Exam #1



Exam #2

Econ 351

Spring 2017

Good Luck!

Name ________________KEY______________________ 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 = 295

Test time = 120 minutes

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

Question #1 = 45 points

Question #2 = 50 points

Question #3 = 50 points

Question #4 = 50 points

Question #5 = 50 points

Question #6 = 50 points

1. (45 points) Use the table below to answer the following questions:

|DATE |i on 1 year GS |i on 2 year GS |i on 3 year GS |

|11/07/16 |.63% |.82% |.99% |

|12/16/16 |.91% |1.28% |1.59% |

a) (5 points) Calculate what has happened to the one year interest rate expected one year from now (i12e) between November 7, 2016 and December 16, 2016. Please show all work.

TWO YEAR

i2 = (i1 + i12e) / 2

11/07......... .82 = (.63 + i12e) / 2 ............... i12e = 1.01%

12/16........ 1.28 = (.91 + i12e) / 2 ............... i12e = 1.65%

b) (5 points) Now calculate what has happened to the one year interest rate expected two years from now (i13e) between November 7, 2016 and December 16, 2016. Please show all work.

THREE YEAR

i3 = (i1 + i12e + i13e ) / 3

11/07.............. .99 = (.63 + 1.01 + i13e) / 3 ............. i13e = 1.33%

12/16............ 1.59 = (.91 + 1.65 + i13e) / 3................. i13e = 2.21%

c) (5 points) Name two possible real world reasons why these expected interest rates (parts a) and b)) changed the way they did.

THE FED RAISED RATES - AND THE EXPECTED PATH OF INTEREST RATES ARE RISING GIVEN THE PROPOSED EXPANSIONARY POLICY BY THE NEW ADMINISTRATION

ELECTION, EXPECT INFLATION RISING WILL RAISE INTEREST RATES TO COMPENSATE INVESTORS FOR THE HIGHER EXPECTED INFLATION - THIS IS THE FISHER EFFECT

d) (10 points) Suppose that you were bullish on bonds and bought one 3 year GS with a coupon payment of 3% on 11/07/2016, the day before the election (data is in Table above). The face value of the bond is $1,000 as is normal. Suppose that you held the bond until 12/16/16, the day after the Fed raised rates. Calculate the price of bond on 11/07 and then on 12/16. Did you make a profit or loss? (you did not receive any coupon payments during this short holding) Please show all work.

|CP |DF |PV | |CP |DF |PV |

|30 |1.0099 |29.70591 | |30 |1.0159 |29.53047 |

|30 |1.019898 |29.41471 | |30 |1.032053 |29.06828 |

|30 |1.029995 |29.12635 | |30 |1.048462 |28.61333 |

|1000 |1.029995 |970.8785 | |1000 |1.048462 |953.7776 |

| | | | | | | |

| | |1059.125 | | | |1040.99 |

YOU SUFFERED A CAPITAL LOSS: 1040.99 - 1059.125 = - 18.135

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 11/07 and closed on 12/16. The coupon payment 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 11/07 and then on 12/16. Did you make a profit or loss?

|CP |DF |PV | |CP |DF |PV |

|30 |1.0082 |29.756 | |30 |1.0128 |29.62085 |

|30 |1.016467 |29.51399 | |30 |1.025764 |29.2465 |

|1000 |1.016467 |983.7995 | |1000 |1.025764 |974.8833 |

| | | | | | | |

| | |1043.07 | | | |1033.751 |

| | | | | | | |

YOU SUFFERED A CAPITAL LOSS: 1033.751 - 1043.07 = - 9.319

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!

YES, YOUR FRIEND IS CORRECT - MORE INTEREST RATE RISK THE FARTHER OUT THE YIELD CURVE YOU GO - YOU LOST OVER $18 AND YOUR FRIEND ONLY LOST A LITTLE OVER $9. IN FACT, YOU NEED TO BE COMPENSATED FOR TAKING ON THIS RISK AS IS CONSISTENT WITH THE FACT THAT THE YIELD ON THE THREE YEAR IS LARGER THAN THE YIELD ON THE TWO YEAR. (ALL ELSE CONSTANT)

2. (50 points total)

We now consider another set of interest rates over the same dates: the 3 month US T-bill and the 10 year US GS. The table below provides the information.

|DATE |i on 3 month T-bill |i on 10 year US GS |

|11/07/16 |.41% |1.83% |

|12/16/16 |.50% |2.60% |

a) (5 points) What has happened to the slope of the yield curve as defined as the i on 10 year GS minus the I on 3 month T-bill?

