Hints for full credit: Write legibly, in full sentences.  Answer essay questions with a minimum of one full paragraph.  For problems, show all work, and label all numbers with appropriate units.

ESSAYS (10 points each) :
1.  U.S. automakers currently control about 65% of the U.S. car market.  Analysts recently predicted that if the Euro, Pound and Yen depreciate against the dollar, that U.S. automakers might lose some of their U.S. market share to foreign automakers.  Explain.
2.  Explain the role that banking regulations played in a) bank failures of the early 1930s and b) bank failures during the S&L crisis of the 1980s and 1990s.
3.  First explain in detail the concept of financial disintermediation in general, and then give 2 or 3 examples of the financial disintermediation that occurred in the 1970s and 1980s because of advances in information technology. Be specific.

PROBLEMS:
1. (15 points total) 1 year zero coupon treasury securities are selling for $925.93 in the U.S. and for £892.86 in the U.K. (assume 1000 face value in both dollars and pounds).  The current ex-rate is $1.44/£.
a.  Calculate the 1 year returns (YTM) in the U.S. and in the U.K. for T-bills (round to 2 places, e.g. 5.50%, 6%.)
b.  Show the formula for, and explain the concept of, “interest rate parity.”  Using your answers from part a, explain whether the British pound should be selling at a forward discount or premium, and explain exactly why it is selling for a discount or premium.
c.  Based on your answer in part b, and using the current spot rate, calculate the expected one year forward ex-rate (quote forward rates to four decimal places) if interest rate parity holds.
d. If interest rate parity does not hold and the actual one year forward rate is $1.3968/£, calculate the actual forward discount or premium.  Using that forward discount or premium and the one year yields from part a, compare an American investor’s rate of return in the U.S. versus the U.K. (For the U.K. investment , assume the U.S. investor would invest at the 1 yr. U.K. Tbill rate and use a forward contract to cover ex-rate risk.)
e.  Based on your answer to part d, what would happen to bond demand, bond prices and interest rates in both the U.S. and U.K. to restore interest rate parity?  Explain exactly why the bond prices and interest would change in each country.

2.  (12 points total) You are given the following information on prices for zero coupon Treasury securities:

Maturity                      Price                Face Value
1 year                        $925.93               $1000
2 years                       $865.33               $1000
3 years                       $827.85               $1000

a.  (4) Solve for the yields (spot rates) on these securities: R₁, R₂, R₃.  Round to two decimal places (e.g. 4.00%, 4.50%, etc.)
b.  (4) Solve for the forward rates: f₂ and f₃.
c.  (4) According to the expectations hypothesis, explain what the above yield curve and forward rates imply about the direction of future short-term interest rates in a short essay.

3.  (13 points total) You are given the following information on a typical S&L in the late1970s.
Assets (All Mortgages):  Average Duration = 6.8 years PV of Assets   =      $800m
Liabilities (All CDs):  Average Duration = 1.2 years PV of Liabilities =  $700m

a.  (7) Scenario 1: Using the above information, assume that interest rates rise by 6%.  What will happen to the bank’s value in PV dollars, and how does that compare to the original value?

b.  (6) Scenario 2: Using the original information above, assume it is 1981 and there is a downward sloping yield curve, and the bank pays out an average of 14.5% on its deposits (liabilities) during a one year period and earns an average of 11.5% on its loan portfolio (assets) during that year.  What would be the bank’s annual net income (profit or loss) in 1981?  (Calculation is required).