Financial Markets and Institutions: Old Exams



Econ 340: Financial Markets & Institutions
Midterm Exam Oct. 11, 2005

Essay (35 minutes): 40 points
Nine out of ten of the U.S. recessions since World War II were preceded by a spike in oil prices. At the same time, oil price spikes tend to cause temporary short term jumps in inflation.

At the end of September, a barrel of light crude sold for almost $70 compared to a price near $30 a barrel in January of 2004. To answer the following questions, assume that bond traders expect inflation to rise from 3 percent in 2005 (history) to 5 percent in both 2006 and 2007 (expected inflation). Also, traders expect the U.S. economy to enter a recession in 2007. Assume that prior to the recent run up in oil prices, bond traders had expected inflation to remain stable in 2006-2007 at 3 percent.

a) (10 points) Using a model of the supply and demand for 1 year t-bills, illustrate and explain the impact of an increase in expected inflation. Explain what your results imply for changes in the yield on 1 year t-bills in 2006 and 2007.

b) (10 points) Using a model of the supply and demand for 1 year t-bills, illustrate and explain the impact of a recession (a business cycle contraction). If bond traders expect that this recession will occur in 2007, what do they expect to happen to yields on one-year t-bills in 2007.

c) (20 points) Write down an equation representing the liquidity premium theory of the term structure of interest rates. Based on this theory, explain how the yields on short term and medium term government bonds are related. Based on your answer to parts (a-b) above, draw and explain a yield curve that represents the relationship between short and medium term bonds.





Multiple Choice (40 minutes): 2 points each
  1. Determine which of the following scenarios is true:
    I. Historically in the U.S. interest rates on three-month Treasury bills on average are higher than interest rates on Treasury bonds.
    II. Historically in the U.S. interest rates on Treasury bonds on average are lower than interest rates on corporate Baa bonds.
    1. I is true, II is false.

    2. Both are true.

    3. I is false, II is true.

    4. Both are false.



  2. A rise in interest rates --- the cost to financial institutions of acquiring funds and --- the income they earn on assets.
    1. lowers; raises

    2. lowers; lowers

    3. raises; lowers

    4. raises; raises





  3. Everything else constant, a stronger dollar will mean that
    1. French cheese becomes more expensive.

    2. vacationing in the United States becomes less expensive.

    3. vacationing in England becomes less expensive.

    4. Japanese cars become more expensive.



  4. A bond denominated in Japanese yen and sold in the United States is known as a
    1. foreign bond.

    2. eurobond.

    3. yenbond.

    4. international bond.



  5. When borrowers know more than lenders about the future prospects of a project to be undertaken with borrowed funds, the lender faces the problem of
    1. default risk.

    2. asymmetric information.

    3. free-riding.

    4. moral hazard.



  6. Which of the following is no longer used to ensure the soundness of financial intermediaries?
    1. restrictions on interest rates

    2. restrictions on assets and activities

    3. restrictions on entry

    4. deposit insurance



  7. A bond that is bought at a price below its face value and the face value is repaid at a maturity date is called a
    1. coupon bond.

    2. discount bond.

    3. simple loan.

    4. fixed-payment loan.



  8. Which of the following are true concerning the distinction between interest rates and return?
    1. The rate of return on a bond will not necessarily equal the interest rate on that bond.

    2. The return can be expressed as the sum of the current yield and the rate of capital gains.

    3. The rate of return will be greater than the interest rate when the price of the bond falls between time t and time t+1.

    4. All of the above are true.

    5. Only (a) and (b) of the above are true.



  9. Which of the following $1,000 face-value securities has the highest yield to maturity?
    1. 5 percent coupon bond with a price of $1,200

    2. 5 percent coupon bond with a price of $1,100

    3. 5 percent coupon bond with a price of $1,000

    4. 5 percent coupon bond with a price of $800

    5. 5 percent coupon bond with a price of $900



  10. Determine whether the below statements are true or false.
    I. Bond prices are inversely related to interest rates.
    II. The smaller a bond's duration, the greater its interest-rate risk.
    1. Both are true.

    2. I is true, II false.

    3. I is false, II true.

    4. Both are false.



  11. If you expect the inflation rate to be 5 percent over the next year and a one-year bond has a yield to maturity of 7 percent, then the real interest rate on this bond is
    1. 2 percent.

    2. -2 percent.

    3. -12 percent.

    4. 12 percent.



  12. Stock A has an expected return of 15% with a standard deviation of returns of 10%. Stock B has an expected return of 15% with a standard deviation of returns of 5%. Most investors are ---, which means they would prefer to invest in ---.
    1. risk averse; Stock B

    2. risk averse; Stock A

    3. risk lovers; Stock A

    4. risk lovers; Stock B



  13. When people expect interest rates to rise in the future, the --- curve for bonds shifts to the ---.
    1. demand; right

    2. supply; left

    3. supply; right

    4. demand; left





  14. Government budget surpluses shift the bond --- curve to the ---.
    1. supply; left

    2. demand; left

    3. supply; right

    4. demand; right



  15. Liquidity refers to
    1. the stability of an asset's expected return.

    2. the size of an asset's expected return.

    3. the ease with which an asset can be turned into cash.

    4. the amount of wealth a person has to invest.



  16. The risk premium is
    1. the interest rate on municipal bonds minus the interest rate on treasury bonds.

    2. the interest rate on corporate bonds minus the interest rate on treasury bonds.

    3. the interest rate on treasury bonds minus the interest rate on default-free bonds.

    4. the interest rate on treasury bonds minus the interest rate on corporate bonds.



  17. An increase in default risk on corporate bonds --- the demand for these bonds and --- the demand for default-free bonds.
    1. moderately lowers; does not change

    2. lowers; increases

    3. increases; lowers

    4. does not change; greatly increases



  18. The interest rate on municipal bonds falls relative to the interest rate on Treasury securities when
    1. corporate bonds become riskier.

    2. income tax rates are raised.

    3. there is a major default in the municipal bond market.

    4. municipal bonds become less widely traded.

    5. none of the above occur.



  19. The relationship between interest rates and maturity dates for various Treasury bonds is called the --- structure of interest rates.
    1. term

    2. risk

    3. chronological

    4. liquidity



  20. According to the market segmentation theory of the term structure,
    1. the interest rate for each maturity bond is determined by supply and demand for that maturity bond.

    2. investors' strong preferences for short-term bonds relative to long-term bonds explains why yield curves typically slope upward.

    3. bonds of one maturity are close substitutes for bonds of other maturities; therefore, interest rates on bonds of different maturities move together over time.

    4. all of the above.

    5. only (a) and (b) of the above.



  21. When yield curves are downward sloping,
    1. short-term interest rates are above long-term interest rates.

    2. medium-term interest rates are below both short-term and long-term interest rates.

    3. short-term interest rates are about the same as long-term interest rates.

    4. long-term interest rates are above short-term interest rates.

    5. medium-term interest rates are above both short-term and long-term interest rates.



  22. Investors use the money market
    1. to earn high returns on their investments.

    2. to reduce the liquidity of their funds.

    3. to reduce the opportunity cost of idle funds.

    4. to gain from expected declines in future interest rates.



  23. Which of the following is always a demander and never a supplier of funds in the money market?
    1. the U.S. Treasury

    2. businesses

    3. the Federal Reserve System

    4. commercial banks



  24. If the government wants to raise the Fed funds rate, then
    1. the Fed will buy securities from the public.

    2. the Treasury will sell fewer T-bills.

    3. the Fed will announce an increase in the rate at its regular meeting.

    4. the Treasury will sell more T-bills.

    5. the Fed will sell securities to the public.



  25. Which of the following typically finances import and export trade?
    1. Repurchase agreements

    2. Freddie Mac

    3. Banker's acceptances

    4. Eurodollars

    5. LIBOR



  26. Which of the following is not a characteristic of Treasury bills?
    1. The interest they pay is based on a coupon rate announced weekly by the Treasury.

    2. They have low interest-rate risk.

    3. They have zero default risk.

    4. The market for them is deep and liquid.



  27. Treasury inflation-indexed bonds reduce investors' inflation risk by increasing the bond's --- when the consumer price index rises.
    1. term to maturity

    2. interest rate

    3. principal

    4. none of the above



  28. Which of the following statements about Treasury bonds is true?
    1. The government faces interest-rate risk since its interest costs will be higher if market interest rates fall.

