Exam #1



Exam #2

Econ 351

Spring 2015

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 = 240

Test time = 120 minutes

One minute for every two points - if you keep this pace you will have 10 minutes left over

To help with time management if spreading time evenly

Question #1 = 40 points..... 20 minutes

Question #2 = 45 points ......22 minutes

Question #3 = 30 points.... 15 minutes

Question #4 = 40 points ....20 minutes

Question #5 = 35 points..... 17 minutes

Question #6 = 25 points.... 12 minutes

Question #7 = 25 points.... 12 minutes

[pic]

1. a) (40 points total) In the space below, draw a reserve market diagram depicting points A, B, and C. Assume that the Fed held reserve supply constant and that the volatility in the effective (actual) federal funds originated entirely from the volatility in reserve demand. Note, this period is well before the Fed obtained the authority to pay interest on reserves. The period we are considering is where the target for the federal funds rate is 7%. During this time, the discount rate was set below the target as was not used by banks since there was such a stigma associated with borrowing from the Fed - so the discount rate is irrelevant for this part of problem.

[pic]

(10 points for correct and completely labeled diagram)

b) (10 points) In hindsight the Fed could have done a better job in terms of hitting their federal funds target = 7%. Explain in words what they should have done to avoid point A and what they should have done differently to avoid point C. Be sure to be clear on two things in your explanation: 1) when we say 'what THEY should have done differently,' who exactly is 'THEY?' and 2) what is the operational aspect of avoiding points A and C - ie., what do 'THEY' have to do and how do they do it and who do they do it with? Please refer to each of the two cases (i.e., avoiding both points A and C). Recall, this is before the Fed had the authority to pay interest on reserves.

To avoid point A, THEY should have conducted open market purchases to increase reserve supply - THEY as in the FF trading desk at the NY FED. THEY - the NY FED, conducts these open market purchases with their primary dealers (member banks). To avoid point C, THEY should have conducted open market sales to decrease reserve supply - THEY as in the FF trading desk at the NY FED. THEY - the NY FED, conducts these open market sales with their primary dealers (member banks).

c) (20 points total: 10 points for diagram and 10 points for explanation) Now let's pretend that we were in a new regime (as they are now) where the Fed sets the interest rate they pay on reserves at 25 basis points below the federal funds target and the discount rate set 25 basis points above the federal funds target = 7% In the space below, redraw the reserve market diagram accounting for this new regime. Make sure you label the new points A, B, and C under this new and current regime. Explain why the old points A and C do not exist anymore - the word arbitrage should be in your answer numerous times - be sure you convey to us you know exactly what is going on here. Note, the shocks to reserve demand occur just as before and the Fed does not respond (i.e., they do not conduct any open market operations). Note also that we are assuming zero transactions costs, that is, there is no cost of arbitrage.

[pic]

(10 points for correct and completely labeled diagram)

Write your essay for part 1.c) in the space below.

Point A would not exist since if the FF is 8.8% and the DR is 7.25%, then banks will borrow 'boat loads' of funds from the discount window and lend them to NY via the FF market - when many banks do so, supply increases in NY driving the FF down since all banks are selling funds (not buying them - why would you buy at 8.8% when you can buy (borrow) funds at the DR = 7.25%. This spread will be arbitraged away until the FF falls to = the DR = 7.25%

Point C would not exist since if FF is 5.5%, Banks would buy (borrow) 'boat loads' of funds from NY and hold them with the Fed and receive 6.75%. This 'infinite' demand for borrowing will drive the FF up

to 6.75% so that there would be zero profit from conducting this arbitrage. (we would settle at the new point C where FF = 6.75%).

2. (45 points) As we know, the Fed recently finished up a two day FOMC meeting on Wednesday March 18. The Table below provides data on selected interest rates. What we want to do in this problem is to explain why the rates changed as a result of the meeting. In particluar, we are comparing interest rates on Tuesday, 3/17 (the day before the FOMC statement and press conference) to Wednesday, 3/18 which is after the announcement and press conference. Please answer the questions below.

[pic]

a) (5 points) In general, what happened to all the interest rates above and why between Tuesday, 3/17 and Wednesday, 3/18? Be sure to use an equation in your answer.

i3 = (i1 + i12e + i13e ) / 3 etc... any equation like this works. All rates fell since the expectations going into the meeting were that the Fed was getting rid of "patient" in their statement which meant that the Fed could start raising rates in June. They did get rid of the word patient but the statement and Yellen were very dovish as in, no worries, we will not be raising rates as soon as you think we will - not in June. This immediately lowered the expected path of interest rates and since all these rates are determined by the expected path of interest rates, all rates fell, consistent with the table above!

b) (10 points) Now calculate what has happened to the one year interest rate expected one year from now between Tuesday, 3/17 and Wednesday, 3/18. Please show all work. Are your results consistent with your answer from part a)?

