To receive maximum credit:
a. Write essays of at least one full page for the essay questions and the T-F-U/Explain question. Write essays using complete sentences.
b. Show all work to support your answers to the problems.
c. Label all numbers, graphs and diagrams with appropriate units.
Essay Questions and T-F-U/Explain
1. (15 points) Assume that you are a U.S. beef farmer and you want to retire in 2002. In one year you will sell off your cattle, hopefully raising somewhere around $2m from the sale. Then you will invest half of your proceeds in U.S. T-Bonds and buy a condominium in Mexico with the other half of your proceeds. You are extremely risk averse. How could you use futures contracts to hedge the three risks that you are exposed to? Be specific - explain the three specific risks you are exposed to, identify the three specific futures contracts you would use, identify the position you would take on each contract, and explain why. Draw a completely and carefully labeled payoff diagram for your exact position in each of the three futures contracts (not both sides, just your side of the contract).
2. (8) a. What is meant by "central bank independence”,
and what is the expected relationship between central bank independence
and price level stability? Use the concept of “political business
cycles” in your answer.
(7) b. What features of the Federal Reserve Bank contribute to its independence?
3. (15 points) T-F-Uncertain/Explain in an essay:
Low interest rates are good for the economy.
Problems - Please label your answers with the appropriate letter (points in parentheses)
1. (15 Points Total)
Royal Caribbean Cruise Lines is in the winter cruise business and is considering using futures contracts to hedge against price risk for oil, one of its main inputs. October 2001 oil futures contracts are trading at $20/bbl. RCCL buys 100,000 barrels every October for the winter cruise season. Additional costs of operation are fixed at $1m per season. Revenues from ticket sales will be $4m for the winter cruise season.
Calculate the profit/loss for RCCL under these two conditions:
a. RCCL does not hedge and oil ends up at $35/bbl in the spot market next October.
b. RCCL does not hedge and oil ends up at $10/bbl in the spot market next October.
c. RCCL now decides to hedge with oil futures at $20/bbl. Explain the position it would take and show a carefully labeled futures payoff diagram for RCCL’s position in oil futures.
For the two scenarios below, calculate RCCL’s profit or
loss using the following format: Clearly label and show i)
The sales revenue, ii) the gain or loss on the futures contract,
iii) the cost of oil at the spot market price, iv) the fixed costs of operation and then v) the net gain or loss for RCCL for the season.
d. RCCL hedges 100,000 barrels at $20/bbl and oil ends up at $35/bbl in the spot market.
e. RCCL hedges 100,000 barrels at $20/bbl and oil ends up at $10/bbl in the spot market.
f. Write an essay explaining the benefits of using futures contracts to reduce risk, referring specifically to your answers to the previous questions in parts a-e.
2. (30 Points Total) You are given the following information: (all dollars are in Billions)
Monetary Base (MB) = $600B
Currency (C) = $450B
Currency / Deposit Ratio ( C / D ) = .375
a. calculate bank deposits (D), the money supply (M1), reserves (R), required reserve ratio (rD), loans & securities, simple deposit multiplier (SDM), the deposit multiplier (DM) and the money multiplier (m).
b. for a $42B 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).
c. for a $42B 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. show the anticipated actual effects of a $42B expansionary OMO on the changes in M1, D, C, R, Loans, and 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 (to four decimal places)
after the OMO?
Use the original monetary values (before the $42 OMO) for the following questions:
h. If the Fed wants to decrease the money supply by 2%,
what size OMO should it implement, and what exact action will the Fed take
in its OMO to decrease the money supply?
i. Assuming that the original amount for the MB stays the same (and assuming that no OMO takes place), what would happen to the money supply in percentage terms if the reserve requirement was changed to 2.5% (rD = .025)? (Hint: Calculate the new money multiplier, and then using the original MB, calculate the new amount of M1, and then calculate the percentage change).
j. 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 .50? (Follow the procedure
outlined for problem i above).