    2. Investors face interest-rate risk since their returns will be lower if market interest rates fall.

    3. Investors face interest-rate risk since their returns will be lower if market interest rates rise.

    4. The government faces interest-rate risk since its interest costs will be higher if market interest rates rise.



  29. The least risky type of corporate bond is a
    1. debenture.

    2. variable rate bond.

    3. secured bond.

    4. subordinated bond.



  30. Suppose the interest rate on a taxable corporate bond is 10% and the marginal tax rate is 25%. What is the equivalent tax-free interest rate on this bond?
    1. 2.5%

    2. 7.5%

    3. 9.25%

    4. 12.5%





Econ 340: Financial Markets and Institutions
Final Exam, Fall 2005
Bonham


Answer the following essay questions in two to three blue book pages or less. Be sure to fully explain your answers using economic reasoning and any equations and/or graphs needed to make your point.


Essay Questions:
  1. Asymmetric Information and Financial Crises (30 points, 30 minutes)
    1. (15 points) Mishkin and Eakins (the textbook) argue that many of the structural aspects of the U.S. financial system can be explained in terms of transactions costs and asymmetric information problems. Define Asymmetric information and the problems that it creates for financial markets. Explain how the structure of the U.S. financial system can be explained by the problem of asymmetric information.

    2. (15 points) Explain the root cause and progression of recent financial crises in other parts of the world (Thailand, Malaysia, South Korea, Indonesia, Japan, Russia, Brazil, Mexico, Argentina, ...)?



  2. Stock Returns and Equity Premiums (25 points, 25 minutes)
    During the 1990s, the equity premium declined significantly. One possible reason for that change is a decline in investorsÍ required rates of return.
    What is the equity premium? What is the required rate of return? What factors may have lead to a decline in the required rate of return during the 90s? Explain how these factors lead to declining equity premiums. Explain carefully how and why a decline in the required rate of return affects stock values and returns. If above average returns during the late 90s were due to declining equity premiums, explain why investors expecting above-average returns in the future may be disappointed.

Multiple Choice (30 minutes, 45 points 1.5 points each)
  1. A bond that is bought at a price below its face value and the face value is repaid at a maturity date is called a
    1. coupon bond.

    2. discount bond.

    3. simple loan.

    4. fixed-payment loan.



  2. With an interest rate of 4 percent, the present value of $100 next year is approximately
    1. $96.

    2. $100.

    3. $92.

    4. $104.



  3. If you expect the inflation rate to be 5 percent over the next year and a one-year bond has a yield to maturity of 7 percent, then the real interest rate on this bond is
    1. 2 percent.

    2. -2 percent.

    3. -12 percent.

    4. 12 percent.



  4. A bond investor faces reinvestment risk if his or her holding period is
    1. shorter than the maturity of the bond.

    2. identical to the maturity of the bond.

    3. longer than the maturity of the bond.

    4. none of the above.



  5. During a business cycle expansion, the supply of bonds shifts to the --- as businesses perceive more profitable investment opportunities, while the demand for bonds shifts to the --- as a result of the increase in wealth generated by the economic expansion.

  6. The Fisher effect is the --- relationship between --- and ---.
    1. direct; expected inflation; interest rates

    2. inverse; expected inflation; interest rates

    3. direct; interest rates; bond prices

    4. inverse; interest rates; bond prices



  7. The risk premium on corporate bonds becomes smaller if
    1. the interest rate of corporate bonds increases.

    2. the liquidity of corporate bonds increases.

    3. the riskiness of corporate bonds increases.

    4. both (a) and (c) occur.



  8. If the expected path of one-year interest rates over the next four years is 6 percent, 5 percent, 3 percent, and 2 percent, then the pure expectations theory predicts that today's interest rate on the four-year bond is
    1. 2 percent.

    2. 5 percent.

    3. 4 percent.

    4. 1 percent.

    5. 3 percent.



  9. Large banks issue --- as an alternative to checking and savings accounts as sources of funds.
    1. Treasury bills

    2. banker's acceptances

    3. commercial paper

    4. negotiable CDs

    5. repurchase agreements



  10. Suppose the interest rate on a taxable corporate bond is 10% and the marginal tax rate is 25%. What is the equivalent tax-free interest rate on this bond?
    1. 2.5%

    2. 7.5%

    3. 9.25%

    4. 12.5%



  11. Potential for conflict of interest arises when
    1. profits can be made providing financial services.

    2. people expected to provide reliable information to the public can profit by not doing so.

    3. bankers can pay depositors low interest rates but charge borrowers high interest rates.

    4. all of the above.



  12. Conflicts of interest
    1. reduce the flow of reliable information in financial markets.

    2. result in misallocation of credit resources.

    3. make adverse selection and moral hazard problems more difficult to solve.

    4. all of the above.



  13. Which of the following are reported as assets on a bank's balance sheet?
    1. (a) bank capital

    2. (b) loans

    3. (c) borrowings

    4. (d) only (a) and (b) of the above



  14. Which of the following are reported as liabilities on a bank's balance sheet?
    1. securities

    2. nontransaction deposits

    3. loans

    4. reserves and cash items



  15. Bank capital
    1. (a) provides a cushion against a drop in the value of assets.

    2. (b) serves to reassure uninsured depositors that the bank is sound.

    3. (c) serves to reassure bank regulators that the bank is not likely to fail due to a few bad loans.

    4. (d) does each of the above.

    5. (e) does only (a) and (b) of the above.



  16. Dividing a bank's net income by its capital gives the bank's
    1. return on assets.

    2. return on equity.

    3. equity multiplier.

    4. net interest margin.



  17. If a bank has more rate-sensitive assets than liabilities, then
    1. a rise in interest rates will raise income.

    2. a fall in interest rates will raise income.

    3. a rise in interest rates will lower income.

    4. none of the above is true.



  18. Suppose a bank has assets of $150 million, liabilities of $132 million, and a duration gap of 1.50. If interest rates fall from 10 percent to 5 percent, then
    1. net interest income will fall by $6.8 million.

    2. net interest income will rise by $6.8 million.

    3. the market value of net worth will fall by $10.2 million.

    4. the market value of net worth will rise by $10.2 million.



  19. Which of the following is not a financial derivative?
    1. options

    2. forward contract

    3. futures contract

    4. interest-rate swap

    5. Treasury bond



  20. Which of the following is not a reason to hedge a portfolio?
    1. to offset a long-position with a short-position

    2. to stabilize income

    3. to limit exposure to risk

    4. to increase the probability of gains



  21. If at expiration a futures contract has a price of 98 while the underlying asset has a price of 99, then arbitrageurs would take --- futures positions and --- the underlying asset.
    1. short; sell

    2. long; buy

    3. short; buy

    4. long; sell



  22. If you sell a futures contract on the S&P 500 Index at a price of 450 and the index falls to 400, then
    1. you will lose $12,500.

    2. you will lose $50.

    3. you will gain $12,500.

    4. you will gain $50.



  23. You paid $2000 for a call option on 100 shares of Dell company stock at $150 per share. At expiration Dell stock is at $125.
    1. Your net profit is $500.

    2. Your net loss is $4500.

    3. Your net profit is $2500.

    4. Your net loss is $2000.



  24. Who hopes a call option finishes öut of the money?"
    1. neither the option purchaser nor the option seller

    2. the option seller

    3. the option purchaser

    4. both the option purchaser and the option seller



  25. Using the Gordon growth model, if a stock's next dividend is expected to be $5, the discount rate is estimated to be 16 percent, and dividends are projected to increase at 6 percent per year indefinitely, then the stock should sell for
    1. $6.10

    2. $31.25

    3. $22.73

    4. $50.00

    5. $83.33



  26. When comparing stocks and bonds, investors find stocks attractive because
    1. there is potential for greater gains investing in stock than there is investing in bonds.

    2. stockholders have a higher priority than bondholders when a firm is in trouble.

    3. firms are legally required to pay dividends on stock each year.

    4. returns are less volatile on stocks than on bonds.



  27. If the inflation rate in the United States is higher than that in Europe and productivity is growing at a slower rate in the United States than in Europe, then, in the long run,
    1. (a) the euro should appreciate relative to the dollar.

    2. (b) the euro should depreciate relative to the dollar.

    3. (c) the dollar should depreciate relative to the euro.

    4. (d) both (a) and (c) will occur.

    5. (e) it is not clear whether the dollar should appreciate or depreciate relative to the euro.



  28. According to the interest parity condition, the domestic interest rate is equal to the foreign interest rate
    1. plus the expected appreciation of the domestic currency.

