FINA 4000 Midterm 2
a) Why is default risk priced for corporate bonds? I am looking for a brief, clear explanation (two or three sentences). Long, rambling, or unfocused responses will be downgraded, even if they include relevant information.
1. Corporate default events imply reduced cash flow to investors in corporate bonds. In addition, corporate bonds are frequently debentures, so that there is no collateral to be seized in the event of default. 2. Default activity is correlated with the business cycle. The default rate among corporate bonds increases significantly during economic recessions. 3. The previous point implies that there is a systematic component to default risk - it is not possible to diversify away default risk by simply holding a large portfolio of corporate bonds. Consequently, default risk should be priced.
b) Name three specific policy strategies proposed by macroeconomists to deal with adverse effects associated with the ZLB:
1.) Aggressively lower short term rates when deflation or a severe downturn threatens. 2.) Central bank should pledge to keep short term rates "lower for longer." One way to accomplish this is via forward guidance, such as the Fed's announcements regarding the likely timing of rate liftoff during the 2009-2014 period. 3.) "Quantitative easing": central bank purchases assets of longer duration such as longer-maturity government bonds
If the real rate of interest is 4%, actual inflation for the last year was 5%, and expected inflation is 8%, the Fisher effect predicts what current level of nominal interest rates?
12%
2. The yield on a three-year Treasury note is 5.4% and the yield on a three-year TIPS is 3.0%. What is the market's estimate of the annual inflation rate over the next three years? a. 1.1% b. 1.6% c. 4.5% d. 2.4% e. 2.1%
2.4%
. The current US unemployment rate is closest to _________. a. 10% b. 7.5% c. 4% d. 2.5%
4%
9. The bank discount rate (ask) on a 71-day T-bill is 4.86%. What is the bond equivalent yield on the T-bill? a. 4.86% b. 4.92% c. 4.98% d. 5.14%
4.98
3. Consider a 180-day T-bill that is purchased at a 6% asked yield (discount yield). Assume that the bill has a face value of $10,000, and calculate its price. Calculate the bond equivalent yield.
6.271%
. What is the current target range for the federal funds rate as announced by the FOMC at the end of December 2017? a. 0.00% - 0.25% b. 1.25% - 1.50% c. 0.50% - 0.75% d. 0.75% - 1.00%
B
2. Explain why banks are singled out for special attention (i.e., are subject to relatively heavy regulation and oversight) in our financial system.
Banks are the dominant type of depository institutions. As such, they deal with consumers (depositors), and consumers' trust in the banking system is extremely important for the flow of funds and ultimately the well-being of the economy. Banks, like other depositories, are highly leveraged (liabilities are often around 90% of total assets, with capital being the other 10%), which makes them much more vulnerable to credit and liquidity risks than other businesses.
2. David Hoffman purchases a $1,000 20-year bond with an 8% coupon rate (annual payments). Yields on comparable bonds are 10%. David expects that, two years from now, yields on comparable bonds will have declined to 9%. Find his expected yield, assuming the bond is sold in two years.
Based on the YTM of 10% at the time of purchase, the purchasing price is $829.73: Calculator: 1000 FV 20 N 10 I 80 PMT PV = $829.73. In two years, based on 18 years remaining to maturity and the YTM of 9%, the bond price is expected to be $912.44: Finally, for the expected yield we have: Calculator: 912.44 FV 2 N PV = -$829.73. 80 PMT i = 14.29%
1. Consider yields on corporate bonds that differ only with respect to the particular feature mentioned below. For each case, state which bond would be expected to trade at a higher yield, and briefly explain your reasoning. Case 1: Senior debt versus subordinated debt Case 2: A debenture versus a mortgage bond Case 3: A convertible bond versus a non-convertible bond Case 4: A callable bond versus a non-callable bond
Subordinated debt should trade at a higher yield as it is subject to greater default risk and/or losses in the event of default. The debenture will trade at a higher yield because it lacks any explicit asset pledged as collateral in the bond indenture. The non-convertible bond will trade at a higher yield because the convertible bond offers investors a valuable option to convert to equity. The callable bond will trade at a higher yield b/c the bond issuer has the right to retire the bond early, and is likely to do so when interest rates fall (capping investors' returns)
4. Briefly explain the relationship between bond price volatility and term-to-maturity, and between bond price volatility and the coupon rate.
The longer the term to maturity (all else equal), the greater the price swings for a given change in interest rates. This is due to the fact that the sensitivity of the present value of a future cash flow to changes in the discount rate is larger the further in the future is the date when the cash flow is received. The smaller the coupon rate (all else equal), the greater the bond price volatility. The intuition behind this result is that a larger coupon rate shifts relatively more of the total value of the bond toward cash flows received earlier in time.
4. Mortgages are now originated, funded, serviced, and insured by different parties. What developments are associated with this unbundling of loan cash flows in recent years?
The securitization phenomenon has helped facilitate the unbundling of loan cash flows: large origination specialists such as Countrywide would be unlikely to thrive without the ability to sell off their mortgages into the secondary market. In addition, increased computing technology, competition, and desire for unbundling by financial institutions and investors have been the major factors behind the separation of origination, servicing, and funding of mortgages.
10 POINTS) Briefly explain what is meant by "too big to fail" with respect to the financial system. Discuss the associated problem of moral hazard and strategies to mitigate this problem.
