Use the three tables below to answer the following questions



Exam #2

Econ 351

Fall 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 1994 – 1995. 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]

a) (10 points) Let's pretend a friend of yours, a non-econ major, is looking at the GS data with you (the 2 graphs above) and notices that between August of 1994 and August of 1995 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 August 1994 (Graph #1) (our notation is i12e) and compare to the one year interest expected one year from August 1995 (Graph #2)

TWO YEAR

i2 = (i1 + i12e) / 2

August 1994......... 6.18 = (5.56 + i12e) / 2 ............... i12e = 6.8%

August 1995 ....... 5.98 = (5.65 + i12e) / 2 ............... i12e =6.31%

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 the fall of 1994 and again in the spring of 1995 - 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 August of 1994 and August of 1995?

Alan Greenspan turned hawkish raising the ff target by 75 basis points in November of 1994 (and 50 basis points in the spring of 1995) and the expected path of rates fell as a result since the Fed would no longer have to fight inflation with higher short rates since Greenspan was so hawkish.

c) (10 points) Now calculate what has happened to the one year interest rate expected two years from now (our notation is i13e) between August 1994 and August 1995. Please show all work.

3 YEAR

i3 = (i1 + i12e + i13e ) / 3

August 1994 .............. 6.5 = (5.56 + 6.8 + i13e) / 3 ............. i13e = 7.14%

Dec 2018 ........... 6.10 = (5.65 + 6.31 + i13e) / 3................. i13e = 6.34%

d) (10 points) We now are going to evaluate what exactly has happened to the expected path of 1-Year rates between August 1994 and August 1995.

i) Let's start with August 1994 - we are focusing on the current and 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 actual and expected 1-Year rates) between August 1994 and August 1995? List the 3 one year rates and comment on the expectations of Fed policy for the next two years. Why were they expecting this? (list the current one year rate (August 1994 and the i12e and i13e).

5.56% 6.8% 7.14% Raise rates to prevent inflation (overheating) – the Fed was behind the curve (dovish)

ii) Let's move on the August 1995 - we are focusing on the current and 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 actual and expected 1-Year rates) between August 1995 and August 1996? List the 3 one year rates and comment on the expectations of Fed policy for the next two years. Why were they expecting this? (list the current one year rate (August 1995 and the i12e and i13e). Compare to your answer above (part i)

5.65 6.31 6.34 Raise rates slightly over the next two years – inflation and inflationary expectations are well contained given the Fed’s hawkish behavior – not worried so much about overheating.

2) (65 points total)

a)(15 points) Using the information from question 1, draw two yield curves: the first associated with August 1994 (Label as YC1), the second associated with August 1995 (Label as YC2).. 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 Alan Greenspan, would you be happy or sad as to what happened to the slope of the yield curve? What explains what happened to the slope of the yield curve?

I WOULD BE HAPPY, THE FLATTER YIELD CURVE INDICATES THAT INFLATIONARY EXPECTATIONS HAVE FALLEN – THE FED WON’T HAVE TO RAISE RATES AS MUCH TO FIGHT INFLATION ANYMORE SINCE THE HAWKISH BEHAVIOR LOWERED INFLATIONARY EXPECTATIONS AND ALONG WITH IT, LOWERED THE EXPECTED PATH OF INTEREST RATES, JUST AS GREENSPAN HAD HOPED!

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 5% in August 1994. The face value of the bond is $1,000 as is normal. Suppose that you held the bond until August 1995 and closed your position. Your bond is now a two year bond.. Calculate your profit / loss AND rate of return. (you received one coupon payment during the one year holding period) Please show all work.

|50 |1.065 |46.94836 | |50 |1.0598 |47.17871 |

|50 |1.134225 |44.08296 | |50 |1.123176 |44.51662 |

|50 |1.20795 |41.39245 | |1000 |1.123176 |890.3324 |

|1000 |1.20795 |827.8491 | | | | |

| | | | | | | |

| | |960.2729 | | | |982.0277 |

| | | | | | | |

| |Return = 7.47% | | |1032.03 | |

d)(10 points) Your friend was also bullish on bonds and bought one 2 year GS with a coupon rate of 5% in August 1994. The face value of the bond is $1,000 as is normal. Suppose that you held the bond until August 1995 and closed your position. Your bond is now a one year bond.. Calculate your profit / loss AND rate of return. (you received one coupon payment during the one year holding period) Please show all work.

|50 |1.0618 |47.08985 | |50 |1.0565 |47.32608 |

|50 |1.127419 |44.34907 | |1000 |1.0565 |946.5215 |

|1000 |1.127419 |886.9815 | | | | |

| | | | | | | |

| | |978.4204 | | | |993.8476 |

| | | | | | | |

|Return = 6.687% | | | |1043.848 | |

| | | | | | | |

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!

