Use the three tables below to answer the following questions



Exam #2

Econ 351

Spring 2019

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!!!

1. (40 points) In this problem we are going to evaluate the movements of selected interest rates in the GS market since Sept of 2018. In particular, we are focusing on the interest rates for the 1, 2, and 3 year GS. Using the three graphics that follow, please answer the following questions.

Graph #1

[pic]

Graph #2

[pic]

Graph #3

[pic]

a) (10 points) Let's pretend a friend of yours, a non-econ major, is looking at the GS data with you (the 3 graphs above) and notices that between September of 2018 and December of 2018 the 1-Year interest rate went up but the 2-Year and 3-Year interest rates went down. They ask you to explain.

In order to answer your friend, first calculate the one year interest rate expected one year from September 2018 (Graph #1) (our notation is i12e) and compare to the one year interest expected one year from December 2018 (Graph #2)

TWO YEAR

i2 = (i1 + i12e) / 2

Sept 2018......... 2.77 = (2.56 + i12e) / 2 ............... i12e = 2.98%

Dec 2018 ....... 2.68 = (2.66 + i12e) / 2 ............... i12e = 2.70%

b)(10 points) What could possibly explain why these two interest rates move in opposite directions?

i) Explain why the 1-Year rate changes the way it did. Be as specific as possible. Was there any news between Sept and Dec of 2018 that would explain this?

The Fed Raised the ff target in Dec, 2018 - policy rates and short rates (1 year) are highly correlated

ii)Explain why the 2-Year rate changes the way it did! Be sure incorporate your answer above in part a). Was there some type of unexpected news between Sept and Dec 2018?

Jerome Powell turned dovish - spoke dovish as in we are done raising rates = expected path of rates fell as a result as in part a above

c) (10 points) Now calculate what has happened to the one year interest rate expected two years from now (our notation is i13e) between Sept 2018 and Dec 2018. Please show all work.

3 YEAR

i3 = (i1 + i12e + i13e ) / 3

Sept 2018 .............. 2.84 = (2.56 + 2.98 + i13e) / 3 ............. i13e = 2.98%

Dec 2018 ........... 2.67 = (2.66 + 2.70 + i13e) / 3................. i13e = 2.65%

d) (10 points) We now are going to evaluate what exactly has happened to the expected path of 1-Year rates between Sept 2018 and Dec 2018.

i) Let's start with Sept 2018 - we are only focusing on the EXPECTED path of rates as defined by i12e and i13e. What do investors think the Fed is going to do with rates (as defined by the 1-Year rate) between Sept 2019 and Sept 2020? Is this bullish or bearish for the economy?

Keep rates the same at 2.98% - not bullish - not necessarily bearish

ii Now consider Dec 2018 - again, we are only focusing on the EXPECTED path of rates as defined by i12e and i13e. What do investors think the Fed is going to do with rates (as defined by the 1-Year rate) between Dec 2019 and Dec 2020? Is this bullish or bearish for the economy?

Lower rates from 2.70% in Dec 2019 to 2.65% in Dec 2020 - this is bearish since it implies the Fed is fighting a recession

2) (65 points total)

a)(15 points) Using the information from question 1, draw three yield curves: the first associated with Sept 2018 (Label as YC1), the second associated with Dec 2018 (Label as YC2) and the third associated with Feb 2019 (Label as YC3). Each yield curve plots data for i1 , i2 and i3. Use the space below.

[pic]

b)(10 points) Assuming the term premium is zero for all three rates, answer the following: If you were Jerome Powell (the Fed Chair), would you be worried as to what happened to the slope and the position of the yield curve from Sept 2018 to Feb 2019? Why or why not? Explain using the theory as to why the yield curve often serves as a good forward economic indicator.