    2. minus the expected appreciation of the domestic currency.

    3. less the expected depreciation of the domestic currency weighted by the domestic interest rate.

    4. minus the expected depreciation of the domestic currency.



  29. An increase in the domestic interest rate shifts the expected return schedule for --- deposits to the --- and causes the domestic currency to ---.
    1. foreign; right; appreciate

    2. domestic; left; depreciate

    3. foreign; left; depreciate

    4. domestic; right; appreciate



  30. The theory of PPP suggests that if one country's price level rises relative to another's, its currency should
    1. float.

    2. depreciate.

    3. appreciate.

    4. do none of the above.





File translated from TEX by TTH, version 3.38.
On 23 Feb 2006, 16:09.

Midterm Exam
March 13, 2003
Essay (40 minutes): 55 points
  1. The Bush administration has proposed significant tax cuts and increases in government spending. As a result, the Congressional Budget Office predicts a significant increase in federal govt. budget deficits over the next three years.
    1. (15 points) Using a supply and demand for bonds model, illustrate and explain the impact these budget deficits are likely to have on treasury bills yields over the next three years (assume the deficit is financed using t-bills).

    2. (20 points) Write down an equation representing some theory of the term structure of interest rates. Based on this theory, explain the relationship between yields on short term and medium term government bonds. Illustrate this relationship using a yield curve and your answer to part (a) above.

    3. (25 points) Write down an equation representing the short run equilibrium in foreign currency markets. Explain the intuition behind your model. Given your answer to part (a), and assuming everything else remains unchanged. Illustrate and explain the impact of the federal govt. budget deficits on the spot exchange rate.



Multiple Choice (20 minutes): 3 points each
  1.   A bond denominated in Japanese yen and sold in the United States is known as a 
    1. international bond.

    2. foreign bond.

    3. yenbond.

    4. eurobond.



  2. Interest rates are determined in the market for 
    1. assets.

    2. bonds and other forms of debt.

    3. foreign currencies.

    4. stocks.



  3. When borrowers know more than lenders about the future prospects of a project to be undertaken with borrowed funds, the lender faces the problem of  
    1. moral indignation.

    2. default risk.

    3. free riding.

    4. asymmetric information.



  4.   If bad credit risks are the ones most actively seeking loans, then lenders are subject to the  
    1. good information problem.

    2. free-rider problem.

    3. principal-agent problem.

    4. moral hazard problem.

    5. adverse selection problem.



  5.   Which of the following is no longer used to ensure the soundness of financial intermediaries?  
    1. restrictions on assets and activities

    2. restrictions on interest rates

    3. deposit insurance

    4. restrictions on entry



  6. Which of the following $1,000 face-value securities has the highest yield to maturity?  
    1. 5 percent coupon bond with a price of $1,500

    2. 5 percent coupon bond with a price of $800

    3. 5 percent coupon bond with a price of $500

    4. 5 percent coupon bond with a price of $1000

    5. 5 percent coupon bond with a price of $1200



  7.    With an interest rate of 4 percent, the present value of $100 next year is approximately 
    1. $100

    2. $96

    3. $104

    4. $92



  8. (I) Prices and returns for short-term bonds are less volatile than those for long-term bonds. (II) The prices of longer-maturity bonds respond more dramatically to changes in interest rates.  
    1. Both are false.

    2. Both are true.

    3. I is true, II is false.

    4. I is false, II is true.





  9. When people expect interest rates to rise in the future, the ---curve for bonds shifts to the ---.  
    1. supply; left

    2. demand; left

    3. demand; right

    4. supply; right



  10.     An increase in the expected rate of inflation causes the demand curve for bonds to --- and the supply curve of bonds to ---.  
    1. rise; remain unchanged.

    2. rise; fall.

    3. fall; fall.

    4. rise; rise.

    5. fall; rise.



  11. Government budget surpluses shift the bond --- curve to the ---. 
    1. demand; right.

    2. demand; left.

    3. supply; right.

    4. supply; left.



  12. When the growth rate of the money supply increases, interest rates end up being permanently higher if  
    1. there is slow adjustment of expected inflation.

    2. there is fast adjustment of expected inflation.

    3. the liquidity effect is larger than the other effects.

    4. the expected inflation effect is larger than the liquidity effect.

    5. none of the above.



  13.  The risk premium on corporate bonds becomes smaller if  
    1. the riskiness of corporate bonds increases.

    2. the liquidity of corporate bonds increases.

    3. either (a) and (b) occur.

    4. the liquidity of corporate bonds decreases.



  14. The relationship between interest rates on various bonds and the time to their maturity is called the --- structure of interest rates. 
    1. chronological

    2. term

    3. risk

    4. liquidity

    5. information



  15. If the today's one-year interest rate is 5%, and the expected path of one-year interest rates over the next three years is 4 percent, 2 percent, and 1 percent, then the pure expectations hypothesis predicts that today's interest rate on the four-year bond is  
    1. 2 percent.

    2. 4 percent.

    3. 3 percent.

    4. 5 percent.

    5. 1 percent.



  16.       According to the market segmentation theory of the term structure,  
    1. the interest rate for each maturity bond is determined by supply and demand for that maturity bond.

    2. investors' strong preferences for short-term bonds relative to long-term bonds explains why yield curves typically slope upward.

    3. bonds of one maturity are close substitutes for bonds of other maturities; therefore, interest rates on bonds of different maturities move together over time.

    4. all of the above.

    5. only (a) and (b) of the above.



  17.  If the inflation rate in the United States is higher than that in Europe, then, in the long run,  
    1. the euro should appreciate relative to the dollar.

    2. the euro should depreciate relative to the dollar.

    3. the dollar should depreciate relative to the euro.

    4. both (a) and (c) will occur.

    5. it is not clear whether the dollar should appreciate or depreciate relative to the euro.



  18. The theory of asset demand suggests that the most important factor affecting the demand for domestic and foreign deposits is the --- on these assets relative to one another.  
    1. expected return

    2. interest rate

    3. risk

    4. liquidity



  19. If the government wants to raise the Fed funds rate, then
    1. the Fed will sell securities to the public.

    2. the Treasury will sell more bills.

    3. the Fed will buy securities from the public.

    4. the Fed will ask bond holders to lower the prices on their bonds.

    5. the Fed will print money.



  20. If the price of a Big Mac in Japan is 294 yen, the price in the United States is $2.54, and the spot yen-dollar excange rate is 124,
    1. the PPP exchange rate is 124, and yen is fairly valued.

    2. the PPP exchange rate is 2.37 and the yen is undervalued.

    3. the PPP exchange rate is 116 and the yen is undervalued.

    4. the PPP exchange rate is .009 and the yen is overvalued.



Final Exam, Spring 2002


Answer the following essay questions in two to three blue book pages or less. Be sure to fully explain your answers using economic reasoning and any equations and/or graphs needed to make your point.


Essay Questions:
  1. (Asymmetric Information and Financial Crises)
    1. (15 points) Mishkin and Eakins (the textbook) argue that many of the structural aspects of the U.S. financial system can be explained in terms of transactions costs and asymmetric information problems. What are their arguments? Are they convincing?

    2. (15 points) Explain the root cause and progression of recent financial crises in other parts of the world (Thailand, Malaysia, South Korea, Indonesia, Japan, Russia, Brazil, Mexico, Argentina, ...)?

    3. (5 points) In what ways, if any, are Mishkin's and Eakin's concerns about asymmetric information problems in securities markets exemplified by the Enron bankruptcy scandal?



  2. (IRP and hedging)
    Over the past 16 months, the U.S. Federal Reserve has cut its fed funds rate (short term interest rate) target 11 times to its current 1.75% rate. Suppose at their next OMC meeting, the FED decides to increse its short term interest rate target by 200 basis points.
    1. (15 points) Write down an equation representing interest parity, and provide an intuitive explanation for the equation. That is, explain how market forces ensure that interest parity holds.

    2. (10 ponts) Use your interest parity model to explain the impact of the Fed's move on the value of the dollar. Provide both a graphical and intuitive explanation of your results. Suppose the Bank of Japan (BOJ) wishes to maintain the yen/dollar exchange rate at its level prior to the Fed's policy move. What action is the BOJ likely to take?

    3. (10 points) As a manager of a bank's portfolio, how would you hedge against the risk your bank faces from changes in Fed policy?





