- Rank the following three securities from the most volatile to the least volatile and explain why? In normal times, which security offers the highest and the lowest yield?
- 6-months US treasury bills
- Long Term US government bonds
- Caa rates Corporate bonds
- Assume that the overall stock prices have increased significantly in the economy. In response, what do you expect the happen to business investment spending and consumers’ decision to spend?
- For the following group of people in the economy, explain whether they are worse-off or better-off after an increase in the interest rate: Current Borrowers, Prospective Borrowers, Current Savers, Prospective Savers
1) Let us assume that you are the CEO of a Turkish company selling junks in the Turkish markets. In your monthly board meeting, you just realized that you have 3 million lira cash that will be needed 1 month from now to pay your suppliers. What can you do with that extra 3 million lira? Which securities/assets you can buy and in which markets?
2) Do you agree with the following statement, please explain: “Money market instruments are safer and more liquid hence offer a lower return than capital market instruments.”
3) As a risk neutral investor, which of the following two options you will choose with your 10,000 Turkish lira savings and why?
- A local bank offers 10% annual interest on saving deposits
- A company offers one-year maturity zero coupon bonds at 25% discount. But, there is a 20% chance the company will go bankrupt and default on their liabilities.
4) Assume that you have inherited 1 million lira from your grandma and you consider alternative investment instruments. You have the option to put your 1 million lira savings in a bank for one year and get 10% interest or buy a corporate bond. Turkish Junklines Company offers one-year maturity corporate bonds with a par value of 1 million and coupon payments of 200,000 lira to be paid by the end of the year. The market price of the bond is 1 million lira. However, there is a 20% chance the company will go bankrupt and you will get nothing at the time of maturity. You also happened to be a close friend of the CEO of the company and he knows for sure whether the company will go bankrupt or not. Your friend will give you the information (whether they will go bankrupt or not) only if you give 20,000 lira donation to his favorite charity organization “Penguin Savers of Turkey”. As a risk-neutral person, what would you do?
- In country X, the share of M1 in M2 is 70% while in country Y, it is just 10%. Come up with a couple of economic justifications that can explain why countries might have different M2 compositions.
- We do not count the money in the ATM machines when we measure M1. What might be the rationale of not counting it as a part of the aggregate money in the nation? What will happen to the monetary aggregates (M1 and M2) if we start counting them as a part of M1?
- Please comment on the following graph:
Is there a close association between M1 and M2 growth rates? Should the growth rates be closely correlated? Why? Why not?
- Please explain in plain English what happens to the present value of an expected future payment if the interest rates increase.
- What is the present value of 1,000 lira you will get a year from now when the interest rate is 20%? What would be the present value of 1,000 lira were the interest rate is 10%? Do you prefer the get 1,000 in one year at 20% interest rate or 10% interest rate environment?
- If a security pays $110 next year and $121 the year after that, what is its yield to maturity if it sells for $200?
- Assume that you hold (bought) a corporate bond a year ago and today, the yield to maturity on this corporate bond increased significantly, are you better off or worse off if there are years to maturity and you are about to dump the bond?
- What is the yield to maturity on a simple loan for 1 million lira (the current market price) that requires a repayment of 2 million lira in five years’ time?
- There is a one-year coupon bond with a par value of 800,000 lira, market price of 820,000 lira, and coupon rates of 10%. Calculate the yield to maturity on this bond.
- There is a one-year coupon bond with a par value of 800,000 lira, market price of 800,000 lira, and coupon rates of 10%. Calculate the yield to maturity on this bond.
- There is a one-year coupon bond with a par value of 800,000 lira, market price of 700,000 lira, and coupon rates of 10%. Calculate the yield to maturity on this bond.
- What is the maximum price you will pay to get a discount bond with five years to maturity, the yield to maturity rate of 6% and par value of 10,000 lira?
- Assume that we have two zero-coupon bonds issued by Turkish government. One is a 2 years maturity zero-coupon bond issued on March 2016 with a par value of 10,000 lira and is sold in the primary market at 9,000 lira. The other one is 10 years maturity zero-coupon bond issued on March 2016 with a par value of 10,000 lira and is traded in the primary market at a price of 7,000 lira. Calculate the yield to maturity for each bond.