YES I WOULD BE WORRIED - GIVEN THAT THE YC WENT FROM HAVING A POSITIVE SLOPE TO HAVING A NEGATIVE SLOPE.... INVESTORS ARE EXPECTING US (THE FED) TO LOWER RATES IN THE FUTURE AND THE ONLY REASON WE WOULD IS TO FIGHT AN IMPENDING RECESSION!

c) (10 points) Suppose that you were bullish on bonds during this period and you bought one 3 year GS with a coupon rate of 2% in Sept 2018. The face value of the bond is $1,000 as is normal. Suppose that you held the bond until Feb 2019 and closed your position. Calculate the price of bond in Sept 2018 and then in Feb 2019. Calculate your profit / loss AND rate of return. (you did not receive any coupon payments during this short holding period) Please show all work.

|20 |1.0284 |19.44769 |  |20 |1.0248 |19.516 |

|20 |1.057607 |18.91062 | |20 |1.050215 |19.04372 |

|20 |1.087643 |18.38839 | |20 |1.07626 |18.58286 |

|1000 |1.087643 |919.4197 | |1000 |1.07626 |929.1432 |

| | |976.1664 | | | |986.2858 |

| | | | | | | |

|PROFIT = 10.12……RETURN = 1.04% | | | |

d)(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 in Sept 2018 and closed in Feb 2019. The coupon rate is the same as above = 2%, face value = $1,000 and you can ignore any coupon payments given the short holding period. Calculate the price of bond in Sept 2018 and then in Feb 2019. Calculate your profit / loss AND rate of return.

|20 |1.0277 |19.46093 | |20 |1.025 |19.5122 |

|20 |1.056167 |18.93639 | |20 |1.050625 |19.03629 |

|1000 |1.056167 |946.8197 | |1000 |1.050625 |951.8144 |

| | |985.217 | | | |990.3629 |

| | | | | | | |

|PROFIT = 5.14……RETURN = .522% | | | |

e)(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 (the 2 year bet) was less risky (safer) than your bet (the 3 year 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! To support your answer, calculate the change in the 2 year rate from Sept 2018 to Feb 2019 and do the same for the 3 year rate.

YES, YOUR FRIEND IS CORRECT - MORE INTEREST RATE RISK THE FARTHER OUT THE YIELD CURVE YOU GO - YOUR GAIN WAS OVER $10 AND YOUR FRIEND ONLY MADE A CAPITAL GAIN OF A LITTLE OVER $5. IN FACT, YOU NEED TO BE COMPENSATED FOR TAKING ON THIS RISK (THREE YEAR VS. THE TWO YEAR) AND YOU ARE

f)(10 points) Finally, let's suppose that you have turned bearish on bonds and thus take a short position on the 3-Year GS by selling futures. Why might you turn bearish - what would have to happen to the expected path of short rates (for you to make money) and what would cause this change in the expected path of short rates. Name three things, one of them being what Jerome Powell might say or do. The other two are incoming economic data. Please be very clear as to how these events would change the expected path of rates in the happy direction given that now you are a bear!

THE EXPECTED PATH OF RATES WOULD HAVE TO GO UP FOR YOU TO MAKE MONEY

POWELL - SAY WE ARE RAISING RATES INSTEAD OF KEEPING THEM THE SAME

INCOMING DATA: HIGH INFLATION, LOW UNEMPLOYMENT RATES - ANYTHING SUGGESTING THAT THE ECONOMY IS OVERHEATING (VERY STRONG, BULLISH)

3)(70 points)

a) (30 points total..20 for graph and 10 for explanation) Use the two graphics below to answer the following question.

[pic]

[pic]

We discussed the risk structure of interest rates. In the space below, draw two graphs side by side with a supply and demand graph of the commercial paper market on the LEFT and the 3-Month Treasury market on the RIGHT. Label as point A consistent with the conditions in March of 2008 (upper graphic) and then label as point B with the conditions in December of 2008 (lower graphic). Explain the movement from the equilibrium at point A to the new equilibrium at point B. Explain exactly what is happening and why! What caused this change. What is this phenomenon referred to why?

