Question 1
Use graphs when necessary
a) During bearish periods in the stock markets severe price declines are observed, with investors becoming net sellers of shares. During these periods of cyclical downturns in the equity market, interest rates also can decline.
Use the loanable funds framework to explain how a cyclical reversal in the equity market, together with a change in sentiment leading to the large-scale selling of stocks, can lead to lower interest rates in the bond markets. (10 marks)
b) Consider the existing economic conditions, including inflation and economic growth. The inflation rate is forecasted to be 0.5% and the growth rate of GDP is forecasted to be 1% for the next three months.
Present a cogent argument to support your views on whether the Central Bank should increase interest rates, reduce interest rates, or leave interest rates at their present levels? (11 marks)
c) Assume that:
i) investors and borrowers expect the economy to contract and inflation to decline,
ii) investors seek a lower liquidity premium from longer investments,
iii) bond markets are partially segmented and the US Treasury currently has a preference for borrowing in short-term bond markets.
Explain how each of these forces would affect the term structure of interest rates, holding other factors constant. Then explain the effect on the term structure overall.
Question 2
a) Assume that the Central Bank’s (CB) primary goal is to correct a weak economy.
How can it use open market operations to achieve its goal? What is a possible adverse effect of this action by the CB (even if it achieves its goal)? (11 marks)
b) Suppose that the Treasury decides to finance its deficit with mostly short term funds. How could this decision affect the term structure of interest rates? If short term and long term markets were segmented, would the Treasury’s decision have a more or less pronounced impact on the term structure? Explain. (10 marks)
c) You need to choose between investing in a one-year municipal bond with a 7% yield and a one-year corporate bond with an 11% yield. If your marginal federal income tax rate is 30% and no other differences exist between these two securities, which one would you invest in? (4 marks)
d) A corporation is planning to sell its 90-day commercial paper to investors offering a 2.4% yield.
i) If the three-month T-bill’s annualized rate is 1.5%, the default risk premium is estimated to be 0.2% and there is a 0.3% tax adjustment, what is the appropriate liquidity premium?
ii) If due to unexpected changes in the economy the default risk premium increases to 0.4%, what is the appropriate yield to be offered on the commercial paper (assuming no other changes occur)? (8 marks)
Question 3
Discuss the following:
(a) Which type of risk can be eliminated by diversifying your portfolio? Which type of risk remains after a portfolio is diversified? Do investors receive compensation for all types of risk?
(b) Write down an equation representing the expected return on an individual security, and explain how the market’s price of risk affects the expected return on the security.
(c) Suppose that Microsoft has a β = 1.5, and the return on 1-year Treasury bills is 6%. If the market return is expected to be 10% this year, what do you expect the return on Microsoft to be? Why?
