Exam #1



Exam #2

Econ 351

Fall 2016

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 = 250

Test time = 120 minutes

To help with time management if spreading time evenly

Question #1 = 50 points..... 24 minutes

Question #2 = 30 points ......14 minutes

Question #3 = 50 points.... 24 minutes

Question #4 = 30 points ....14 minutes

Question #5 = 50 points..... 24 minutes

Question #6 = 40 points.... 19 minutes

1. (50 points) Use the graphics to answer the following questions:

[pic]

[pic]

1) (50 POINTS TOTAL)

a) (5 points) Calculate what has happened to the one year interest rate expected one year from now between October 15, 2015 and December 17, 2015. Please show all work.

b) (5 points) Now calculate what has happened to the one year interest rate expected two years from now between October 15, 2015 and December 17, 2015. Please show all work.

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

d) (10 points) Draw a picture of the yield curves (using these three interest rates) representing conditions on October 15, 2015 and another representing the conditions on December 17, 2015 (ON THE SAME DIAGRAM). What has happened to the slope of the yield curve between these to dates? The slope in this case is defined as the long rate (3 yr) minus the short rate (1 yr). Please give me values. YOUR DIAGRAM WILL EVENTUALLY HAVE ONE MORE YIELD CURVE FOR A TOTAL OF THREE YIELD CURVES.

e) (5 points) We spoke numerous times about what is referred to as the conundrum interest rates - are your results consistent with a conundrum? Define the long rate as the 3 year and the short rate as the 1 year. Why or why not?

f) (5 points) The graph below updates us to the present = October 20, 2016. Calculate the one year interest rate expected one year from now and calculate the one interest rate two years from now.

[pic]

g) (5 points) In part a), as of 10/14/2015, you calculated what the one year interest rate was expected to be in one year....we have that number = .66% (for October 20, 2016 - not exactly one year but close enough!). Was the number in part a) higher or lower (from 10/14) than the actual one year = .66% (that occurred one year later) on 10/20/2016? What could cause such a difference?

h) (10 points) Now compare the slope of the yield curve, as defined above, between 10/14/15 and 10/20/16. What has happened to the slope and given the traditional signal that the slope of the yield curve sends, what does it tell us about the future state of the economy? i.e, why would this happen???? PLEASE ADD THIS YIELD CURVE TO YOUR YIELD CURVE DIAGRAM ABOVE, BEING SURE TO PUT DATES ON ALL THREE OF YOUR YIELD CURVES. (more space on next page)

2) is skipped

3) (50 points)

a)(10 points) In the space below, draw a bond market diagram and explain why bond demand has the slope that it has and explain why bond supply has the slope that it has.

use the space above for your graph

write your explanation here:

b)(10 points for graph and 10 points for explanation) The graphic on the left depicts the spread between AAA corporate bonds and 10 year US government securities. As you can see, the spread rises dramatically during the fall of 2008. At point A, the spread was 1.5 percent and at point B, it was 3.5 percent. Use the space below the graph to depict this change in the spread - draw two diagrams, the US government security (bond) market on the left and the corporate bond market on the right. Depict points A and B on both diagrams and EXPLAIN the intuition as to why the spread has increased (i.e., explain why we go from point A to B).

10 points for complete and correctly labeled diagrams

write your explanation here: (more room on next page)

c) (20 points - 10 for graph, 10 for explanation) We also modeled quantitative easing using the same two graphs - explain how you would model quantitative easing using these same two graphs and explain clearly how the analysis changes. Use the space below to draw the two graphs in a world of quantitative easing and label as point A before quantitative easing and point B as the conditions during quantitative easing.

10 points for complete and correctly labeled diagrams

write your explanation here:

4)(30 points) Use the information below:

[pic]

a)(10 points) Calculate the market cap and the earnings per share (EPS) for MSFT on 10/24/16.

b)(5 points) Calculate the P/E ratio on October 20, where the price of MSFT was $57.50 per share.

c)(10 points) Suppose that you purchased a 3 year government security (face value = $1000) in October 2015 where the interest rate was .84% and the coupon rate was 2%. You held on to the security for one year and sold it in October 2016, a two year bond now, when the interest rate was .98% These numbers are real. Calculate your profit or loss and rate of return.

d)(5 points) Calculate the price of a 2 year government security with face value of $1000 where the interest rate is 5% and the coupon payment is also 5%.

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) (40 points)

In class, we discussed credit default swaps (CDS) and collateralized debt obligations (CDOs) in the context of the "Magnetar Trade."

a) (10 points) Referring to the picture below (this is from the video we watched in class), explain exactly how the Magnetar trade worked.

Please begin your answer here:

b) (5 points) We discussed the email communication between two rating analysts at Standard & Poors (see below):

– Rahul Dilip Shah: btw: that deal is ridiculous Shannon Mooney: I know right ... model def does not capture half of the risk

– Rahul Dilip Shah: we should not be rating it Shannon Mooney: we rate every deal

– Shannon Mooney: it could be structured by cows and we would rate it

How does "model def does not capture half of the risk" and "it could be structured by cows and we would rate it" apply to the Magnetar trade? Why did S&P rate every deal and who structured it like cows and why?

d)(10 points) We discussed the conundrum that the Greenspan fed dealt with. What exactly is the conundrum and when did it occur? Using the expression for the 10 yr GS, provide two explanations as to why the 10 yr GS behaved the way it did.

e)(5 points) Some are worried about conundrum #2. What is that all about and explain why it might very well become a reality.

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