TWO YEAR

i2 = (i1 + i12e) / 2

Tuesday before......... .70 = (.27 + i12e) / 2 ............... i12e = 1.13%

Wednesday after...........57 = (.23 + i12e) / 2 ............... i12e = .91%

YES! The expected one year rate expected one year from now has fallen from 1.13% to .91%

c) (10 points) Now calculate what has happened to the one year interest rate expected two years from now between Tuesday, 3/17 and Wednesday, 3/18. Please show all work. Are your results consistent with your answer from part a)?

3 YEAR

i3 = (i1 + i12e + i13e ) / 3

Tuesday before .............. 1.07 = (.27 + 1.13 + i13e) / 3 ............. i13e = 1.81%

Wednesday after ........... .92 = (.23 + .91 + i13e) / 3................. i13e = 1.62%

YES! The expected one year rate expected two years from now has fallen from 1.81% to 1.62%

d) (10 points) The two graphics below show the reaction of the federal funds futures contract for Dec. of 2015 from two events - one event is the reaction of this federal funds futures contract as a result of the FOMC meeting as above and the other is the reaction of this federal funds futures contract from the employment report Friday, March 6, 2015. Identify which graph applies to the FOMC meeting (graphic A or B) and which graph applies to the employment report (graphic A or B). Make sure you explain exactly why this federal funds futures contract reacted the way it did and whether, with perfect hindsight, you should have been a bear or a bull on this futures contract for each event. Please identify on each graphic when the news came out , what the news was exactly, and whether the reaction of the fed futures contract is consistent with the efficient market theory.

Graphic A

[pic]Graphic B

[pic]

Write your answer to part d) here:

Employment report was better than expected suggesting the Fed is going to raise rates sooner rather than later - the fed funds futures price fell like a 'rock' reflecting this new information immediately (falling prices same as higher yields). FOMC statement and press conference lowered the future path of rates since the statement and Yellen both indicated that they are not in any hurry to raise rates - expected rates fell which is same as futures prices rising - note, this was pretty much immediate. Both consistent with EMT!

e) (10 points) Now explain what happened in the stock market after most recent FOMC meeting and why. Please use the stock price determination expression we used in class to support your explanation. Finish your essay commenting on the following: A Fed watcher, commenting on the results of the FOMC meeting was quoted as saying: "on one hand, there was no news, on the other hand, there was plenty of news." What was this Fed watcher talking about? Please refer to each of the Fed watcher's hands.

PV/#shares = SP = [exp earn 1 / 1 + i] + [exp earn 2 / (1 + i e ) 2] + [exp earn 3 / (1 + i e ) 3]...........

Since the expected path of interest rates fell after Fed meeting, the PV of future earnings (see above) rose immediately resulting in a HUGE stock market rally. The no news was that the Fed removed the word patient from the statement but the news was that they are in no hurry to raise rates (the possible June hike is 'no longer in the cards.')

3) (30 points, 10 points for each explanation) Explain the three reasons why the Fed wanted to pay interest on reserves. Please be as specific as possible and feel free to refer to question #1 on this exam for one of the reasons (you already did this work!). For reason #3, use the balance sheet below and identify, by CLEARLY marking on the graph below when the Fed got the authority to pay interest on reserves. Also locate on the graph the period of sterlization and be sure to explain what exactly sterilized intervention means.

[pic]

write your answer to question #3 here:

1) WHEN THE FED PAYS ZERO INTEREST ON RESERVES THIS ACTS AS A TAX TO BANKS SINCE THEY COULD HAVE EARNED INTEREST (TYPICALLY THE FED FUNDS RATE) IF THEY LENT IT OUT BUT THEY ARE NOT ALLOWED - THIS ARGUABLY GAVE INTERNATIONAL BANKS, THOSE THAT ARE NOT SUBJECTED TO THE RESERVE REQUIREMENT RATIO, A COMPETITIVE ADVANTAGE. PAYING INTEREST ON RESERVES LOWERS THIS TAX AND MAKE US BANKS MORE COMPETITIVE. ALSO, BANKS USED TO AVOID THIS TAX BY SWEEPING OUT THEIR DEPOSITS INTO REPURCHASE AGREEMENTS - VERY INEFFICIENT USE OF SCARCE RESOURCES.

