Use the three tables below to answer the following questions



Exam #2

Econ 351

Fall 2018

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 POSSIBLE = 300 POINTS

40 + 60 + 40 + 50 + 50 + 50

1. (50 points) Let's go back in time, to the soft landing in 1994 - 95. The Greenspan Fed began started raising rates early in 1994. At the November 1994 FOMC meeting, Alan Greenspan and the FOMC decided to raise the target for the Federal Funds Rates by 75 basis points (.75%) Please answer the questions below.

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a) (10 points) Calculate what has happened to the one year interest rate expected one year from now (our notation is i12e) between Tuesday, 11/15/94 and Wednesday, 12/7/94. Please show all work. Is your answer consistent with the abrupt move (aka Hawkish move) by the Fed? Why or why not?

b) (10 points) Now calculate what has happened to the one year interest rate expected two years from now (our notation is i13e) between Tuesday, 11/15/94 and Wednesday, 12/7/94. Please show all work. Is your answer consistent with the abrupt move (aka Hawkish move) by the Fed? Why or why not?

c) (10 points) Now calculate what has happened to the one year interest rate expected three and four years from now (our notation is i14e and i15e ) between Tuesday, 11/15/94 and Wednesday, 12/7/94. Since we can only solve for the sum of i14e and i15e , for simplicity, let us assume they are both the same (take the average). Please show all work. Is your answer consistent with the abrupt move (aka Hawkish move) by the Fed? Why or why not?

d) (10 points) Using the expression below, show with arrows (up or down) what has happened (the change) to the expected path of one year interest rates along with the 5 year rate given the abrupt increase in the federal funds rate target.

i5 = (i1 + i12e + i13e + i14e + i15e ) / 5

2) (60 points total)

a)(10 points) Using the information from question 1, draw two yield curves: the first associated with Tuesday, November 15, 1994, the day of the FOMC meeting. The second associated with Wednesday, December 7, 1994. Please use all 4 interest rates (1yr, 2yr, 3yr, 5yr) for each yield curve.

b)(10 points) We know Alan Greenspan was watching these rates along with the yield curve and movements in it very closely at this time. Was Mr. Greenspan happy with the results above? Why or why not?

c) (10 points) Suppose that you were bearish on bonds during this 1994 soft landing event and you sold one 3 year GS with a coupon rate of 4% on 11/15/1994 when the yield is 7.41% as above. The face value of the bond is $1,000 as is normal. Suppose that you closed your position on 12/07/1994 when the yield is 7.62%.. Calculate the price of bond on 11/15/1994 and then on 12/07/1994. Calculate your profit / loss AND rate of return. (you did not receive any coupon payments during this short holding period) Please show all work.

d)(10 points) Your friend was also bearish on bonds but played the 2 year GS market instead. Same as above, your friend sold one 2 year GS on 11/15/1994 (yield = 7.10%) and closed on 12/07/1994 (yield = 7.48%). The coupon rate is the same as above = 4%, face value = $1,000 and you can ignore any coupon payments given the short holding period. Calculate the price of bond on 11/15/1994 and then on 12/07/1994. Calculate your profit / loss AND rate of return.

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 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!

f)(10 points) Comment on the probable behavior of the term premium during this episode, between 11/15/1994 and 12/07/1994. Although we can't directly observe it, comment on whether it rose or fell and why. In your answer be sure to define exactly what a term premium is and what determines its size and sign? Is your answer consistent with the conundrum that occurred 10 years later? Why or why not.

3)(40 points)

a) (20 points total..10 for graph and 10 for explanation) We discussed the so called safe haven argument in terms of bond demand and bond supply where investors rush to the safe haven of US Treasuries, primarily 10 year GS. Using the template below, start at point A (on both graphs) before the rush to the safe haven. Then show as point B on both graphs after the rush to the safe haven. Be sure to label graph with BRSH, point A, (before rush to safe haven) and ARSH, point B, (after rush to safe haven).

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Use the space below to explain what is happening in both markets and what happens to the corp - GS10 spread as defined by corpspread = icorp - iGS. and why? Be sure to connect the movements in the prices of each bond to the yield on each bond!

b) (20 points total..10 for graph and 10 for explanation) We discussed the how quantitative easing (QE) worked in terms of bond demand and bond supply where the Fed effectively prints money out of thin air and purchases massive amount of GS. For a while, during QE#3, the Fed was purchasing $45 billion of GS every month. Using the template below, start at point A (on both graphs) before the QE. Then show as point B on both graphs during the QE. Be sure to label graph with BQE (before QE) and DQE (during QE).

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Use the space below to explain what is happening in both markets and what happens to the yield and price on GS after the QE and why. Now comment on what happened to the yield and price on corps and why. Why is QE defined as an expansionary monetary policy exactly?

4)(50 points) Use the information below to answer a) and b)

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a)(5 points) Calculate the market cap for Progressive Corp on 10/22/18.

b) (5 points) Calculate the earnings per share (EPS) for Progressive Corp on 10/22/18.

c)(10 points) Please fill in the following blanks - 2 points for each correct answer

We discussed the magnetar trade. First the CDO manager purchases the _________ portion of the _______

and then structured it like ___________. At the same time, the CDO manager purchased a lot of

_____________________ that would payoff in case the _________ fails.

d)(10 points) In a current event article we discussed how Janet Yellen recently stated that the slope of the yield curve is no longer reliable (joining Alan Greenspan and Ben Bernanke) in terms of predicting the future state of the economy. Explain the theory and intuition underlying the ability of the slope of the yield curve to predict future economic activity. In your answer, make sure you refer to what a steep yield curve (positive slope) implies and why and what an inverted yield curve (negative slope) implies and why.

Now on to Janet Yellen's comment: from the WSJ, Oct. 15, 2018

Ms. Yellen said she wasn’t overly concerned about a so-called inversion of the yield curve, when short-term rates rise above long-term rates. Yield-curve inversions have typically predated recessions, but Ms. Yellen said unusual factors in the bond market that have lowered the premium investors demand for holding longer-term bonds have made the yield-curve signal less reliable than in the past.

“If I were sitting there and asking myself the question, ‘should the Fed absolutely stop before the yield curve inverts,’ I might be willing to say this time is different.”

e)(10 points) Explain the following statement : unusual factors in the bond market that have lowered the premium investors demand for holding longer-term bonds

What are the unusual factors in the bond market and what premium is Janet Yellen speaking of?

f)(10 points) Explain why your answer in e) above relates to have made the yield-curve signal less reliable than in the past. For example, the yield curve is almost flat right now - explain why exactly, according to Janet Yellen's arguments, we should not be worried about it. To support your answer, comment on what the slope of the yield curve would be now if it wasn't for the unusual factors in the bond market.

5)(40 points)

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).

a)(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?

b)(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?

c)(10 points) Explain why the slope of the yield curve used to serve as a good forward indicator and why it doesn't now and if there was anyone to blame, who would we blame and why???

d)(10 points) We discussed the Taper Tantrum episode in a bit of detail. What is the taper tantrum, when did it occur, and what happened to the slope of the yield curve as a result of the taper tantrum?

e)(10 points) In the space below, draw a bond demand - bond supply diagram starting at point A, before the taper tantrum (label a BTT). Then show what happened during taper tantrum (label as DTT) label as point B.

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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:

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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.

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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.

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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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