Multiple Choice 2 points each
  1. If the inflation rate in the United States is higher than that in Germany and productivity is growing at a slower rate in the United States than in Germany, then, in the long run,
    1. the German mark should appreciate relative to the dollar.

    2. the German mark should depreciate relative to the dollar.

    3. the dollar should depreciate relative to the German mark.

    4. both (a) and (c) will occur.

    5. it is not clear whether the dollar should appreciate or depreciate relative to the German mark.





  2. The present value of $400 received in two years with interest rate i is:
    1. $400/(1+i)

    2. $200*(1+i)

    3. $400/(1+i)2

    4. $400*(1+i)2



  3. If a bond sells at a premium, where price exceeds face value, then we would expect to see:
    1. market interest rates could be the same, higher, or lower than the coupon rate.

    2. market interest rates below the coupon rate.

    3. market interest rates above the coupon rate.

    4. market interest rate the same as the coupon rate.



  4. Financial intermediaries, particularly banks,
    1. are experts in the production of information about firms so that it can sort good risks from bad ones.

    2. overcome the free-rider problem by primarily making private loans, rather than purchasing securities that are traded in the open market.

    3. play a greater role in moving funds to corporations than do securities markets.

    4. all of the above.

    5. only (a) and (b) of the above.



  5. Interest rate risk is:
    1. the risk the coupon rate on the bond will fall.

    2. the risk the government or firm will not make interest payments.

    3. the risk associated with change in return with changes in interest rates.

    4. the risk the coupon payment will rise



  6. An increase in the expected inflation rate will:
    1. increase the supply of loanable funds (bond demand), increase the demand for loanable funds (bond supply) and increase the interest rate.

    2. decrease the supply of loanable funds (bond demand), increase the demand for loanable funds (bond supply) and increase the interest rate.

    3. increase the supply of loanable funds (bond demand), decrease the demand for loanable funds (bond supply) and increase the interest rate.

    4. decrease the supply of loanable funds (bond demand), decrease the demand for loanable funds (bond supply) and increase the interest rate.



  7. Bank capital
    1. acts as a cushion against a drop in the value of assets.

    2. acts to reassure uninsured depositors that the bank is sound.

    3. acts to reassure loan customers that the bank is not likely to fail due to a few bad loans.

    4. does each of the above.

    5. does only (a) and (b) of the above.



  8. The risk premium on a corporate bond is:
    1. the difference in interest rates between that bond and a S&P 500 firm bond.

    2. the difference in interest rate between that bond and a bank CD.

    3. the difference in interest rate between that bond and a municipal bond.

    4. the difference in interest rate between that bond and a US government bond.



  9. A U.S. company which exports to Germany can hedge the exchange rate risk by
    1. taking a long position in futures contracts on German Marks.

    2. taking a short position in futures contracts on German Marks.

    3. both of the above.

    4. none of the above.



  10. If a bank has more rate-sensitive assets than liabilities, then
    1. a fall in interest rates will leave its income unchanged.

    2. a fall in interest rates will raise income.

    3. a rise in interest rates will lower its income.

    4. a rise in interest rates will raise its income.



  11. A bank manager uses the duration gap calculation to obtain
    1. the change in the market value of liabilities if interest rates change.

    2. the change in the market value of assets if interest rates change.

    3. the change in net interest income if interest rates change.

    4. the change in return on assets if interest rates change.

    5. the change in net worth as a percentage of assets if interest rates change.



  12. Using the Gordon growth model, if the next dividend on a stock is expected to be $5, the discount rate is estimated to be 16 percent, and dividends are projected to increase at 6 percent per year indefinitely, then the stock should sell for
    1. $31.25

    2. $50.00

    3. $60.00

    4. $6.15

    5. $0.50



  13. Which of the following is not a reason to hedge a portfolio?
    1. to immunize a portfolio.

    2. to limit exposure to risk.

    3. to increase the probability of gains.

    4. to stabilize income.



  14. To reduce the moral hazard problem caused by FDIC insurance, the government also:
    1. encourages risky off-balance-sheet activities.

    2. regulates the amount of risky assets a bank can own.

    3. repealed risk-based capital requirements.

    4. sets maximum bank leverage ratios.



  15. The price of a financial futures contract:
    1. will be the same as the price of the underlying asset to be delivered when the contract is negotiated.

    2. will be greater than the price of the underlying asset to be delivered at the expiration date.

    3. will be less than the price of the underlying asset to be delivered at the expiration date.

    4. will be the same as the price of the underlying asset to be delivered at the expiration date.

    EXTRA CREDIT!

  16. If a bank wants to hedge a bond that differs from those underlying futures contracts, then it can use
    1. a micro hedge.

    2. a cross hedge.

    3. a macro hedge.

    4. open interest.



  17. According to the expectations theory of the term structure, if the interest rate on a one year bond is 4% and the interest rate on a two year bond is 8%, then:
    1. the market expects the interest rate on a two year bond in one year to be 12%.

    2. the market expects the interest rate on a one year bond in one year to be 12%.

    3. the market expects the interest rate on a two year bond in one year to be 9%.

    4. the market expects the interest rate on a one year bond in one year to be 6%.



Midterm Exam, Spring 2002
  1. The U.S. Federal Reserve has been cutting its fed funds rate target for more than a year. The Fed funds rate has declined from 6.5% in November of 2000 to 1.75% today. The Fed's primary goal has been to stimulate the economy so as to avoid a recession. Today, most economists believe the economy has reached the trough of the business cycle and will resume substantial growth over the next several years.
    1. (15 points) Using a supply and demand for fed funds (supply and demand for very short term bonds) model, illustrate and explain how the central bank is able to reduce the fed funds rate.

    2. (15 points) Based on the theory of Asset Demand, and using a supply and demand for T-bills model, illustrate and explain what you think will happen to short term interest rates as the economy enters the expansion phase of the business cycle.

    3. (15 points) Write down an equation representing the expectations hypothesis for the term-structure of interest rates. (Three years is long enough.) Given your answer to part (b) above, draw and explain the shape of a yield curve for bonds with terms to maturity from 1 to 3 three years?

    4. (10 points) Use the data below on T-bill yields to calculate the expected 1-year tbill rate one year from now (in year t+1) and two years from now (year t+2). Compare your results with your answer in part (c) above.
      Term to maturity Yield To Maturity as of today (t)
      1-year 2.57
      2-year 3.56
      3-year 4.14


    5. (15 points) Write down an equation for the Security Market Line (CAPM equation). If you are considering purchasing Cisco System, which has a b = 2.0, calculate the impact on your required rate of return if the risk free rate changes as you predicted in your answer to part (d). Explain your results.



Multiple Choice 3 points each
  1. Holding everything else constant,
    1. if an asset's risk rises relative to that of alternative assets, the demand will fall.

    2. the more liquid an asset, relative to alternative assets, the greater will be the demand.

    3. the lower the expected return relative to alternative assets, the greater will be the demand.

    4. all of the above.

    5. only (a) and (b) of the above.



  2. The liquidity premium theory is based upon the idea that, other things remaining equal,
    1. investors are indifferent between short-term and long-term bonds.

    2. investors prefer intermediate-term bonds.

    3. investors prefer short-term bonds.

    4. investors prefer long-term bonds.



  3. The risk premium on corporate bonds becomes smaller if
    1. the riskiness of corporate bonds increases.

    2. the liquidity of corporate bonds increases.

    3. the liquidity of corporate bonds decreases.

    4. both (a) and (c) occur.



  4. Which of the following $1,000 face-value securities has the highest yield to maturity?
    1. A 5 percent coupon bond with a price of $600

    2. A 5 percent coupon bond with a price of $800.

    3. A 5 percent coupon bond with a price of $1,000.

    4. A 5 percent coupon bond with a price of $1,200.

    5. A 5 percent coupon bond with a price of $1,500.



  5. If the interest rates on all bonds rise from 5 to 6 percent over the course of the year, which bond would you prefer to have been holding?
    1. A bond with one year to maturity

    2. A bond with five years to maturity

    3. A bond with ten years to maturity

    4. A bond with twenty years to maturity



  6. If you expect the inflation rate to be 4 percent this year and a one year bond has a yield to maturity of 7 percent, then the real interest rate on this bond is
    1. -3 percent.

    2. -2 percent.

    3. 3 percent.

    4. 7 percent.



  7. The interest rate that equates the present value of payments received from a debt instrument with its value today is the
    1. simple interest rate.

    2. discount rate.