1.83 - .41 = 1.42% = slope 11/07

2.60 - .50 = 2.10% = slope 12/16

the slope has risen

b)(15 points) Now explain 3 different reasons that the i on the 10 year GS rose the way it did. (5 points for each reason). Be sure to explain each reason.

THINKS OF THE DECOMPOSITION OF THE 10 YEAR YIELD FROM BERNANKE'S SPEECH

1) FISHER EFFECT the election results increased expected inflation due to expected demand side stimulus and according to the Fisher equation/effect, long term nominal interest rates will rise with the expected inflation.

i10 = r + πe ....... πe up, i10 up, investors need to be compensated for the higher expected inflation

2) HIGHER EXPECTED RATES

i10 = i1 + i12e + i13e + i14e + i15e + i16e + i17e + i18e + i19e + i110e

-------------------------------------------------------------------------------

10

Higher expected short rates will cause i10 to rise since the Fed will need to worry about overheating

3) LARGER TERM PREMIUM

The volatility of the ten year will rise given the unexpected Trump victory - this will raise the term premium

c) (10 points) We now consider the period called the 'soft landing' during 1994. Recall this is the period that the Alan Greenspan Fed was in a tightening cycle. In particular, they began tightening in March 1994 as is shown as point A on the graphic below. As the Fed was tightening through the summer and fall of 1994, the interest rate on the 10 year went from 6.5% (March) to 8% in November of 1994 (point B on graphic). Using the equation for the pure expectations theory of the term structure, explain why we would expect long rates to rise during a tightening cycle.

i10 = i1 + i12e + i13e + i14e + i15e + i16e + i17e + i18e + i19e + i110e

-------------------------------------------------------------------------------

10

Since i10 is determined by the average of the future expected path of short rates, when the expected path of short rates rises, as they will in a tightening cycle, the i10 should follow suit.

[pic]

d) (10 points) Even though we would expect long rates to rise with the tightening cycle, Alan Greenspan was not happy at all, in fact, he was actually mad. Explain exactly Greenspan was not happy about and what did he do about it and why.

Greenspan felt that the rise in long rates was too abrupt (much) and indicated that investors were expecting higher inflation - a central bankers worst nightmare- Greenspan showed that he is not an inflation dove by jacking up the ff target by 75 basis points in November of 1994, something he has never done before. He also raised the target by 50 basis points in February of 1995. The idea was to lower expected inflation.

e)(10 points) As you can see, the yield on the 10 Year fell after November to 7% in April of 1995. This made Greenspan very happy and his colleagues were impressed.

"I learned that when it comes to tactics, you should just defer to Greenspan," Mr. Blinder says in an interview. In a 2002 book, Mr. Blinder and Ms. Yellen wrote: "This stunningly successful episode ... elevated Greenspan's already lofty reputation to that of macroeconomic magician."

What do they (Blinder and Yellen) mean when they tactics in this episode and why is it considered 'stunningly successful'? Use the equation for the pure expectations theory of the term structure along with the Fisher effect to support your answer.

Since the ten year rate fell, the conclusion was that it was due to a fall in inflationary expectations - exactly what Greenspan's objective was - Brilliant Watson! I mean Alan.

PET - the first few terms were rising as before - but since he was so hawkish, future rate declined from where they were before since the Fed won't have to fight inflation anymore

[pic]

Fisher Equation:

i10 = r + πe if inflationary expectations fall, so will i10 - don't need to be compensated for higher inflation anymore

3) (50 points total)

a) (5 points) We discussed the conundrum in quite a bit of detail. When the Penn State Economics Association visited the Fed Boardroom for the first time in March of 2005, we were in the midst of the conundrum. Explain exactly what is meant by the conundrum? Don't explain why we had a conundrum, just what the conundrum is.

CONUNDRUM = PUZZLE - WHY WASN'T THE INTEREST RATE ON THE 10 YEAR GS RISING SINCE THE FED WAS IN A TIGHTENING CYCLE - IT ALWAYS RISES IN A TIGHTENING CYCLE

b)(15 points) Consider the following information on the yield curve during this conundrum period:

|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% |

Plot these three yield curves on ONE diagram, labeling each with the appropriate dates

[pic]

15 points for correct and completely labeled graph

Now consider the graphic below from Ben Bernanke's speech titled "Long-term Interest Rates" from March 1, 2013. The three dates used for your graphic above are marked accordingly.

[pic]

c) (5 points) If it wasn't for the fall in the term premium, what would the yield on the 10 year GS have been on March 1, 2005? (i.e. assume that the term premium stayed the same as it was on June 30, 2004.... TP = 1.33, when the Fed started their tightening cycle).