- Assume that you are running a corporation and will issue a corporate bond with a 5 years maturity and a face value of 100,000 lira. The bond will be a zero-coupon type bond with no coupon payments. You would like the yield to maturity on the bond to be 5%. For how much you should sell the bond at the primary market. Please show your work.
- Please fill in the blanks for the market for bonds:
- The higher the wealth in the nation, the ______ the demand for bonds.
- Lower expected interest rates in the future ____ the expected future return on bonds and _______ the demand for bonds.
- The higher the volatility of the current bonds price, the ______ the demand for it for a given price of the bond
- The more liquid a bond is , the _______ the demand for it
- If lenders expect lower inflation in the future, they will be____ willing to lend now buy demanding _____ bonds.
2.Please fill in the blanks for the market for bonds:
- When borrowers expect profitable investment opportunities in the future, then they supply ___________bonds now.
- When borrowers expect higher prices in the future, then they supply ___________ bonds now.
- The higher the government budget deficit, the _____ the supply of
- In recessions, supply of bonds and demand for bonds ____, price of bonds will ____.
- In expansions, the supply of bonds and demand for bonds ____, the price of bonds will ____.
- With expected deflation in the economy, demand for bonds will ____, supply of bonds will ___________. Price of bonds will __________.
3) Analyze the impact of a sharp decline in expected inflation on the bond market.
4) Raising money supply will lead to higher income and wealth in the nation in normal times. What will be the predicted impact on the interest rate of an increase in income and wealth in the money market and bond market?
5) If the money supply increases significantly, since price level will rise in the long run, current inflation expectation will increase as well. What will be the predicted impact on the interest rate of an increase in increase in inflation expectation in the money market and bond market?
6) Assume that the interest rate is determined in the bonds market by the intersection of demand and supply of bonds as described in chapter 5. Keeping all other factors constant, what do you think will happen to the equilibrium interest rates in the bonds market if, in the gold market, market participants expect a better gold return in the future than before? Please support your answer with a graph.
7) Assume that the interest rate is determined in the bonds market by the intersection of demand and supply of bonds as described in chapter 5. Keeping all other factors constant, what do you think will happen to the equilibrium interest rates in the bonds market if there is an unexpected increase in the inflation expectations in the economy? Please support your answer with a graph.
- Assume that the economy is in an expansion phase (booming economy) and the market expects that the Central Bank will raise the short-term interest rate in the future to reduce the inflationary pressures. What do you expect the shape of the yield curve to be in this economy? Is it steep or flat, please explain.
- For the US economy, the treasury yields data as of April 07, 2016 is as follows:
What type of information you can infer about the economy (growth and inflation prospects) by looking at 2007 yield data.
3) We also have the following yield data for January 02, 2007.
What type of information you can infer about the economy (growth and inflation prospects) by looking at 2007 yield data.
4) Assume that a country is at a zero lower bound (current short-term interests rate is almost zero) and has an almost flat yield curve. Then, things have changed in the economy and the market participants expect now that the economy will soon enter into a recession. What do you think will happen to the shape of the yield curve? Please explain.
5) Municipal bonds holders are exempt from tax on interest income while treasury bond holders are not. In 2013, the US Congress passed a legislation to increase the tax rate on high-income taxpayers by 4%. As a result of this, what do you expect to happen to the interest rate on municipal bonds relative to the interest rates on treasury bonds? Please show your answer on a graph.
6) A two-year bond offers 8% interest while a one-year bond offers 6%. For the no-arbitrage condition, what should be the approximate expected rate of interest on a one-year bond a year from now?
7) Given the following yield curve, what is the market expectation of inflation rates and short-term interest rates for the period at which the yield curve is flat? How about for the period at which the curve is upward-sloping?
8) If bond investors decide that 30-year bonds are no longer as desirable an investment as they were previously, predict what will happen to the yield curve if expectation theory holds?
9) If the yield curve suddenly became steeper, how would you revise your predictions of future sort-term interest rates?
- The current market price of a share of stock is $17. You expect that the stock will pay a dividend of $1 per share in one year, and also you expect to be able to sell it in one year for $20 per share. If you require a 15% return on the stock, would you buy the stock?
- Given the following stock price valuation equation implied by the Growth Model, what do you expect to happen to the current price of the stock if people expect dividend payments to decrease significantly in the future?