    3. yield to maturity.

    4. real interest rate.



  8. The interest rate on municipal bonds falls relative to the interest rate on Treasury securities when
    1. there is a major default in the municipal bond market.

    2. income tax rates are raised.

    3. municipal bonds become less widely traded.

    4. corporate bonds become riskier.

    5. none of the above occur.



  9. When an economy grows out of a recession, normally the demand for corporate bonds ? and the supply of corporate bonds ?.
    1. increases; increases

    2. increases; decreases

    3. decreases; decreases

    4. decreases; increases



  10. If the expected path of one-year interest rates over the next four years is 5 percent, 4 percent, 2 percent, 1 percent, then the expectations theory predicts that today's interest rate on the four-year bond is
    1. 1 percent.

    2. 2 percent.

    3. 3 percent.

    4. 4 percent.

    5. 5 percent.

    Extra Credit! 2 points each

  11. The yield on a discount basis of a 90-day, $1,000 Treasury bill selling for $950 is
    1. 5.5 percent.

    2. 10.0 percent.

    3. 15.0 percent.

    4. none of the above.



  12. Which of the following are true concerning the distinction between interest rates and return?
    1. The rate of return on a bond will not necessarily equal the interest rate on that bond.

    2. The return can be expressed as the difference between the current yield and the rate of capital gains.

    3. The rate of return will be greater than the interest rate when the price of the bond falls between time t and time t+1.

    4. All of the above are true.

    5. Only (a) and (b) of the above are true.



  13. The term structure of interest rates is
    1. the relationship among interest rates of different bonds with the same maturity.

    2. the structure of how interest rates move over time.

    3. the relationship among the term to maturity of different bonds.

    4. the relationship among interest rates on bonds with different maturities.



  14. According to the liquidity premium theory of the term structure
    1. when short-term interest rates are expected to rise in the future, the yield curve will be steeply upward sloping.

    2. when short-term interest rates are expected to remain unchanged in the future, the yield curve is likely to be slightly upward sloping.

    3. when short-term interest rates are expected to decline moderately in the future, the yield curve is likely to be flat.

    4. all of the above.

    5. only (a) and (b) of the above.



  15. The theory of efficient capital markets suggests that allocating your funds in the financial markets on the advice of a financial analyst
    1. will certainly mean higher returns than if you had made selections by throwing darts at the financial page.

    2. will always mean lower returns than if you had made selections by throwing darts at the financial page.

    3. is not likely to prove superior to a strategy of making selections by throwing darts at the financial page.

    4. is good for the economy.



Final Exam, Fall 2001

Essay Questions:
The U.S. economy entered a recession in March of 2001, but there are a number of signs that we are near the bottom of the business cylce. This view is reinforced by the expectation of substantial fiscal stimulus (deficit spending) being discussed in Washington.
  1. (20 points) Using a S&D for loanable funds model, illustrate and thoroughly explain how a business cycle expansion (accompanied by expansionary fiscal policy) would affect interest rates on short term government bonds. Assuming a constant expected return on the overall stock market (and constant b), predict the impact on the required return on a risky stock or portfolio based on the CAPM.

  2. (20 points) While inflation has been declining over the past year, as the economy begins to accelerate out of the business cylce trough, bond traders will expect rising inflation over the next few years. Using your answer to the question above, and a model of the term structure of interest rates, explain how the business cycle expansion (accompanied by expectations of rising inflation) will affect interest rates on intermediate and longer term government bonds.

  3. (30 points) Given your answers to questions 1 and 2 above, explain the interest rate risk faced by a bank. How would you hedge against such interest rate risk using financial futures? How would you hedge against this risk using options? Which method would you recommend. Why?


Multiple Choice 2.5 points each
  1. US Treasury Bills:
    1. pay no interest and are sold at a discount.

    2. are very illiquid.

    3. have substantial default risk.

    4. are loans from the Federal Reserve System.



  2. Corporate Bonds:
    1. are very liquid.

    2. are issued by the Federal Reserve System.

    3. typically have higher yields to maturity than similar government bonds.

    4. are only sold at a discount.



  3. The present value of $200 received in two years with interest rate i is:
    1. $200/(1+i)

    2. $100*(1+i)

    3. $200/(1+i)2

    4. $200*(1+i)2



  4. If a bond sells at a premium, where price exceeds face value, then we would expect to see:
    1. market interest rates could be the same, higher, or lower than the coupon rate.

    2. market interest rates below the coupon rate.

    3. market interest rates above the coupon rate.

    4. market interest rate the same as the coupon rate.



  5. For a $1000 one year discount bond with a price of $975, the yield to maturity is:
    1. $975/$1000.

    2. $1000/$975.

    3. ($1000-$975)/($1000).

    4. ($1000-$975/($975).



  6. Interest rate risk is:
    1. the risk the coupon rate on the bond will fall.

    2. the risk the government or firm will not make interest payments.

    3. the risk associated with change in return with changes in interest rates.

    4. the risk the coupon payment will rise



  7. An increase in the expected inflation rate will:
    1. increase the supply of loanable funds (bond demand), increase the demand for loanable funds (bond supply) and increase the interest rate.

    2. decrease the supply of loanable funds (bond demand), increase the demand for loanable funds (bond supply) and increase the interest rate.

    3. increase the supply of loanable funds (bond demand), decrease the demand for loanable funds (bond supply) and increase the interest rate.

    4. decrease the supply of loanable funds (bond demand), decrease the demand for loanable funds (bond supply) and increase the interest rate.



  8. At interest rates below the equilibrium rate of interest
    1. there is an excess demand for loanable funds and the interest rate will rise.

    2. there is an excess supply of loanable funds and the interest rate will rise.

    3. there is an excess demand for bonds and the interest rate will rise.

    4. there is an excess supply of bonds and the interest rate will fall.



  9. The risk premium on a corporate bond is:
    1. the difference in interest rates between that bond and a S&P 500 firm bond.

    2. the difference in interest rate between that bond and a bank CD.

    3. the difference in interest rate between that bond and a municipal bond.

    4. the difference in interest rate between that bond and a US government bond.



  10. According to the expectations theory of the term structure, if the interest rate on a one year bond is 4% and the interest rate on a two year bond is 8%, then:
    1. the market expects the interest rate on a two year bond in one year to be 12%.

    2. the market expects the interest rate on a one year bond in one year to be 12%.

    3. the market expects the interest rate on a two year bond in one year to be 9%.

    4. the market expects the interest rate on a one year bond in one year to be 6%.



  11. The liquidity premium theory is based upon the idea that, other things remaining equal,
    1. investors prefer long-term bonds.

    2. investors prefer intermediate-term bonds.

    3. investors are indifferent between short-term and long-term bonds.

    4. investors prefer short-term bonds.



  12. According to the law of one price, if the Japanese price level falls by 1%, and the U.S. price level increases by 2%, then:
    1. the dollar will depreciate by 2%.

    2. the dollar will appreciate by 2%.

    3. the dollar will appreciate by 1%.

    4. the dollar will depreciate by 3%.



  13. Which of the following will cause a countrys currency to appreciate?
    1. A relative decrease in the productivity of a country.

    2. A rise in a countrys relative price level.

    3. Increasing tariffs.

    4. A decrease in the demand for a countrys exports.



  14. The relative expected return on deposits in terms of dollars is given by:
    1. Relative RETD = iD - iF + (Eet+1 - Et)/Et

    2. Relative RETD = iF - iD + (Eet+1 - Et)/Et-1

    3. Relative RETD = iF - iD + (Eet+1 - Et)/Et

    4. Relative RETD = iD - iF - (Eet+1 - Et)/Et



  15. The largest source of external funds for U.S. firms is:
    1. stocks.

    2. trade debt.

    3. bonds.

    4. loans.



  16. A bad credit risk seeks out loans more actively. This is a(n):
    1. liquidity problem.

    2. moral hazard problem.

    3. principal-agent problem.

    4. adverse selection problem.



  17. The free-rider problem:
    1. will only occur if information costs are zero.

    2. is that people who do not pay for information take advantage of information other people have paid for.

    3. makes it easier for an investor to continue to buy securities at less than the true value.

    4. will make more people willing to provide information services.



  18. A reason for the decline in the profitability of traditional banking is:
    1. banks are gaining loan business from other financial institutions.

    2. non-interest checking accounts are growing as a source of bank funds.

    3. bank customers are skipping commercial paper markets and using banks for short-term loans.