TERM PREMIUM FELL BY .67%

4.38 + .67 = 5.05%

d) (5 points) If it wasn't for the fall in the term premium, what would the yield on the 10 year GS have been on Dec. 30, 2006? (i.e. assume that the term premium stayed the same as it was on June 30, 2004.... TP = 1.33, when the Fed started their tightening cycle).

TERM PREMIUM FELL BY 1.16%

4.38 + 1.16 = 5.54%

g) (10 points) Provide a discussion as to why we might have expected the term premium to fall as it did on the 10 year GS during this time. Be as specific as possible.

GREENSPAN WAS A VICTIM OF HIS OWN SUCCESS - THE GREAT MODERATION - ALSO, FOREIGN CENTRAL AND COUNTRIES WERE GETTING RICHER AND BUYING UP US GS - THE GLOBAL GLUT OF SAVINGS KEPT THE PRICE OF GS HIGH AND YIELD LOW - THE PROBABILITY OF A CAPITAL LOSS (HIGHER RATES) WAS LOW GIVEN THIS FOREIGN DEMAND RESULTING IN A FALL IN THE TERM PREMIUM

h) (10 points) So you are having a discussion with a friend about the slope of the yield curve and your friend compares the slope of the yield curve from 6/30/04 to the slope of the on yield curve on 12/30/06, one year before the great recession started and argues that the slope of the yield curve is in fact a reliable predictor of future economic activity in this episode. You reply, on one hand, you are absolutely correct and on the other hand, you are totally wrong. Explain exactly what you mean.

CORRECT - YES THE YIELD CURVE WAS INVERTED ONE YEAR BEFORE THE GREAT RECESSION STARTED - THE TYPICAL SIGNAL FROM PREVIOUS RECESSIONS

TOTALLY WRONG - FOR THE WRONG REASONS - IT SHOULD BE INVERTED DUE TO LOWER EXPECTED SHORT RATES SINCE THE FED WILL BE FIGHTING THE ENSUING RECESSION BUT WE KNOW FROM ABOVE THAT THE YIELD CURVE WAS INVERTED DUE TO THE FALLING TERM PREMIUM - NOT FALLING EXPECTED SHORT RATES.

4)(50 points) Use the information below:

[pic]

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

477.17 x $4.90 = $2,338.133 million (2.338 Billion)

b) (5 points) Calculate the Market Cap.

477.17 M x $856.97 = 408,920 M (408.920 B)

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

$408.920/2.338 B = 174.9 = PE

d) (5 points) Now calculate the P/E ratio using the EPS (earnings per share).

856.97/4.90 = 174.8979 = PE

e)(5 points) Comment on this P/E ratio. Is it high or low, relative to the norm? What would cause the P/E ratio to take on such a value?

VERY HIGH - CURRENT YEAR EARNINGS ARE SMALL RELATIVE TO THE MARKET CAP - EXPECT VERY HIGH PROFITS WELL OUT INTO THE FUTURE - LOTS OF EXPECTED EARNINGS GROWTH!

Use the graphics below to answer part f) below

[pic][pic]

[pic]

f) (10 points) Calculate the price of this 2 year GS and show that it is very close to the price in stocktrak equal $998.4. Note the coupon rate is 1.25%.

|CP |DF |PV |

|12.5 |1.01297 |12.33995 |

|12.5 |1.026108 |12.18195 |

|1000 |1.026108 |974.5561 |

| | | |

| | |999.078 |

g)(5 points) Is this bond selling at a premium or a discount. What determines whether a bond sells at a premium or discount and apply this concept to this bond.

DISCOUNT - SINCE THE TWO YEAR INTEREST RATE (1.297%) IS GREATER THAN THE COUPON RATE (1.25%).. ANYTIME THE INTEREST RATE IS HIGHER THAN COUPON RATE - BOND SELLS AT DISCOUNT - IF COUPON RATE IS HIGHER THAN INTEREST RATE, BOND SELL AT A PREMIUM

h) (10 points) The graphic below shows the reaction of various interest rates to the most recent Fed hike as you can see from the arrows. The Fed Funds jumped 25 basis points to .91. In viewing the reaction of the Treasuries of varying maturities, is the Fed happy with this reaction and is this reaction consistent with the third mandate that we talked about in class and is this reaction consistent with the efficient market theory. Why or why not?