- According to the Lemons problem, due to asymmetric information, sellers of good quality items will not want to sell at the price for average quality so we have few suppliers in the market and most of them are selling low-quality products. On the other hand, many buyers left the market because they do not want to buy low-quality products. Why do you think people call this outcome a problem? What is wrong with having few suppliers and buyers in the market, please comment?
- In the US used-car markets, there are some private companies that collect and sell information for each individual car to prospective buyers. A used-car buyer can pay a small fee and run the history of the car (the model and make of the car, the emission history, the accident history if any and the severity of the damage, the actual mileage etc.) by typing in the Vehicle Identification Number (VIN). If we assume that the fee for this service is very minimal, we can expect more buyers in the market as they have more accurate information about the cars they are looking for. How about the supply side of the used-car market? Do you expect more/less good quality/ bad quality car sellers in the market?
- We see banks seeking for a collateral when they make out big loans such as mortgage or car loans. What do you expect to happen to adverse selection and moral hazard problems when creditors require collateral on the loan they give?
- Does higher collateral on a loan reduce or raise the moral hazard problem? As a result, do the incentives of the borrowers and lenders to converge (align) or diverge?
- What specific procedures do financial intermediaries use to reduce asymmetric information problems in lending?
- Does free-rider problem increase the adverse selection or moral hazard problem?
- What happens to the return on equity if banks pay out more dividends or buy back some of its shares?
- What happens to excess reserves and required reserves at the First National Bank if one person withdraws $1,000 of cash and another person deposits $500 of cash? Assume that the required reserve ratio is 20%. Use T-chart to explain your answer.
- Suppose you are the manager of a bank that has $30 million of fixed-rate assets, $15 million of rate-sensitive assets, $20 million of fixed-rate liabilities, and $25 million of rate sensitive liabilities. Conduct a gap analysis for the bank, and show what will happen to bank profits if interest rates fall by 5 percentage points.
- Suppose you are the manager of a bank whose $200 billion of assets have an average duration of five years and whose $90 billion of liabilities have an average duration of 7 years. Conduct a duration analysis for the bank, and show what will happen to the net worth of the bank if interest rates rise by 5 percentage points.
- Given the T-chart of a bank below, if there is an immediate withdrawal in the amount of $10 million when the required reserve ratio is 10%, does the bank face a liquidity problem?
6. Do you agree with the following statement or not?
” If the bank is able to raise funds with liabilities that have high interest costs and is able to acquire assets with low interest income, the net interest margin will be high, and the bank is likely to be highly profitable. If the interest cost of its liabilities rises relative to the interest earned on its assets, the net interest margin will increase, and bank profitability will improve.”
7. Given the information below, please calculate the followings:
Calculate the impact of a 10% decrease in interest rate on:
- income on assets
- payments on the liabilities
- net impact on bank profits
8. Of the following two securities, which one has a shorter effective maturity (lower duration) and why?
- 10-years maturity zero-coupon bonds
- 10% coupon bond with 10 years maturity
9. The bank manager wants to know what happens when interest rates rise from 10% to 11%. The total asset value is $100 million, and the total liability value is $95 million. Use Equation below to calculate the change in the market value of the assets and liabilities. (Duration of assets=2.7, duration of liabilities=1.03)
10. The bank manager wants to know what happens when interest rates rise from 10% to 11%. The total asset value is $100 million, and the total liability value is $95 million. Use the equations below to calculate the change in the net worth as a percentage of total assets (Duration of assets=2.7, duration of liabilities=1.03, duration gap=1.72 years)
- What is wrong with having higher competition in the banking sector? Why do regulators try to restrict too much competition in the sector? Please answer the question in light of the adverse selection/moral hazard problems?
- Assume that you are regulating the banking sector and you plan on adopting the too-big-to fail policy as a part of macro-prudential measure. It is also known that too-big-to fail policy increases moral hazard problem. What precautions would you have in your policy to lower the moral hazard problem?
- As a part of the deposit insurance system, the depository institutions in the nation pay their premiums to the deposit insurance fund. If the system is designed in such a way that riskier banks pay a higher premium than the less riskier ones, what would be the consequences of this policy in lowering moral hazard problem in the banking sector?
- A countercyclical capital requirement in the banking sector indicates that the banks should have higher capital/asset ratio during booms times and eased requirement during the contraction in the economy. What are the risks (if there are any) of having loose capital requirements during a recession in the economy?