    4. the removal of interest rate ceilings has increased costs.



  19. To reduce the moral hazard problem caused by FDIC insurance, the government also:
    1. encourages risky off-balance-sheet activities.

    2. regulates the amount of risky assets a bank can own.

    3. repealed risk-based capital requirements.

    4. sets maximum bank leverage ratios.



  20. The price of a financial futures contract:
    1. will be the same as the price of the underlying asset to be delivered when the contract is negotiated.

    2. will be greater than the price of the underlying asset to be delivered at the expiration date.

    3. will be less than the price of the underlying asset to be delivered at the expiration date.

    4. will be the same as the price of the underlying asset to be delivered at the expiration date.



  21. EXTRA CREDIT! Which of the following does not generate a higher premium on call options?
    1. A more volatile price for the underlying asset.

    2. A greater term to maturity.

    3. A lower strike price.

    4. A more liquid underlying asset.



Midterm Exam, Fall 2001

  1. In January 2001 the U.S. Federal Reserve Board began cutting its fed funds rate (short term interest rate) target. This policy move has brought the fed funds rate from 6.5% to 2.5% not in response to lowered expectations of inflation, but in an attempt to forestall recession.

    1. (10 points) Write down an equation representing interest parity, and provide an intuitive explanation for the equation. That is, explain how market forces ensure that interest parity holds.
    2. (30 ponts) Use your interest parity model to explain the impact of the Fed's policy move on the value of the dollar. Provide both a graphical and intuitive explanation of your results. Suppose the Bank of Japan (BOJ) wishes to maintain the yen/dollar exchange rate at its level prior to the Fed's policy move. What action is the BOJ likely to take?

  2. If lawmakers and the Bush administration ultimately embrace the most expensive proposals under discussion, the result would be to wipe out all of the $170 billion to $180 billion surplus Washington expected to collect in the fiscal year that begins Oct. 1,..." Such a tax-and-spending plan "would represent the biggest fiscal jolt Washington has delivered to the economy since the Vietnam War era."

    When the Federal Government runs a budget deficit, it must sell Treasury bonds to finance that deficit. To analyze the impact of increased government spending, assume the Treasury will be selling nearly $200 billion in new 30-year Treasury bonds over the next several years.

    1. (20 points) Use a supply and demand for loanable funds model to determine what is likely to happen to interest rates on 30-year bonds. (Explain your graph)
    2. (10 points) Given your answer to part a) and the actions by the Federal Reserve described in question 1., use a liquidity premium model of the term-structure to predict the shape of the yield curve.
Multiple Choice 3 points each
  1. Fed Funds are:
    1. loans between banks.
    2. loans from the Treasury Department.
    3. loans from a foreign government.
    4. loans from the Federal Reserve System.

  2. The essential role of financial markets is:
    1. Provide a method of borrowing.
    2. Provide a method of channeling funds between borrowers and savers.
    3. Provide a way for the government to finance a budget deficit.
    4. Provide a method of saving.

  3. The present value of $100 received in two years with interest rate i is:
    1. $100/(1+i)
    2. $100*(1+i)
    3. $100/(1+i)2
    4. $100*(1+i)2

  4. If a bond sells at a premium, where price exceeds face value, then we would expect to see:
    1. market interest rates could be the same, higher, or lower than the coupon rate.
    2. market interest rates below the coupon rate.
    3. market interest rates above the coupon rate.
    4. market interest rate the same as the coupon rate.

  5. The real interest rate is:
    1. the nominal rate minus the expected inflation rate.
    2. the product of the nominal rate and the CPI.
    3. the nominal rate plus the expected inflation rate.
    4. the nominal interest rate/the CPI.

  6. An increase in the expected inflation rate will:
    1. increase the supply of loanable funds (bond demand), increase the demand for loanable funds (bond supply) and increase the interest rate.
    2. decrease the supply of loanable funds (bond demand), increase the demand for loanable funds (bond supply) and increase the interest rate.
    3. increase the supply of loanable funds (bond demand), decrease the demand for loanable funds (bond supply) and increase the interest rate.
    4. decrease the supply of loanable funds (bond demand), decrease the demand for loanable funds (bond supply) and increase the interest rate.

  7. According to the expectations theory of the term structure, if the interest rate on a one year bond is 5% and the interest rate on a two year bond is 7%, then:
    1. the market expects the interest rate on a one year bond in one year to be 6%.
    2. the market expects the interest rate on a two year bond in one year to be 6%.
    3. the market expects the interest rate on a two year bond in one year to be 9%.
    4. the market expects the interest rate on a one year bond in one year to be 9%.

  8. The liquidity premium theory is based upon the idea that, other things remaining equal,

    1. investors are indifferent between short-term and long-term bonds.
    2. investors prefer intermediate-term bonds.
    3. investors prefer short-term bonds.
    4. investors prefer long-term bonds.

  9. According to the law of one price, if the French price level rises by 10%, and the U.S. price level increases by 5%, then:

    1. the dollar will depreciate by 5%.
    2. the dollar will appreciate by 5%.
    3. the dollar will appreciate by 10%.
    4. the dollar will depreciate by 10%.

  10. Which of the following will cause a countryŐs currency to appreciate?

    1. A relative decrease in the productivity of a country.
    2. A rise in a countryŐs relative price level.
    3. Increasing tariffs.
    4. A decrease in the demand for a countryŐs exports.

Econ 340: Money, Banking and Financial Markets

Final Exam, Spring 2001

Answer the following essay questions in two to three blue book pages or less. Be sure to fully explain your answers using economic reasoning and any equations and/or graphs needed to make your point.

  1. 35 points
    The equity premium has declined in recent years. One possible reason is a decline in required rates of return.

    What is the equity premium? What is the required rate of return? What factors may have lead to a decline in the equity premium and required rate of return in recent years? Explain how these factors lead to declining equity premiums. Explain carefully how and why a decline in the required rate of return affects stock values and returns.

  2. 45 points
    At the end of 1999 the governemnt of Japan abandoned plans to move to an FDIC form of deposit insurance for Japanese Banks. Instead, Japan has maintained its implicit guarantee of all bank deposits despite the fact that Japanesse banks may have as much as $700 billion (total) in bad loans on their books—even more bad loans than they had five years ago. In addition, the Japanese government has racked up the largest national debt (114% as a percentage of real GDP) of any nation in the world.

    1. Explain the role of asymmetric information in financial markets. How does the existence of asymmetric information explain the importance of banks in financial markets?
    2. Suppose that investors decided that the Japanese government was about to default on its national debt. Use a Supply and Demand for loanable funds framework to explain how expectations of a default could impact interest rates in Japan.
    3. What impact would fear of default have on the Japanese currency? Use a theory of asymetric information to explain how a financial crisis could occur in Japan. Be sure to explain how interest rate and exchange rate movements could aggravate adverse selection and moral hazard problems inherent in the banking system. If such a crisis did occur, should an international lender of last resorts step in to bail out Japan?
    Short Answer: (20 points)-- Do Both Questions!
  1. "If inflation had not increased so dramatically in the 1960s and 70s, the banking industry might be healthier today." Is this statement true, false, or uncertain? Explain your answer.

  2. If you buy a call option on a $100,000 Treasury bond futures contract with an exercise price of 110 and the price of the Treasury bond is 111 at expiriation, 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 $1500?


Econ 340: Money, Banking and Financial Markets

Midterm Exam, Spring 2001
ANSWER KEY

Answer the following essay questions in two to three blue book pages or less. Be sure to fully explain your answers using economic reasoning and any equations and/or graphs needed to make your point.


(40 points)
1.   Begining in January 2001, the U.S. Federal Reserve Board began cutting its fed funds (short term interest rate) target. This policy move was not in response to lowered expectations of inflation, rather it was an attempt to forestall a slowing of growth in real output.

a.   Write down an equation representing interest parity, and provide an intuitive explanation for the equation. In particular, explain how market forces ensure that interest parity holds.

b.   Use your interest parity model to explain the impact of the Fed's policy move on the value of the dollar. Provide both a graphical and intuitive explanation of your results. Suppose the Bank of Japan (BOJ) wishes to maintain the yen/dollar exchange rate at its level prior to the Fed's policy move. What action is the BOJ likely to take?

(35 points)
2.   The Bush administration has proposed significant tax cuts, including elmination of the top tax bracket. One result would be that the highest income earners would be moved to a lower marginal tax rate.

a.   Use a supply and demand for loanable funds model to explain the impact of such a tax cut on the yields on municipal bonds. If investors anticipate these policy changes, what will happen to municipal bond yields today?

b.   What impact would you predict on the yield on treasury bonds?