YES, YOUR FRIEND IS CORRECT - MORE INTEREST RATE RISK THE FARTHER OUT THE YIELD CURVE YOU GO - YOUR GAIN WAS OVER $71.75 (7.47% RETURN) AND YOUR FRIEND ONLY MADE A CAPITAL GAIN OF A LITTLE OVER $65.43 (6.687%). IN FACT, YOU NEED TO BE COMPENSATED FOR TAKING ON THIS HIGHER RISK (THREE YEAR VS. THE TWO YEAR) AND YOU ARE

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 October of 1998 (upper graphic) and then label as point B with the conditions in January of1999 (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.

Write your explanation here - room for graphs on next page

FINANCIAL MARKETS CALMED DOWN FROM A TO B – THE DEMAND FOR PAPER ROSE (PEOPLE WEREN’T SO SCARED ANYMORE) AND THE DEMAND FOR THE SAFE SUBSTITUTE (TBILLS) FELL RESULTING IN THE SPREAD DECLINING (i on paper fell, i on Tbills ROSE)

[pic]

20 points for correct and completely labeled graphs

b)(10 points) We see that the risk spread or risk premium has decreased October 1998 to January 1999. What signal does a large spread (as in October 1998) send to policymakers and compare to the signal that a smaller spread 'sends' to policymakers (as in January 1999). Use the word substitute in your answer

A LARGE SPREAD MEANS THAT PAPER AND BILLS ARE NOT CLOSE SUBSTITUTES A SMALL SPREAD MEANS THAT THEY ARE CLOSE SUBSTITUTES – THE SMALLER SPREAD INDICATES THAT FINAINCIAL MARKETS ARE HEALTHY AND THE ECONOMY IS SOLID

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

[pic]

a)(5 points) Calculate the Market Cap for FutureFuel Corp.

MC = 12.62 X 43.74 = 551.998 MILLION

b) (5 points) Calculate the P/E Ratio for FutureFuel Corp.

12.62 / .47 = 26.851

Suppose the expected earnings stream for the next three years for ABC company is $130,000, $150,000, and $180,000 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 1.5 % 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).

| |130000 |1.015 |128078.8 |

| |150000 |1.030225 |145599.3 |

| |180000 |1.045678 |172137.1 |

| | | |445815.1 |

| | | | |

| | | |44.58151 |

Suppose now that Jerome Powell makes some hawkish statements and thus expected interest rates for the next three years are now 2.5% (instead of 1.5% as above). All else remains the same.

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

|130000 |1.025 |126829.3 |

|150000 |1.050625 |142772.2 |

|180000 |1.076891 |167147.9 |

| | |436749.3 |

| | | |

| | |43.67493 |

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

went down from 445,815.1 / 130,000 = 3.429 to 436,749.3 / 130,000 = 3.359

f)(10 points) Consider the following information on the yield curve during this conundrum period along with a graphic from Ben Bernanke’s speech. We can see that the yield on the 10 year GS actually fell from 6/30/04 to 12/30/06. Draw two yield curves, one for the conditions for 6/30/04 and another for the conditions for 12/30/06. We know now that the source of the conundrum was the falling term premium.

|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% |

[pic]

Draw your yield curve graph here.

[pic]

g)(10 points) We are now going to add a third yield curve to your diagram, one that holds the term premium constant at its level at 6/30/04 = 1.33 (see graphic) We can see that the term premium fell to .17 on Dec. 30, 2006. Calculate what the yield on the 10 yr GS would have been if it wasn’t for the fall in the term premium. Then add this hypothetical yield curve to your diagram. Is the conundrum gone? Explain.

