Exam #1



Exam #2

Econ 351

Spring 2018

Good Luck!

Name _____________________________________ Last 4 PSU ID __________

Please put the first two letters of your last name on the top right hand corner of this cover sheet. Also, ONLY NON-PROGRAMMABLE CALCULATORS ARE ALLOWED - THERE ARE NO SUBSTITUTES. THANKS FOR YOUR COOPERATION!

GOOD LUCK!!!

Total Points for exam = 290

Test time = 120 minutes

To help with time management if spreading time evenly - spend about 20 minutes on each question

Question #1 = 55 points

Question #2 = 45 points

Question #3 = 55 points

Question #4 = 45 points

Question #5 = 40 points

Question #6 = 50 points

1. (55 points) Let's go back in time, 2 years ago to March 2016. The FOMC met and made an announcement on Wednesday, March 16, 2016. What we want to do in this problem is to explain why the rates changed as a result of the announcement. In particular, we are comparing interest rates on Tuesday, March 15 to rates on Wednesday, March 16. Please answer the questions below.

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a) (5 points) In general, what happened to the 1-year, 2-year, 3 year, 5 year, 7 year, and 10 year interest rates between and WHY between Tuesday, March 15 and Wednesday, March 16? What was the NEWS exactly? Be sure to support your answer and also, be sure to use an equation in your answer.

b) (10 points) Now calculate what has happened to the one year interest rate expected one year from now between Tuesday, 3/15 and Wednesday, 3/16. Please show all work. Are your results consistent with your answer from part a)?

c) (10 points) Now calculate what has happened to the one year interest rate expected two years from now between Tuesday, 3/15 and Wednesday, 3/16. Please show all work. Are your results consistent with your answer from part a)?

d) (10 points) Suppose that you were bullish on bonds and bought one 3 year GS with a coupon rate of 3% on 3/15/2016 (data is in Table above). The face value of the bond is $1,000 as is normal. Suppose that you held the bond until 3/16/2016 (one day). Calculate the price of bond on 3/15/2016 and then on 3/16/2016. Calculate your profit / loss AND rate of return. (you did not receive any coupon payments during this short holding period) Please show all work.

e)(10 points) Your friend was also bullish on bonds but played the 2 year GS market instead. Same as above, your friend bought one 2 year GS on 3/15/2016 and closed on 3/16/2016. The coupon rate is the same as above = 3%, face value = $1,000 and you can ignore any coupon payments given the short holding period. Calculate the price of bond on 3/15/2016 and then on 3/16/2016. Calculate your profit / loss AND rate of return.

f)(10 points) So you and your friend are having lunch after you both closed your position(s) and your friend says, "I told you that my bet was less risky (safer) than your bet, I learned that in Chud's econ 351 class - you should take that class!" Is your friend correct? Why or why not? Explain the theory as to why your friend may be correct - this is worth 10 points!

2. (45 points total) We discussed three specific episodes in yield curve history. The first was the soft landing that occurred in 1994 - 1995 under the Greenspan Fed.

a) (10 points) Explain what happened during the first 8 months of 1994 and explain why Greenspan was upset. Use the Fisher effect / Fisher equation and Pure Expectations Theory of the term structure in your answer. Why did the ten year GS react the way it did?

b)(10 points) Now explain what Greenspan did in the latter part of 1994 - early 1995. Why did he do it and what was he trying to accomplish? Did it work and how could he tell if it worked or not? Use the Fisher effect / Fisher equation and Pure Expectations theory of the term structure in your answer. Why did the ten year GS react the way it did?

c)(20 points) Now draw three yields curves depicting this episode. Label the first as YCA which is the yield curve at the beginning of 1994. Now add in YCB, which is the yield curve consistent with Greenspan being upset (October 1994). Finally, add a third yield curve, YCC consistent with March 1995, the soft landing! Explain briefly what signals these movements in the YC send (from YCA to YCB then from YCB to YCC, consistent with your answers above. The graphs on the next page will help with the numbers.

d)(5 points) What exactly does soft landing mean in central banking talk and did the Greenspan Fed achieve the soft landing - how would we know?

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3. (55 points total)

The second YC episode we discussed was the infamous conundrum that occurred in 2005. From the WSJ:

Greenspan's Interest Rate Conundrum

by Bill McBride on 2/20/2005 06:44:00 PM

Last week, during Greenspan's testimony to Congress, he referred to the behavior of long term rates as a "conundrum".

I also stated in class that March 2005 was the first time the PSU Economics Association visited the Board of Governors in Washington DC. It was at this time when I asked the chief of staff if Alan Greenspan spends each day staring at the movements of the ten year Government Security. The chief of staff replied “that is exactly what he does.”

From Webster’s dictionary:

Definition of conundrum

1 a : an intricate and difficult problem

a)(10 points) Explain, using the equation for the liquidity premium theory of the term structure, what is exactly meant by the conundrum in this context (early 2005) and why did Greenspan consider this as a “difficult problem?”

b)(10 points) Using the expression of the liquidity premium theory of the term structure, name two possibilities that explain the conundrum. Be as specific as possible.

c)(10 points) Consider the following information on the yield curve during this conundrum period along with a graphic from Ben Bernanke’s speech. Which of your answers from part b) above apply – that is, how can we use the graphic to explain the conundrum.

|DATE |i on 3 month TBill |i on 10 year GS |

|6/30/04 |1.30% |4.62% |

|3/1/05 |2.7% |4.38% |

|12/30/06 |4.9% |4.38% |

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Write your answer here: be sure to explain the intuition that explains the conundrum (i.e., why did the conundrum occur and was there anyone to blame for the conundrum?)