(25 points)
3. What is the theory behind the Big Mac PPP (purchasing-power parity)? How does The Economist use Big Mac prices to compute an implied PPP for each currency? What are the arguments for and against using the Big Mac as a standard for applying the theory of PPP?

Econ 340: Money, Banking and Financial Markets

Final Exam, Fall 2000

Answer the following essay questions in two to three blue book pages or less. Be sure to fully explain your answers using economic reasoning and any equations and/or graphs needed to make your point.

  1. 35 points
    In early 1999, the US Central Bank began raising its Fed Funds rate target from a low of 4.5% to 6.5% by the end of 2000. Using an interest parity model, explain how the rising US interest rates would affect the value of the Euro. What action would the European Central Bank have to take to maintain the EURO exchange rate at its 1998 level?


  2. 45 points
    At the end of 1999 the governemnt of Japan abandoned plans to move to an FDIC form of deposit insurance for Japanese Banks. Instead, Japan has maintained its implicit guarantee of all bank deposits despite the fact that Japanesse banks may have as much as $500 billion (total) in bad loans on their books—even more bad loans than they had five years ago. In addition, the Japanese government has racked up the largest national debt (114% as a percentage of real GDP) of any nation in the world.

    1. Explain the role of asymmetric information in financial markets. How does the existence of asymmetric information explain the importance of banks in financial markets?
    2. Suppose that investors decided that the Japanese government was about to default on its national debt. Use a Supply and Demand for loanable funds framework to explain how expectations of a default could impact interest rates in Japan.
    3. What impact would fear of default have on the Japanese currency? Use a theory of asymetric information to explain how a financial crisis could occur in Japan. Be sure to explain how interest rate and exchange rate movements could aggravate adverse selection and moral hazard problems inherent in the banking system. If such a crisis did occur, should an international lender of last resorts step in to bail out Japan?
    Short Answer: (20 points)-- CHOOSE ONE
  1. Define b. Write down and provide a detailed explanation of the Security Market Line. Suppose that Microsoft has a b = 2.0, and the return on 1-year Treasury bills is 6%. If the market returns 10% this year, what do you expect the return on Microsoft to be? Why?


  2. If you buy a put option on a $1000,0000 Treasury bond futures contract with an exercise price of 95 and the price of the Treasury bond is 120 at expiriation, 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 $4000?

Econ 340: Money, Banking and Financial Markets
Midterm Exam, Fall 2000

Example Answer to Question 1

Answer the following essay questions in two to three blue book pages or less. Be sure to fully explain your answers using economic reasoning and any equations and/or graphs needed to make your point.

Question 1 (80 points)

When the federal government runs a budget deficit, it must sell new bonds (assume these are 30 year treasury securities) to pay for the difference between current spending and current tax revenues. In addition, it must sell new bonds to pay off existing bond holders when their bonds mature. Currently the US government is running a budget surplus and is paying off the debt by buying some of the existing 30 year bonds using surplus cash. Also, when existing bonds mature, they are paid off with surplus cash rather than issuing new bonds (refinancing).

A.  Using a supply and demand for loanable funds model of the 30 year treasury market, explain in detail the effects of the budget surplus on the 30 year bond yield. Explain the effect of Treasury Departments' plan to pay off thirty year bonds as they mature.

B.   When the Federal Reserve attempts to slow money growth, it sells Treasury bills to banks (taking reserves in exchange for the bills). Use a model of the supply and demand for loanable funds for 1 year bills to explain the effects of Fed tightening on the yields of 1 year bills.

C.   Use a model of the term structure of interest rates to explain the current shape of the yield curve (steeply downward sloping). Do your answers to A and B above help explain the downward sloping yield curve?

Question 2 (20 points)

A.   Define b. Write down and provide a detailed explanation of the Security Market Line. Suppose that Microsoft has a b = 2.0, and the return on 1-year Treasury bills is 6%. If the market returns 10% this year, what do you expect the return on Microsoft to be? Why?

B.  Suppose your portfolio is evenly distributed between Microsoft, Intel (b=1.2), Ford (b=1.0), and Nabisco (b=.6). Can you quantify the riskiness of your portfolio?

Economics 340
Final Exam
5/12/00

Answer the following essay questions in two to three blue book pages or less. Be sure to fully explain your answers using economic reasoning and any equations and/or graphs needed to make your point.

Part A (80 points)

According to a recent REUTERS news report,

"[T]here is an overwhelming expectation on Wall Street that the key fed funds overnight bank lending rate will be raised by a half-percentage point to 6.5 percent next week, following the five quarter-point increases implemented since June of last year. That was the gospel according to 26 of 29 leading U.S. brokerages polled by Reuters after news last Friday the nation's jobless rate fell to a 30-year low of 3.9 percent....

[P]olicymakers [are] worried about an uptick in inflation, the very thing they are paid to prevent. Spurred by a drum-tight labor market, wages and salaries appear to be on the increase. Energy prices, too, have done their bit to drive up recent headline inflation."

In related REUTERS news,

"The euro, which has shed around a quarter of its value against the dollar over the past 16 months, stumbled anew in early trade after a German central bank official said he saw few signs of sustainable euro strength in the short term."


Question 1 (50 points) Using an Interest Parity model of exchange rates, explain the impact on the value of the dollar (relative to the euro), of the:
  1. rapidly growing US economy,
  2. increasing expected US inflation rate, and
  3. rising US short term interest rates.
Question 2 (30 points)

Explain the role of asymmetric information in financial markets. How does the existence of asymmetric information explain the importance of banks in financial markets?

Use a theory of asymetric information to explain how financial crises may occur. In particular, explain how rising US interest rates could impact developing market financial markets aggrevating the adverse selection and moral hazard problems inherent in the banking system. How could such events lead to a financial crisis?

Part B (20 points--CHOOSE ONE)

Choice #1
Currently the US government is running a budget surplus and is not selling new 30 year bonds. Also, the treasury has begun paying off the debt by paying off 30 year bonds as they mature using the current budget surplus, i.e. not issuing new 30 year bonds.

Using a supply and demand for loanable funds model of the 30 year treasury market, explain in detail the effects of the budget surplus on the 30 year bond yield. Explain the effect of Treasury Departments' paying off thirty year bonds as they mature.

Choice #2
Suppose that you are the manager of a bank that has $25 million of fixed-rate assets, $15 million of rate-sensitive assets, $20 million of fixed-rate liabilitites, and $20 million of rate sensitive liabilities.

Conduct a gap analysis for the bank, and show what will happen to bank profites if interest rates rise by 2 percentage points. What actions could you take to reduce the bank's interest-rate risk?

Economics 340
Midterm Exam
3/6/00

Answer the following essay questions in two to three blue book pages or less. Be sure to fully explain your answers using economic reasoning and any equations and/or graphs needed to make your point.

Question 1 (80 points)

When the federal government runs a budget deficit, it must sell new bonds (assume these are 30 year treasury securities) to pay for the difference between current spending and current tax revenues. In addition, it must sell new bonds to pay off existing bond holders when their bonds mature. Currently the US government is running a budget surplus and is not selling new 30 year bonds. Also, the treasury plans to begin paying off the debt by paying off 30 year bonds as they mature using the current budget surplus, i.e. not issuing new 30 year bonds.

A.  Using a supply and demand for loanable funds model of the 30 year treasury market, explain in detail the effects of the budget surplus on the 30 year bond yield. Explain the effect of Treasury Departments' plan to pay off thirty year bonds as they mature.

B.   Suppose there are no changes in the governments need for short term funds, in expected inflation, etc. Use a model of the term structure of interest rates to explain how your answer to A above will affect the term structure.

Question 2 (20 points)

Define adverse selection. How can the adverse selection problem explain why you are more likely to make a loan to a family member than to a stranger?

Economics 340
Final Exam
12/13/99

Answer the following essay questions in three to four blue book pages or less. Be sure to fully explain your answers using economic reasoning and any equations and/or graphs needed to make your point.

  1. 35 points
    In early 1994, the US Central Bank began raising its Fed Funds rate target from the unusually low rate of 3% to nearly 5.5% by the end of 1994, and to over 6% by mid 1996. Using an interest parity model, explain how the rising US interest rates would affect the value of the Mexican Peso. What action would Banco de Mexico (the central bank) have to take to maintain the peso/dollar exchange rate at its 1993 level?