Write your explanation here - room for graphs on next page

THERE WAS A RUSH TO THE SAFE HAVEN OF T-BILLS - (CAUSE) THIS WAS DURING THE FINANCIAL CRISIS - PEOPLE GOT SCARED.....THE DEMAND FOR T- BILLS RISES RAISING PRICE LOWERING YIELD AND IN GRAPHIC. THE OPPOSITE OCCURS IN THE PAPER MARKET - INVESTORS SHUN PAPER, DEMAND FALLS, PRICES FALL AND RATES ON PAPER RISES, CONSISTENT WITH GRAPHIC.

[pic]

20 points for correct and completely labeled graphs

b)(10 points) We see that the risk spread or risk premium has increased from March of 2018 to December of 2008. What signal does a small spread (as in March 2008) send to policymakers and compare to the signal that a large spread 'sends' to policymakers (as in Dec 2008). Use the word substitute in your answer

A SMALL SPREAD MEANS THAT PAPER AND BILLS ARE CLOSE SUBSTITUTES - A LARGE SPREAD MEANS THAT THEY ARE NOT CLOSE SUBSTITUTES AND THEREFORE SIGNALS THAT FINANCIAL MARKETS ARE UNSETTLED - INVESTORS ARE SEEKING SAFETY.

c)(30 points total) When we draw any bond market diagram, we draw the demand curve as downward sloping and the supply curve upward sloping just like any other demand and supply diagram. Focusing on only the demand and supply graph for the commercial paper market that you drew above. Answer the following questions:

i)(10 points) Explain exactly why the demand curve in the commercial paper market slopes downward - be sure you write your answer relating the price of commercial paper to the yield on commercial paper. What are we holding constant along this demand curve for commercial paper?

DEMAND SLOPES DOWNWARD SINCE AS PRICE FALLS, YIELDS RISE, INVESTORS ARE DRAWN TO PAPER - HIGHER RETURN, HIGHER QUANTITY DEMANDED, ALL ELSE CONSTANT

ii)(10 points) Explain exactly why the supply curve in the commercial paper market slopes upward - be sure you write your answer relating the price of commercial paper to the yield on commercial paper. What are we holding constant along this supply curve for commercial paper?

SUPPLY IS UPWARD SLOPING BECAUSE WHEN PRICE RISES, YIELDS FALL, FIRMS ISSUE MORE PAPER SINCE THE COST OF BORROWING FALLS - MORE INVESTMENT PROJECTS PASS THE COST BENEFIT TEST

iii)(10 points) Name three things/economic events that would increase the demand for commercial paper - be sure to explain why demand would rise given each economic event.

THIS IS A TOUGH ONE - THINK ABOUT WHAT WOULD CAUSE INVESTORS TO PURCHASE MORE PAPER AT THE SAME PRICE, SAME INTEREST RATE

LOWER EXPECTED INFLATION - HIGHER EXPECTED REAL RETURN

LESS (PERCEIVED) DEFAULT RISK - STRONGER ECONOMY - GOOD FIRM NEWS QUANTITATIVE EASING - THE FED LOWERING INTEREST RATES OR GIVING FORWARD GUIDANCE THAT THEY WILL

4)(25 points) Use the information below to answer a) and b)

[pic]

a)(5 points) Calculate the Market Cap for Lithia Motors.

$88.59 X 22.35M = $1.979.99 BILLION

b) (5 points) Calculate the P/E Ratio for Lithia Motors.

88.59 / 10.89 = 8.13

Suppose the expected earnings stream for the next three years for ABC company is $100,000, $120,000, and $130,000 respectively (assume the firm falls off the face of the earth in three years as we did in class). Meanwhile, interest rates are expected to be 2 % for the next three years. Given 10,000 shares outstanding, please answer the following questions:

c) (5 points) What is the current 'spot' price of the firm? (round to two decimals).

MC = 98,039 + 115,340 + 122,502 = 335,881/10,000 = 33.59

Suppose now that Jerome Powell makes some dovish statements and thus expected interest rates for the next three years are now 1% (instead of 2% as above). All else remains the same.

d)(5 points) Calculate the new spot price for this firm.