- Please comment on the following statement: ” Restrictions on interest paid on deposits led to disintermediation”
- Please comment on the following statement: ” Rising inflation led to rise in interest rates and disintermediation”
- What can you say about the level of asymmetric information at times of high credit spread (credit spread measures the difference between the interest rate on corporate bonds and government bonds)?
- What happens to the solvency of a bank that borrowed a lot of government bonds, a and gov’t needs to raise the interest rate to prevent a currency collapse?
- After a bursting of a bubble in a market (stock or housing), what happens to the net worth of companies that have some security holdings in that bubbled market? What do you expect to happen to the moral hazard problem in the market where these companies are the borrowers?
- If there is a very high unanticipated decrease in the overall price level in the economy, what happens to the (real or nominal) net worth of companies that borrowed heavily from the market? As a result, what do you expect to happen to the moral hazard and adverse selection problems in the market?
- The author of the book claims that the failure of a major financial institution can increase the uncertainty in financial markets, as a result, it will be hard for lenders to screen good from bad credit risks. Could you please comment on this?
- Why do bank panics worsen asymmetric information problems in credit markets?
- Why do people choose to buy insurance even if their expected loss is less than the payments they will make to the insurance company?
- The US economy observed two severe negative supply shocks in 1970s which shoot up the inflation to two-digit levels. To combat with the inflation problem, the Fed pursued contractionary monetary policies by raising the interest rate. If you were a bank owner in the US in 1980s, would you welcome higher interest rate in the economy?
- If the pension fund you manage expects to have an inflow of $120 million six months from now, what forward contract would you seek to enter into to lock in current interest rates 5%? If you take part in the forward contract, then are you taking a long or short position?
- Assume that the portfolio you manage is holding $25 million of 6s of 2035 Treasury bonds with current price of 110. You plan to sell the bonds a year from now and would like to hedge against the interest rate risk as you fear that the interest rate can go up in a year period. What forward contract would you enter into to hedge the interest-rate risk on these bonds over the coming year? With that contract, are you taking a long or shosrt position.
- When you sell a $100,000 June contract for 115 on Feb, you agree to deliver 100,000 face value long term by June for $115,000. Are you taking a long or short position on the bond? As the seller of this contract, what is your expectation of interest rates? Do you expect rates to go up or down? If, by the end of the June, the interest rates on contracted bonds falls, then are you better off or worse off by writing this contract?
- If, on the expiration date, the deliverable Treasury bond is selling for 101 but the Treasury bond futures contract is selling for 102, then how can you make money in this market?
- Suppose the pension fund you are managing is expecting an inflow of funds of $100 million next year, and you want to make sure that you will earn the current interest rate of 8% when you invest the incoming funds in long-term bonds. How would you use the futures market to do this?
- You buy a put option on a $100,000 Treasury bond futures contract with an exercise price of 95. Assume that at the expiration date, the price of the Treasury bond is 120. Is the contract in the money, out of the money, or at the money? What is your profit or loss on the contract if the premium was $4,000?
- Consider a put option contract on a zero-coupon T-bond with an exercise price of 102. The contract represents $100,000 of bond principal and has a premium of $1,500. The actual T-bond price falls to 99 at the expiration. What is the gain or loss on the position?
- Suppose that you buy a call option on a $100,000 Treasury bond futures contract with an exercise price of 110 for a premium of $1,500. If, upon expiration, the futures contract has a price of 111, what is your profit or loss on the contract?
- If the Japanese price level rises by 5% relative to the price level in the United States, what does the theory of purchasing power parity predict will happen to the value of the Japanese yen in terms of dollars?
- When the Federal Reserve conducts an expansionary monetary policy, what happens to the money supply? How does this affect the supply of dollar assets?
- Suppose the president of the United States announces a new set of reforms that includes a new anti-inflation program. Assuming the announcement is believed by the public, what will happen to the exchange rate on the U.S. dollar?
- If nominal interest rates in America rise but real interest rates fall, predict what will happen to the U.S. dollar exchange rate.
- In US, the price level is 200 while in Euro Area it is 100. (i) If the Purchasing power parity theorem holds, what should be the nominal exchange rate between these currencies (find the euro price of a dollar, E €/$) . (ii) Next year, US observes 5% inflation while in Greece the prices increase by 10% (inflation rate in Greece is 10%). For the purchasing power parity theorem to hold, how much should the nominal exchange rate, E €/$, depreciate/appreciate?