23 in the U.K. (assume 1000 face value, round interest rates to the nearest whole or half percentage, e.g. 6% or 6.5%, etc.).  The current ex-rate is $1.58/£.
a. Calculate the one year returns in the U.S. and in the U.K.
b. If interest rate parity holds, should the pound be selling at a forward discount or premium?  why?
c. based on your answer, calculate the expected one year forward ex-rate.
d. If interest rate parity does not hold and the actual forward rate is $1.5563/£, calculate the forward discount or premium of the £, and calculate and compare your rate of return in the U.S. versus the U.K.  For the U.K. investment, assume that you use a forward contract to cover ex-rate risk.
e. If the actual forward rate is $1.5563/£, and given the one year interest rates from part a, what would happen to bond prices and interest rates in the U.S. and U.K. to restore interest rate parity?

2. (10 Points) As reported in today’s WSJ, November 2000 crude oil futures contracts are trading at $28.50/bbl.  Assume that you have reliable inside information not yet available to the public that the Clinton administration will soon announce that oil exploration drilling will be allowed in currently protected oil-rich areas of Alaska, creating a significant increase in the world supply of crude oil.
a. Explain how you would use this information to speculate in the futures market, describe what position you would take and show a payoff diagram of your potential profits and losses.
b. If the actual spot rate for oil in November turns out to be $28.25, and you have one contract of 1000 barrels, did you make or lose money?  How much?
c. If the actual spot rate for oil in November turns out to be $29.25, and you have one contract, did you make or lose money?  How much?
d. If you total initial investment in the contract was $1000, calculate your rate of return on your investment in oil futures in parts b and c.
(Rate of return (%)  = [$Profits (or $Losses) /  $Initial Investment]  x  100.)
e. Futures markets are considered to be extremely risky because they are highly leveraged.  Use this problem as an example and explain this.

3. (20 Points) You are given the following information: (all dollars are in Billions)
Monetary Base (MB) = $625B
Currency (C) = $500B
Currency / Deposit Ratio ( C / D ) = .50
a. calculate bank deposits (D), the money supply (M1), reserves (R), required reserve ratio (rD), and loans & securities.
b. for a $25B expansionary Open Market Operation (OMO), what is the absolute MINIMUM change in the Money Supply (M1), and under what extreme conditions would that occur? (Hint: the person who sells the T-bill to the Fed cashes the check for currency, no money stays in the banking system).  c. for a $25B OMO, what is the absolute MAXIMUM change in M1, and under what extreme conditions would that happen?  (Hint: NO currency leaks out of the banking system )
d.  now show the actual effects expected from a $25B expansionary OMO on the changes in M1, D, C, R, Loans, MB.
e. show a fully labeled funnel diagram of the OMO, with the changes in the variables from part d.
f. what is the percentage change in M1 from the OMO?
g. Before the OMO, the $/£ ex-rate was $1.50.  Assuming that the supply of British pounds remains unchanged and that the change in the supply of dollars is fully reflected in a change in the exchange rate value of the dollar, predict the ex-rate after the OMO?

Use the original monetary values (before the $50 OMO) for the following three questions:
h. Assuming the original amount for the MB, what would happen to the money supply in percentage terms if the reserve requirement was changed to 10% (rD = .10)?  (Hint: Calculate the new money multiplier, then the dollar change and then calculate the percentage change).
i. Assuming the original MB and the original rD, what would happen to the money supply in percentage terms if an increase in drug trafficking raised the C/D ratio to .75?  (Hint: calculate the new money multiplier)
j.  Assuming the original M1 and the original money multiplier, if the Fed wants to decrease the money supply by 4%, what size and type of OMO should it implement?

4. (15 points)

A bank has the following financial assets and liabilities in PV dollars:

Assets                                            Average Duration
Cash Reserves           $5m                         20 years
Auto loans                 $10m                        3 years
Business loans           $25m                        2 years
Credit Card debt        $15m                        1 year
Mortgages(fixed)        $40m                        8 years
Mortgages(variable)     $5m                         2 years

Liabilities                                             Average Duration
Checking accounts     $75.2                        1 years
Savings accounts         $18.8m                    2 years

a) what is the duration of the asset portfolio?
b) what is the duration of the liabilities?
c) what is the current value of the bank?
d) what is the new value of the bank if interest rates increase by 4%?
e) what is the new value of the bank if interest rates decrease by 2%?
f) summarize the main implication of this problem.