Midterm Examination for Money and Banking ECN 314 - Summer 2001

For maximum credit: write legibly in full sentences, label all numbers with appropriate units, carefully label graphs and diagrams, and show all work to get maximum partial credit.  Essays and True-False-Uncertain/Explain questions should be answered with at least one full paragraph of 3 or 4 sentences.  Points are indicated in parentheses, 100 points total.

Essays

1.  (10 points) T-F-Uncertain/Explain.  State an answer (True, False or Uncertain) and then completely explain your answer in a short essay of a minimum of one full paragraph.  “Inflation will always benefits debtors.”

2.  (10 points) U.S. automakers controlled about 65% of the U.S. car market in 2000.  Analysts recently predicted that U.S. automakers might lose some of their U.S. market share to foreign automakers in 2001 because of the strong U.S. dollar.  Explain.

3.  (10 points) Evidence shows that interest rates are procyclical (interest rates rise during economic expansions, and fall during economic contractions).  Explain the statement above using either the S & D for Bonds or the S & D for Credit model in your answer, showing what happens to interest rates both during an expansion and during a contraction, showing separate graphs.   Clearly label your graphs.

4.  (10 points total) Assume that the Federal Reserve implements expansionary monetary policy.
a. What action would it most likely take to carry out this policy? (2 points)
b. Using the Supply and Demand for Bonds model and the Supply and Demand for Money model, show graphically the Fed’s action and explain what happens to bond prices and interest rates in the short run?  (4 points)
c. explain what happens to interest rates in the long run under the most likely scenario, explaining the various effects on interest rates in the long run.  Use a graph to support your answer (with interest rates on the vertical axis and time on the horizontal axis).  (4 points).

PROBLEMS (Hint: Be sure calculator is set to 1 PMT/YR for all problems).   SHOW ALL WORK

1. (10 points total, 2 points for each part) Given the data below:
a.  Calculate the annualized, compounded nominal rate of return for each country’s stock index using the formula: FV = PV (1 + i)n or the calculator.
b. Calculate the annualized, compounded rate of inflation in each country.
c. Calculate the real rate of return for each stock market.
d. Which country had the highest nominal return?

YEAR
1990       1996
Germany  Stock Index   650        1825
CPI     622         760

Italy   Stock Index         2000       9725
CPI          998        3200

CPI          125       200

2.  (20 points total, 4 points each part) 1 year zero coupon treasury securities are selling for \$925.93 in the U.S. and for £892.86 in the U.K. (assume 1000 face value in both dollars and pounds).  The current ex-rate is \$1.44/£.
a.  Calculate the 1 year returns (YTM) in the U.S. and in the U.K. for T-bills (round to 2 places, e.g. 5.50%, 6%.)
b.  Show the formula for, and explain the concept of, “interest rate parity.”  Using your answers from part a, explain whether the British pound should be selling at a forward discount or premium, what should the premium or discount be,  and explain exactly why it is selling for a discount or premium.
c.  Based on your answer in part b, and using the current spot rate, calculate the expected one year forward ex`-rate (quote forward rates to four decimal places) if interest rate parity holds.
d. If interest rate parity does not hold and the actual one year forward rate is \$1.3968/£, calculate the actual forward discount or premium.  Using that forward discount or premium and the one year yields from part a, compare an American investor’s rate of return in the U.S. versus the U.K. (For the U.K. investment , assume the U.S. investor would invest at the 1 yr. U.K. Tbill rate and use a forward contract to cover ex-rate risk.)
e.  Based on your answer to part d, what would happen to bond demand, bond prices and interest rates in both the U.S. and U.K. to restore interest rate parity?  Explain exactly why the bond prices and interest would change in each country.

3. (30 points total, as indicated) You are given the following information on bonds in the year 2000 when the CPI is 170.  (Remember: Coupon payment = Coupon Rate x Face Value)

Type                       Coupon Rate          FV              Term                 Price
Zero Coupon Corporate   -                  \$1000           5 years                \$700
Regular T-note             6.75%             \$1000           5 years               \$950
Indexed T-note             3.5%               \$1040           5 years               \$975
Muni-bond                   4.25%             \$1000           5 years                \$955

a. calculate the yield to maturity (YTM) for each bond. (10 points)
b. using the information above, calculate the expected rate of inflation over the next five years.  Explain in a short essay specifically how expected inflation can be calculated from treasury bond yields.   (5 points)
c. Using our answer from part b, and assuming the CPI in 2005 is 187, calculate the actual rate of inflation.  Would a person who bought the regular T-note in 2000 and held it until maturity be helped or harmed by the actual rate of inflation?  Explain in a short essay.  (5 points)
d. assuming that Regular T-notes are fully taxable, would a person in the 28% tax bracket prefer the muni-bond (tax-free) or the Regular T-note?  Explain your answer.  (Assume that there is no difference in risk) A calculation is required for this problem. (5 points)
e. Explain in a short essay of three or more sentences why the Regular T-note, the Indexed T-note and the Muni-bond are all selling at a discount.  (5 points)