YES YES YES - THE FED WAS HAPPY, HARDLY ANY MOVEMENT CONSISTENT WITH THE THIRD MANDATE = FINANCIAL STABILITY.... ALSO CONSISTENT WITH THE EFFICIENT MARKET THEORY - THERE WAS NO NEWS - THE FED LET EVERYONE KNOW VIA FORWARD GUIDANCE - NO NEWS, NO MOVEMENT, CONSISTENT WITH EMT!

[pic]

5. 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:

[pic]

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.

[pic]

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.

6) (50 points total)

In class, we discussed credit default swaps (CDS) and collateralized debt obligations (CDOs) in the context of the "Magnetar Trade." We also watched a song titled "Bet Against The American Dream." The pic below should refresh your memory.

[pic]

a) (10 points) In the caption below the pic the guy is saying "Write a check for $10 million dollars". How does this statement apply to CDOs and the Magnetar trade? What do you write the check for and what do you do after you write the check. Explain.

WRITE THE CHECK TO BUY THE EQUITY PORTION (THE TRAY) OF THE CDO WHICH GIVES YOU THE RIGHT TO STRUCTURE THE CDO (SINCE EQUITY PORTION IS THE MOST RISKY AND GETS PAID LAST). YOU THEN STRUCTURE THE CDO LIKE 'COWS' TO MAKE SURE IT FAILS, BECAUSE IF IT FAILS, YOUR CDS'S THAT YOU PURCHASE PAY OFF BIG TIME!

b) (10 points) Betting against the American Dream? How does this apply to the Magnetar trade. What is the American dream in this context and how do you bet against it. How do you make money by betting against the American dream?

THE AMERICAN DREAM REFERS TO OWNING YOUR OWN HOUSE - YOU BET AGAINST THE AMERICAN DREAM BY BUYING CREDIT DEFAULT SWAPS - WHEN HOMEOWNERS GET BEHIND AND EVENTUALLY DEFAULT ON THEIR MORTGAGE PAYMENT (BAD AMERICAN DREAM), THE CDO, WHICH IS MADE UP OF MORTGAGE BACKED SECURITIES, FAILS AND AS A RESULT AND YOU MAKE THE MONEY OF YOUR CDS BET.

c)(10 points) We made the statement that the Fed lowers interest rates by raising them in the context of the soft landing. How can the Fed pull this off - Explain using the equation for the pure expectations theory of the term structure.

[pic]

GREENSPAN ROSE THE FUNDS RATE TARGET (ABRUPTLY) BY 75 BASIS POINTS IN NOV OF 1994 - INVESTORS PERCEIVED THIS AS A SERIOUS ATTACK ON RISING INFLATIONARY EXPECTATIONS - AS A RESULT, THEY LOWERED THEIR EXPECTED PATH OF SHORT RATES FARTHER OUT IN FUTURE (RED ARROWS) SINCE THE FED WILL NO LONGER HAVE TO FIGHT INFLATION IN THE FUTURE SINCE THEY ARE TAKING CARE OF BUSINESS NOW. THIS EFFECT WAS SO STRONG THAT THE NET EFFECT WAS A FALLING YIELD ON THE 10 YEAR GS.

d)(10 points) We discussed the Taper Tantrum. When did the taper tantrum occur and what is meant by the term taper - taper what? Who told us about tapering and when?

THE TAPER TANTRUM OCCURRED IN THE SUMMER (JUNE) OF 2013 WHEN BERNANKE SAID THAT THE FED MAY TAPER OR SLOWDOWN THEIR PURCHASES OF GS AND MBS - THIS WAS IN THE MIDST OF QE #3.

e) (10 points) This question apples to the taper tantrum. Using the liquidity premium of the term structure, explain what happened to the yield on the 10 GS and why. Be sure to explain the intuition as to how and why the 10 year yield moved the way it did referring to your equation.

i10 = i1 + i12e + i13e + i14e + i15e + i16e + i17e + i18e + i19e + i110e

------------------------------------------------------------------------------- + lnt

10

TWO POSSIBLE STORIES - COULD BE THAT THE EXPECTED PATH OF SHORT RATES WERE RISING BECAUSE INVESTORS PROCESSED THE 'TAPER' TO MEAN HIGHER RATES IN FUTURE

MORE LIKELY STORY, THE TERM PREMIUM ROSE BECAUSE THERE IS A HIGHER PROBABILITY OF A CAPITAL LOSS (LONG RATES RISING) SINCE THE FED DOESN'T HAVE OUR BACK ANYMORE - NOT THERE AS MUCH AS BEFORE TO MAKE SURE LONG RATES DON'T RISE.

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