4.38 + (1.33 - .17) = 5.54% WOULD HAVE BEEN THE YIELD ON THE 10 YR IF IT WASN’T FOR THE DECREASE IN THE TERM PREMIUM

YES, THE CONUNDRUM IS GONE – THE 10 YR RATE WENT UP AS EXPECTED AS THE FED WAS TIGHTENING!

5)(50 points total )

a) (10 points) We discussed the taper tantrum from 2013 (see the pic below).

What caused the taper tantrum exactly? What happened at the June 19, 2013 FOME meeting and press conference exactly?

THE TAPER TANTRUM OCCURRED IN JUNE OF 2013 - BERNANKE STATED THAT THE FED MAY BEGIN TAPERING THEIR PURCHASES OF TREASURIES AND MBS'S. THE 10 YEAR RATE WENT STRAIGHT UP AS A RESPONSE OF BERNANKE'S WORDS

b)(10 points) Now consider the pic below. Was the taper tantrum caused by higher expected short rates or a higher term premium? Explain and why would the term premium rise given what happened on June 19, 2013?

HIGHER TERM PREMIUM (see pic!) – INTEREST RATE RISK WENT UP FOR THE 10 YR SINCE THE FED WAS GOING TO TAPER THEIR PURCHASES OF TREASURIES – INVESTORS WERE CONCERNED ABOUT AN UPWARD SPIKE IN LONG RATES. THE FED SOESN’T HAVE OUR BACK ANYMORE!

[pic]

c)(10 points) We now go back to the soft landing period in 1994. Given the graphic below and the behavior of the Fed, why would we expect the term premium to rise before the November 1994 FOMC meeting? In your answer, be sure to expalin why we have a term premium in the first place?

INVESTORS WERE THINKING THAT THE FED (AG) WAS DOVISH, THEY WEREN’T TOO SERIOUS ABOUT THEIR PRICE STABILITY OBJECTIVE – THEY WERE WORRIED ABOUT HIGHER LONG RATES DUE TO HIGHER INFLATION – THE TERM PREMIUM EXISTS TO COMPENSATE INVESTORS ON THE LONG END OF THE YIELD CURVE SINCE LONG RATES ARE MORE VOLATILE THAN SHORT RATES (THEY REACT MORE TO NEWS!)

d)(10 points) Now explain why the term premium fell given the behavior of Alan Greenspan and the Fed during November of 1994 and the spring of 1995? What were investors thinking of at this time?

THE FED BUMPED RATES UP BY 75 BP IN NOV AND THEN 50 MORE BP IN SPRING SHOWING THEIR RESOLVE IN CONTAINING INFLATION – THEY WERE HAWKISH! NO MORE WORRIES ABOUT HIGHER INFLATION AND HIGHER INFLATIONARY EXPECTATIONS DRIVE UP RATES CAUSING CAPITAL LOSSES – THE FED WAS BEING HAWKISH!

[pic]

e)(20 points) We see that the latest term premium is at negative 1.0054 (9/30/2019), the lowest it has ever been. Why is it so low and what does this mean with regard to the slope of the yield curve becoming a poor and unreliable forward economic indicator? (this is a 20 pointer!!)

SO LOW…..VERY WELL BEHAVED INFLATION AND INFLATIONARY EXPECTATIONS OVER THE LAST DECADE HAS RESULTED IN A LOWER TERM PREMIUM – NOT AFRAID OF THE FISHER EFFECT – HIGHER INFLATION (EXPECTIONS) CAUSING UPWARD SPIKES IN LONG RATES

VERY STRONG DEMAND FROM FOREIGN CENTRAL BANKS/COUNTRIES KEEPING PRICES UP AND YIELDS DOWN – NO END IN SIGHT – GLOBAL GLUT OF SAVINGS!

WITH A NEGATIVE TERM PREMIUM EQUAL -1% (NEGATIVE 1%) IT WOULD BE MORE LIKELY TO HAVE AN INVERTED YIELD CURVE … IN FACT, IF SHORT RATES ARE EXPECTED TO BE CONSTANT, THE YIELD CURVE WOULD BE INVERTED BY 1%!.EVEN IF RATES WERE EXPECTED TO RISE SLIGHTLY THE YIELD CURVE WOULD BE INVERTED – BAD SIGNAL – DON’T FREAK OUT IF ITS INVERTED GIVEN THE NEGATIVE TERM PREMIUM.

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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