2) THE RATE PAID ON RESERVES SERVES AS AN LOWER BOUND FOR THE FEDERAL FUNDS RATE, GIVING THE FED MORE CONTROL, AT LEAST ON THE DOWNSIDE, OF THE FEDERAL FUNDS RATE - WE SHOWED AND EXPLAINED EXACTLY HOW THIS WORKS IN THE FIRST QUESTION (CHECK ANSWER IN FIRST QUESTION ??)

3) THE ECONOMY NEEDED A LOT OF LIQUIDITY AND THE FED WAS RUNNING OUT OF BALANCE SHEET CAPACITY - THEY USED UP 380 BILLION OF GS STERILIZING PREVIOUS INTERVENTIONS AND IT BECAME CLEAR THAT THEY WOULD RUN OUT OF BALANCE CAPACITY (NOT ENOUGH GS TO STERILIZE) THE AUTHORITY TO PAY INTEREST ON RESERVES GAVE THE FED UNLIMITED BALANCE SHEET CAPACITY AND THEY USED THAT UNLIMITED BALANCE SHEET CAPACITY IMMEDIATELY AND PUMPED TRILLIONS OF $ OF LIQUIDITY IN THE SYSTEM. THEY COULD DO THIS ONCE THEY GOT THE AUTHORITY SINCE THEY KNEW THE BANKS WOULD HOLD THE ER AND IT WOULD NOT ENTER INTO THE MULTIPLE DEPOSIT EXPANSION PROCESS.

4) (40 points) The table below contain some money supply data - we are going to compare and contrast the information in the last row of each table (2008-01-01 and 2014-08-01). The target for the federal funds rate at the end of January of 2008 was 3% (this is the rate we use) and was a range or 0 - .25% in August of 2014. All numbers are in billions of dollars except for the ratios and money multiplier (MM).

[pic]

[pic]

a) Let's return to January 2008 (2008-01-01), the beginning of the year that will go down in history as one of the worst years ever for the global economy. Recall that this was before the Fed obtained the authority to pay interest on reserves that happened in October of 2008. In the space below, draw a reserve market diagram depicting these conditions and label as point A (assume that the Fed does perfect in terms of predicting reserve demand so that the actual funds rate is equal to its target rate = 3%). The discount rate was 3.5% at the end of January 2008.

[pic]

(10 points for correct and completely labeled diagram)

b) Let us update to August of 2014. As you know, since the Fed has hit the 'zero bound' in December of 2008, where the official target for the federal funds rate is now and has been a range: 0% - .25% or in words, zero to 25 basis points. In the space below, redraw the diagram as above with point A (from January 2008) and add a point B, that corresponds to the conditions in August of 2014. Assume importantly and for simplicity, that the position of reserve demand remains constant from January 2008 to August 2014. Assume also that the actual funds rate is at its upper bound of the target range. The discount rate was set at .75% (75 basis points) in August of 2014.

[pic]

(10 points for correct and completely labeled diagram)

c. (10 points) If the Fed wants to raise the federal funds rate to 3.00% like it was at the end of January, 2008, what type and how many open market operations would they need to conduct? What are the implications on the economy if the Fed pursued such a strategy?

$ 2.797 TRILLION OF OPEN MARKET SALES TO GET RESERVE SUPPLY BACK TO $45 BILLION. IF THEY DID THAT, BOND PRICES WOULD PLUMMET = YIELD ON BONDS WOULD SKYROCKET AND WITH IT, THE ECONOMY WOULD GET SLAMMED - NOT WHAT WE NEED IN THIS SLUGGISH RECOVERY.

d) (10 points) Given that the Fed preferred not to conduct the open market operations as above in part c), what else could they do to raise the federal funds rate to 3%. Be very specific and explain exactly how this 'alternative' policy would work in terms of influencing the federal funds rate and why. The word arbitrage needs to be in your answer.

THEY WOULD RAISE THE IOR THEREBY INCENTIVIZING BANKS TO BORROW OFF OF THE FED AND MAKE PROFITS BY EARNING THE HIGHER IOR. THE DEMAND FOR FF WOULD RISE AND WITH IT, THE FF RATE ITSELF - THIS AGAIN WOULD BE A CASE OF ARBITRAGE. THE BANKS WOULD ARBITRAGE THIS SPREAD AWAY UNTIL THERE WAS ZERO PROFITS BY CONDUCTING THIS ARBITRAGE. IF TRANSACTIONS COSTS WERE ZERO, THESE TWO RATES WOULD BE EQUAL.

