Study Guide for Chapter 6 - Money and Banking
1. Using the loanable funds framework, show the effect of
a) a corporate bond being downgraded from BBB to BB and
b) a corporate bond being upgraded from A to AA.
2. Using the loanable funds framework, show the effect of a decrease in federal income tax rates on treasury bonds and muni bonds.
3. Using the loanable funds framework, show the effect of the stock market crash on the market for junk bonds and the market for treasury bonds, as described on page 147 in the text.
4. Corporate bonds are yielding 10% and municipal bonds are yielding 7%. What is the predicted tax bracket of the marginal investor. If the tax bracket of the marginal investor increases by 10 percentage points, and the corporate bond rate increases to 10.5%, what is the expected rate on munis?
5. Assume that you observe a very steep, upward sloping yield curve. Using the three theories of the term structure, explain the shape of the yield curve.
6. According to the market segmentation theory,
what effect each of the following independent events would have
a. there is an increased demand for housing and mortgages.
b. there is a decreased demand for car loans.
c. there is an increase in investment in the student loan market.
d. student scholarships are cut and replaced with student loans.
e. Congress passes favorable tax legislation for real estate development.
f. the Treasury introduces new indexed bonds, but only for ten year maturities.
g. corporations expect interest rates to increase in the future, so they issue lots of long-term debt to take advantage of low interest rates.
h. the Federal government drastically increases government short-term borrowing to finance spending.
i. investors are nervous about the stock market and transfer funds to the long term bond market.
j. there is a new investment tax credit for investing in capital equipment like machinery with a depreciable life of 5 years.
k. capital gains are indexed for inflation, resulting in $100B of capital being freed up for investment. Investment in the bond market in general increases as a result.
l. treasury bonds are no longer tax-exempt from state income tax.
T-F-U, explain answer:
1. A company's bonds are upgraded from AA to AAA status at the same time that their bonds become less liquid. The bond's price will rise and the interest rate will fall and the quantity demanded will increase.
2. Michigan state municipal bonds are upgraded from AA to AAA at the same time that federal income tax rates are increased. The price of the Michigan munis will rise, the interest rate will fall and the quantity demanded will increase.
3. If income taxes were lowered, the interest rates on municipal bonds would rise.
4. The expectations hypothesis does a better job of explaining why the yield curve flattens out or gets steeper than the other two theories of the term structure.
1. a. Based on the following spot rates from the yield curve, calculate the one year forward rates in years 2-5 for case #1 and case #2.
Case 1 Case 2
R1 = 5% 18%
R2 = 6% 17%
R3 = 7% 15%
R4 = 8% 14%
R5 = 9% 12%
b. Assume a constant real rate of interest of 2%. What is the expected inflation in years 1- 5?
c. Assume now that the forward rates include a liquidity premium (risk premium) for years 2-5 of: .4%, .5%, .75%, 1%. What is the expected rate of inflation in years 2-5?
d. For Case #1, show that a $1000 investment would have the same payoff after 3 years under each of the following strategies:
1) invest at the 3 year spot rate,
2) invest for 2 years at the 2 year spot rate and reinvest in the third year at f3 and
3) invest at the one year spot rate for year 1, reinvest at f2 in year 2 and f3 for year three.
2. Based on the 1 year spot rate and the forward
in years 2-5, calculate the spot rates from year 2-5.
Case 1 Case 2
R1 = 3% 12%
f2 = 3.5% 11%
f3 = 4% 11%
f4 = 4.5% 10%
f5 = 5% 10%
3. Corporate bonds are yielding 10% and municipal bonds are yielding 7%. What is the predicted tax bracket of the marginal investor. If the tax bracket of the marginal investor increases by 10 percentage points, and the corporate bond rate increases to 10.5%, what is the expected rate on munis?
4. Assume that munis are yielding 6%, corporate bonds are yielding 9% and the tax bracket of the marginal investor is 30%. Why is the market out of equilibrium? What adjustments would take place to bring about market equilibrium?
5. Assume that treasury bonds yield 10% and are
at the federal level at 42%. Corporate bonds are taxable at the
level (42%) and the state level (6%). If the yields differ only
tax differences, what would the corporate bonds yield?
6. Using a current edition of the Wall Street Journal, go to the Credit Markets in Section C and find the most recent Treasury Yield Curve.
a) Using the three theories of the term structure, explain the movement of the yield curve during the year (Monday edition only).
b) Using the spot rates from the yield curve calculate the forward rates for years 2, 3, 4 and 5.
c) assume a constant real rate of interest of 1.5%. What is the expected inflation in years 2-5?
7. Given the following bond prices for zero
bonds with a face value of $1000, calculate the spot rates for
and forward rates for years 2-4. (Round to two decimal places
interest rate, i.e. set your calculator to two decimal places.)
Yrs to Maturity Price