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Please show all work

d)(5 points) Calculate the current year earnings.

e)(5 points) Calculate the Market Cap.

f)(5 points) Calculate the P/E ratio using the Market Cap:

g) (5 points) Now calculate the P/E ratio using the EPS

h) (5 points) We can see from the graphic that FB has not been doing all that well. Compare the market cap when the spot of FB was 185.03 on 3/16/18 to the market cap currently (according to graphic, part e) above) . How much value has the firm lost since March 16?

4)(45 points)

a)(10 points) Another YC episode was the taper tantrum. What is the taper tantrum and when did it occur?

b)(10 points) Draw two yield curves – one before the taper tantrum (label as YCBTT) and one during it (YCDTT).

c)(10 points) Using the expression for the liquidity premium theory of the term structure, give two alternative possibilities that

explain the taper tantrum.

d)(10 points) Using a bond market diagram (supply and demand), and the graphic below, show the movement from A to B (label your graph accordingly). Why did your diagram change the way it did?

[pic]

Draw your diagram and write your explanation here

e)(5 points) If you knew this was going to happen ahead of time, should you be a bull or bear on this 10 year GS?

5) (45 points total)

a) (10 points) The graphic below is from stock trak and shows the numbers for a 2 year treasury bond - face value = $1000 and the coupon rate is 8.75%. The current interest rate on a 2 year T-note is 2.00%.

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Calculate the price of this bond and show that it is close to the price quote in stock trak .

b)(20 points) We discussed the Magnetar trade in quite a bit of detail. Explain what the Magnetar trade was. To get full credit you must use the following words/terms in your essay.. Please circle each time you use the terms to help us with the grading. More room on next page.

CDS..........Structure it like cows .........Bet against the American dream...... triple A rating.... rating agencies... equity tray.......CDO manager, CDO, tranches.

c)(10 points total) We discussed that the slope of the yield curve, defined as the yield on the 10 year GS minus the yield on the 3 month Tbill used to be a good forward economic indicator but now it is not. I show some empirical results in class. Consider the following equation/regression.

GDP grow t = α + β(i10 - i3mtbill) t - 4 + et

the t - 4 subscript means that we are using the slope of the yield curve lagged one year (4 qtrs).

i)(5 points) when the slope of the yield curve did serve as a 'good' forward economic indicator, what would be the expected empirical results with regard to the R 2 , sign of β, and the t - statistic on β?

ii)(5 points) when the slope of the yield curve did failed to serve as a 'good' forward economic indicator, what would be the expected empirical results with regard to the R 2 , sign of β, and the t - statistic on β?

6. Merck Problem. (50 points total) Pretend that you are hired by Merck to do some research on the behavior of their stock price. The CEO wants you to develop a report investigating two rumors that she has been hearing about Merck stock: 1) The behavior of Merck stock is consistent with the efficient market theory and 2) Changes in Merck stock, just like any other stock, are impossible to predict. That is, Merck stock follows a random walk.

In this problem, you are going to prepare the report. I will help!

To begin, I went to Yahoo finance and copied a picture depicting the behavior of Merck’s stock for the week of (10/31/05 – 11/04/05). I also went to the WSJ online and copied and pasted an excerpt from “Merck and Qualcomm Gain, But ImClone, Guidant Decline”

By KAREN TALLEY, DOW JONES NEWSWIRES November 4, 2005.

Excerpt

“Merck was the best percentage gainer among the Dow industrials, rising $1.07, or 3.8%, to $29.48. The drug maker scored a court victory in its second Vioxx liability case; thousands of cases lie ahead.”

Answer the following questions:

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a) (5 POINTS) To begin this “make believe” report (the CEO treasures completeness), explain exactly what determines stock prices. Write out our general formula of stock price determination, explaining exactly what each term means, and the intuition underlying the formula itself.

Now discuss some of the factors that could influence the terms of your expression above.

b) (5 POINTS) Now use your expression above to explain the movement in Merck stock on Thursday, November 3. Be specific as to the cause of the movement as well as well the movement itself, i.e., the duration.

c) (5 POINTS) Use the expression in a) above to explain the behavior of Merck stock on Tuesday, November 1, the day the FOMC raised their target for the federal funds rate. Again, be very specific as to the cause of this behavior, using your expression in a). Below is an excerpt fromthe official statement from the 11/1 meeting.

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Release Date: November 1, 2005

For immediate release

The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 4 percent.

Write your answer for part c) here.

d) (10 POINTS) Are your results consistent with the efficient market theory? Begin your answer with explaining exactly what the efficient market theory is making sure you refer to the best investment advice assuming that markets are efficient. Apply your definition of the efficient market theory to your answers on both b) and c) above. Be very specific and be sure to use the term NEWS numerous times in your explanations.

We now move on to addressing whether or not changes in Merck stock are predictable. Begin with a little notation. Let MRKt be the current spot price of Merck at time t (right now; today) and let MRKet+1 be the spot price of Merck expected tomorrow.

Of course the information set available to you is Ωt and includes all information, relevant or not, that is available up until time t (right now!).

e) (10 POINTS) According to the efficient market theory (along with our class discussion), what is the best forecasting model that you can come up with to predict MRKt+1 (the price of Merck stock tomorrow)? Be very specific and justify the choice of your forecasting model (i.e., justify why your model is the best of all the possible choices, being sure to identify some of the other possible forecasting models! (hint – redundant variables everywhere!!)).

f) (15 POINTS TOTAL, 5 FOR EACH EQUATION WITH SOLID ACCOMPANYING DISCUSSION) We are now ready to test whether or not Merck (stock) follows a random walk. Using the forecasting model above, explain exactly how we would test whether or not Merck follows a random walk. Be sure to identify the expected empirical results using all the equations that we set up in class. There are a minimum of three equations to set up and discuss. Be sure to continuously refer to the efficient market theory and the random walk properties of Merck throughout your discussion.

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