5. (35 points) We discussed the important results from a research paper on forward guidance.

a) (10 points) Fill in the blank below.

[pic]

The authors of this paper argue that the FED could have done better in their forward guidance. Write an essay explaining how forward guidance is supposed to work in terms of influencing the economy and what the Fed should have done differently and why (according to the authors). Use the two graphics (below) to support your answer. That is, mark the period where the Fed achieved maximum 'bite' on their forward guidance as 'maximum bite' on both diagrams identifying the date and what the Fed did exactly to achieve this 'maximum bite.'

THE IDEA OF FORWARD GUIDANCE IS TO EXPLOIT THE PURE EXPECTATIONS THEORY (PET) OF THE TERM STRUCTURE THROUGH COMMUNICATION POLICY - TYPICALLY VIA THE FOMC STATEMENT. IF THE FED CAN KEEP EXPECTATIONS OF SHORT TERM INTEREST RATES LOW, THEN THIS WOULD ALSO LOWER LONGER RATES VIA PET. THE MAIN CONCLUSION IS THAT THE FED SHOULD HAVE PUT A DATE ON THEIR FORWARD GUIDANCE BECAUSE THAT IS WHEN THE FORWARD GUIDANCE HAD MAXIMUM BITE IN TERMS OF LOWERING AN STABILIZING THE EXPECTED PATH OF SHORT TERM INTEREST RATES. THEY SHOULD HAVE PUT A DATE ON IT EARLIER - AT OR NEAR THE TIME THE FED HIT THE ZERO BOUND.

[pic]

[pic]

b) (10 points) Now explain how we can use the diagrams to identify the period of maximum bite. That is, on the first graph, how exactly can we tell, by viewing the graph, the period of maximum bite. Be sure to comment on the similarities or differences in the movement of the various interest rates before the period of maximum bite as well as during the period of maximum bite.

ON THE FIRST GRAPH, WE SEE THAT RATES FELL QUITE DRAMATICALLY AT THE TIME OF MAXIMUM BITE - THEY ALSO BECAME MORE STABLE, CONSISTENT WITH LOWERING AND SOLIDIFYING EXPECTATIONS OF LOW FUTURE SHORT TERM INTEREST RATES. THE FACT THAT THE RATES BECOME MORE STABLE SUGGESTS THAT THESE RATES ARE REACTING LESS TO NEWS - THAT IS THE PERIOD OF MAXIMUM BITE!

c) (10 points) Similarly, using the second graphic, how can we identify the period of maximum bite in the Fed's forward guidance? Be sure to comment on what exactly the vertical axis represents in the second graph and how we should interpret it before the period of maximum bite as well as during the period of maximum bite. How does all of this relate to the pure expectations theory of the term structure (PET)?

THE VERTICAL AXIS REFERS THE SENSITIVITY COEFFICIENT OF THE INTEREST RATE TO NEWS. NORMAL REACTION TO NEWS IS DEFINED AS THE COEFFICIENT EQUALING ONE. IF THE SENSITIVITY PARAMETER IS ZERO, THEN THAT IMPLIES THAT THE INTEREST RATE IS COMPLETELY CONSTRAINED AS DEFINED BY ABSOLUTELY NO REACTION TO NEWS - THIS IS THE PERIOD OF MAXIMUM BITE - NO MATTER WHAT THE EMPLOYMENT REPORT IS, ETC, EXPECTATIONS OF FUTURE SHORT TERM REMAIN LOW AND CONSTANT.

d) (5 points) Let’s go back to question #2 (TYPO HERE) on this exam - How would the graphics A and B in question #2 of this exam be different , if at all, if we were still in a period of maximum bite in the Fed’s forward guidance? – explain.

THE REACTION OF THE FF FUTURES CONTRACT TO NEWS WOULD DISAPPEAR - ESP WITH REGARD TO EMPLOYMENT REPORT - THE OTHER NEWS, YELLEN SAYING CHILL, WE ARE NOT GOING TO RAISE RATES IS IN FACT FORWARD GUIDANCE - SO IF YOU HAD MAXIMUM BITE BEFOREHAND, THEN YOU CAN ARGUE THERE ALSO WOULD BE LITTLE MOVEMENT IN THE FUTURES CONTRACT.

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:

[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.

NEW GRADER) 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.

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download