MC = 99,010 + 117,636 + 126,177 = 342,823/10,000 = 34.28

e)(5 points) What happened to the P/E ratio from parts c) to d)?

went up from 3.36 to 3.43

335,881/100,000 vs 342,822/100,000

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 showed 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).

f)(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 with regard to the equation above?

R2 > 0, SIGN OF β GREAT THAN ZERO (POSITIVE) ...T-STAT GREATER THAN 2 IN ABSOLUTE VALUE MEANING THAT β IS SIGNIFICANTLY DIFFERENT THAN ZERO

g)(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 with regard to the equation above?

R2 CLOSE TO ZERO, SIGN OF β NO MATTER - CLOSE TO ZERO AND INSIGNIFICANTLY DIFFERENT THAN ZERO ...T-STAT LESS THAN 2 IN ABSOLUTE VALUE

5)(50 points total )

a) (10 points) We discussed the pic below and various others that clearly shows that when the slope of the YC gets negative (inverted), problems lie ahead, perhaps a recession. Explain this theory that a negatively sloped YC spells trouble to the economy moving forward.

When the yield curve gets inverted (negative slope), the expected path of rates are falling, implying that the Fed will be fighting a recession (lowering rates)

b) (10 points) Now provide arguments that things are different now - that we shouldn't worry that the YC is flat. What exactly is so different now, relative to the past, that suggests that the slope of the YC is no longer a reliable forward economic indicator. Please be as specific as possible discussing events related to the short end of the yield curve along with events related to the longt end of the yield curve.

(Long end) The term premium is still negative (or zero) meaning that the slope of the yield curve is flatter than it was before the rounds of QE. Therefore, a slight decrease in the expected path of rates will now invert the yield curve.

On the short end, the Treasury has been issuing a good deal of short term bills - the increase in supply lowers the price and raising the yield on the bills, flattening the yield curve

c)(10 points) Write a short essay explaining the soft landing in 1994-95. In your essay use the following words/terms/phrases and circle them - 2 points each

The Fisher Effect, Inflationary Expectations, I am not a dove, 75 basis points, lower interest rates by raising them

During the soft landing, inflationary expectations were rising and according to the Fisher effect, long term interest rates were rising faster than Greenspan wanted them to - Greenspan basically said to the investors I am not a dove and raised the funds rate by 75 basis points. Eventually the long rates came down so Greenspan lowered interest rates (long rates) by raising them (the funds rate)

d)(20 points) Write an essay explaining the conundrum period in 2005. In your essay make sure you explain exactly what the conundrum is and then, using the liquidity premium theory of the term structure (write out the equation), offer two alternative explanations of the conundrum. Finally, using the graph at the end, provide an argument as to which explanation of the conundrum is most likely the correct one!

The conundrum was the fact that the Fed was raising rates and the long rate (10 year GS) was not moving (and actually fell) - typically, when the Fed is in a tightening cycle, long rates rise. Two possibilities:

[pic]

SHORT RATES ARE RISING BUT INVESTORS BELIEVE THAT THE ECONOMY IS NOT VERY STRONG AND THAT THE FED WILL HAVE TO LOWER RATES IN THE FUTURE TO PREVENT A RECESSION - INVESTORS ARE LESS BULLISH ON THE ECONOMY THAN THE FED IS

[pic]

THE FALL IN THE TERM PREMIUM IS SO LARGE THAT THE NET EFFECT ON THE LONG RATE IS NEGATIVE, EVEN THOUGH SHORT RATES ARE RISING - THIS COULD BE CAUSED BY GREENSPAN'S SUCCESS IN HITTING THE INFLATION TARGET (INFLATIONARY EXPECTATIONS ARE WELL ANCHORED) ALONG WITH THE LARGE DEMAND FOR TREASURIES FROM ABROAD, LOWERING THE LIKELIHOOD OF HIGH INTEREST RATES, LOW PRICES...THE DREADED CAPITAL LOSS.

FALL IN TERM PREMIUM IS THE CORRECT ANSWER ACCORDING TO THE GRAPH!

[pic]

[pic]

6. Merck Problem. (55 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) (10 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.

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