  2. 45 points
    1. Explain the role of asymmetric information in financial markets. How does the existence of asymmetric information explain the importance of banks in financial markets?
    2. Use a theory of asymetric information to explain how financial crises may occur. Explain how rising interest rates in Mexico, and a substantial increase in the peso/dollar exchange rate (an appreciation of the dollar) could aggravate the adverse selection and moral hazard problems inherent in the banking system. How could such events lead to a financial crisis?

Answer one of the following (20 point) questions in two blue book pages or less.

  1. "The commercial banking industry in Canada is less competitive than the commercial banking industry in the United States, because in Canada only a few larage banks dominate the industry while in the United states there are almost 8,000 commercial banks."

    Critically evaluate the above statement. Is it true, false, or uncertain? Thoroughly explain your answer using your knowledge of the structure of the banking industry in these countries.


  2. Suppose that you are the manager of a bank that has $15 million of fixed-rate assets, $30 million of rate-sensitive assets, $30 million of rate-sensitive assets, $25 million of fixed-rate liabilitites, and $20 million of rate sensitive liabilities.

    Conduct a gap analysis for the bank, and show what will happen to bank profites if interest rates rise by 5 percentage points. What actions could you take to reduce the bank's interest-rate risk?

    3. Economics 340
    Midterm Exam
    10/27/99

    Answer the following essay questions in one to two blue book pages or less. Be sure to fully explain your answers using economic reasoning and any equations and/or graphs needed to make your point. In 1990, a survey of professional forecasters indicated that the average forecaster expected the US CPI to increase by an average of about 4.2% during 1991. In 1999, the same survey indicates an expected inflation rate of just 2.4% for 2000.

    1. (35 points) Using a supply and demand for loanable funds framework, show the effect of such a decline in expected inflation on current interest rates. Be sure to explain the relationship between nominal interest rates and expected inflation, i.e. the Fisher effect.

    2. (30 points) Given your answer to question 1., explain the impact of such a decline in expected inflation and the resulting short term interest rate movements on both the long run expected exchange rate and the current spot exchange rate. Assume that foreign inflation rates (current and expected) and foreign interest rates are unchanged.

    3. (35 points) If you expect inflation to decline further in 2001-2002, what do you think will happen to short term interest rates in the future? Draw a hypothetical yield curve and explain why it has the shape that it does. Be sure to explain the economic intuition behind your answer. (In other words, why does the slope of your yield curve make economic sense?)

     

    Midterm Exam
    October, 1997

    (80 points) Answer the following essay questions in four to five blue book pages or less. Be sure to supplement your written economic reasoning with equations and/or graphs that would make your analysis more clear.

    1. Assuming that there are no changes in U.S. interest rates, or in the long run expected exchange rate, thoroughly explain the short run effects of an increase in Japanese interest rates on the spot «/$ exchange rate.

    2. An important way that the Federal Reserve increases the money supply is by buying bonds from banks and the public. Using the loanable funds framework, show what effect this action has on nominal interest rates. Assume that monetary policy is the only factor that moves interest rates. Given the stylized fact (empirical regularity) that interest rates move procyclically (with the business cycle), what does your answer to the first part of this question imply about monetary policy and the business cycle?

    (20 points)
    Answer one of the following questions in one-two blue book pages or less.

    1. Thoroughly explain how expected inflation would affect the shape of the yield curve?

    2. How do we measure an asset's marginal contribution to the riskiness of the market portfolio? How is this measure used to predict (form expectations about) an asset's return?

    Final Exam
    12/19/97

    (80 points) Answer the following essay questions in four to five blue book pages or less. Be sure to supplement your written economic reasoning with equations and/or graphs that would make your analysis more clear.

    1. In early 1994, the US Central Bank began raising its Fed Funds rate target from the unusually low rate of three percent to nearly 5.5% by the end of 1994, and to over 6% by mid 1996. Using an interest parity model, explain how the rising US interest rates would affect the value of the Mexican Peso. What action would Banco de Mexico (the central bank) have to take to maintain the peso/dollar exchange rate at its 1993 level?

    2. In the early 90s, Mexican banks borrowed heavily at low US interest rates (loans denominated in dollars) and increased their lending to the nonfinancial business sector in Mexico from about 10% of GDP in 1988 to over 40% of GDP in 1994. Explain how rising interest rates in Mexico, and a substantial increase in the peso/dollar exchange rate (an appreciation of the dollar) could aggravate the adverse selection and moral hazard problems inherent in the banking system. How could such events lead to a financial crises? Thoroughly explain.

    (20 points) Answer one of the following questions in one-two blue book pages or less.

    1. Using a loanable funds or supply and demand model for the bond market, predict what will happen to interest rates on a corporation's bonds if the federal government guarantees that it will pay creditors if the corporation goes bankrupt. What will happen to the interest rates on Treasury securities. What happens to the risk premium on the corporation's bonds?

    2.What is interest rate risk. How does it affect individual and institutional investors? Why was interest rate risk not of great concern to U.S. bankers before 1980? How do banks use interest rate futures to manage interest rate risk?

    Midterm Exam
    10/19/93

    (80 points)

    Answer the following essay questions in two pages (four blue book pages) or less.

    1. Why is there an inverse relationship between the price of a coupon bond and its yield to maturity? Demonstrate your answer by referring to the equation that links the price of the bond to the sum of the present values of all payments.

    2. An important way that the Federal Reserve decreases the money supply is by selling bonds to the public. Using the loanable funds framework, show what effect this action has on interest rates.

    Suppose that monetary policy is the only factor that moves interest rates. Given the stylized fact (empirical regularity) that interest rates move procyclically (with the business cycle), what does your answer to the first part of this question (2) imply about monetary policy and the business cycle?

    (20 points)

    Answer the following questions in one paragraph (one blue book page)

    1. How does expected inflation affect the shape of the yield curve?

    2. How do we measure an asset's marginal contribution to the riskiness of the market portfolio? How is this measure used to predict (form expectation about) an asset's return?

    Final Exam
    12/14/93

    (60 points)

    Answer the following essay question in three to five blue book pages or less.

    1. Explain the problems for financial markets created by asymmetric information. How does the market deal with asymmetric information? How can the existence of asymmetric information provide a rationale for government regulation of financial markets? How did this type of regulation contribute to the wide spread failures of S&Ls in the 1980s?

    (20 points each)

    Answer the following questions in one to two blue book pages

    1. Under what circumstances could federal deposit insurance be eliminated in the U.S. without making the banking system more prone to panics?

    2. What is interest rate risk. How does it affect individual and institutional investors? Why was interest rate risk not of great concern to U.S. bankers before 1980? How do banks use interest rate futures to manage interest rate risk?

    Midterm Exam
    2/28/92

    Answer the follwing essay questions in two pages or less.

    1. Why is there an inverse relationship between the price of a coupon bond and its yield to maturity? Demonstrate your answer by referring to the equation that links the price of the bond to the sum of the present values of all payments.

    2. Using the loanable funds model, explain the strong procyclical movement of interest rates.

    3. Discuss what evidence has convinced economists that the preferred habitat theory of the term structure is preferable to either the segmented markets hypothesis or the expectations hypothesis. How has this evidence convinced economists that the segmented markets hypothesis and the expectations hypothesis have major failings?

    Final Exam
    5/13/92

    Answer the following essay questions in two to four (blue book) pages.

    1. Use the loanable funds framework to explain how a fed funds targeting policy can lead to procyclical movement of the monetary aggregates. Provide a carefully-labeled diagram and a verbal explanation. What policy did the Federal Reserve follow during the period from 1950 to 1979? Use the loanable funds framework and assumptions about Fed policy to explain the upward trend in nominal interest rates over this period.

    2. In recent quarters M2 growth has been extremely sluggish, while M1 growth has been quite strong by historical standards. Using T accounts and a loanable funds model, explain how RTC closing of failed thrifts might affect M1 and M2. Does your explanation tell us why M2 growth is weak relative to that of M1? If not, discuss some of the popular explanations of the divergent growth rates. What is your explanation?

    3. Discuss what evidence has convinced economists that the preferred habitat theory of the term structure is preferable to either the segmented markets hypothesis or the expectations hypothesis. How has this evidence convinced economists that the segmented markets hypothesis and the expectations hypothesis have major failings? How do economists use the slope of the term structure as an indicator of future inflation?