The term "too big to fail" refers to large financial institutions deemed to pose a systemic risk to the financial system and broader economy. There are negative externalities associated with the failure of such institutions. Because financial intermediaries facilitate the flow of funds from savers to borrowers, the failure of a large institution can curtail the amount of credit available to firms and consumers. The resulting contraction in credit can lead to a reduction in aggregate demand and an economic recession. Additionally, large institutions are often counterparties to many financial contracts. When such an institution fails, other intermediaries become more likely to also fail. When an institution is "too big to fail," the government implicitly pledges to bail-out or support the institution if necessary. This creates a moral hazard in which the institution is incentivized to take on large risks. (The institution benefits if things go well, while government pays if they don't.) To mitigate this problem, "too big to fail" institutions are subject to various forms of monitoring (e.g., bank examinations, stress testing), restrictions on activities (e.g., proprietary trading limits), and capital requirements.
A Berkshire Hathaway corporate bond maturing in 2026 trades at a yield of 2.75%. A tax-exempt municipal bond issued by the school district of Warren, MI (a suburb of Detroit), also maturing in 2026, trades at a slightly higher yield. Briefly discuss two reasonable explanations for this yield pattern.
The two most compelling explanations are 1) that the Warren, MI muni bond carries higher default risk relative to the Berkshire Hathaway bond; and 2) that the Warren, MI muni bond is less liquid than the Berkshire Hathaway bond. Regarding default risk, Warren MI is a suburb of Detroit, which filed for bankruptcy in 2013. The class slides/text emphasize that municipal bonds are often relatively illiquid. [Note that the tax-exempt status of the muni bond is not an explanation for the yield pattern: this consideration alone would suggest that the muni should trade at a lower yield relative to the BH bond.]
Short Answer Questions (3 questions) 1. (15 POINTS) The following questions pertain to the Federal Reserve's implementation of monetary policy over the past decade. a) What is the zero lower bound ("ZLB")? How does it constrain conventional monetary policy? Discuss very briefly (1-2 sentences).
The zero lower bound refers to the fact that interbank lending rates cannot be negative. Consequently, when such lending rates approach zero, traditional expansionary monetary policy cannot further reduce short term interest rates and consequently is unlikely to impact real economic activity. NOTE: the ZLB does not refer to the practice of charging negative interest rates on excess reserves as the Bank of Japan recently announced.
b) Based on the above table, one of your associates argues that your fund should sell its holdings in 1-3 year government notes and buy 10-year notes, since the latter offer a much higher yield. What is your response to this suggestion?
There are two key points here: 1. The associate's suggestion makes little sense under the expectations theory. In fact, the entire point of the ET is that yields adjust such that investors are indifferent between investing long term or short term with plans to rollover at future short rates. 2. The 10-year bond is subject to greater price risk and is generally less liquid. Your personal recommendation didn't matter much to me so long as you made these points.
3. Currently a community bank has $45,000 in reserves, demand deposits of $200,000, and loans of $145,000. It unexpectedly receives an inflow of deposits of $50,000 into checking accounts and another $25,000 into time deposits. Current reserve requirements on demand deposits and time deposits are 10 percent and 3 percent, respectively. What is the motivation for having a lower reserve requirement for time deposits relative to demand deposits? What is the bank's reserve position? What is the maximum dollar amount of loans the bank could make?
Total reserves are $45,000 plus the newly arrived cash of $75,000, or $120,000. Required reserves = 0.1*(200,000 + 50,000) + 0.03*25,000 = $25,750 Excess reserves = $120,000 - $25,750 = $94,250. The bank may immediately loan out the $94,250 of excess reserves and still meet the reserve requirement. (This would increase the balance of outstanding loans to $145,000 + $94,250 = $239,250.) NOTE: There is a subtlety here. The initial DD are $200K and reserves and loans sum to only $190K. So where is the other $10K? It's not clear - perhaps it is held by the bank as investments ($10K in Treasury bills), or perhaps it is associated with a bad loan that has been written off. None of this affects the answer up to the final question regarding the maximum amount of loans that could be made. If it is assumed that the extra $10K is held as investments and we ignore capital gains/losses and assume perfectly liquid resale, then the bank could potentially liquidate the investments position and loan out the proceeds for a total of $249,250.
1. The following annual inflation rates have been forecast for the next 5 years: Year 1 3% Year 2 4% Year 3 5% Year 4 5% Year 5 4% Use these inflation rate forecasts and an assumed 3% real rate to calculate the appropriate contract rate for a 1-year and a 5-year loan. How would your contract rates change if the Year 1 inflation forecast increases to 5%? Discuss the difference in the impact on the contract rates from the change in inflation.
Use the Fisher equation to determine the "appropriate" contract rates. The Fisher equation says: 1+i=(1+r)(1+∆P_e ) For the 1-year contract rate, just plug in the real rate and inflation forecast for year 1: For the 5-year contract rate, we need to find the (annualized) inflation rate over the next 5 years: Now just use the Fisher equation: If expected inflation next year increases to 5%, all else equal, the one-year rate will increase to 8.15% (same method as above), while the five year expected inflation rate becomes: And the resulting rate is 7.73%. The impact on the one-year rate is higher, because over a five-year period the change in next year's expected inflation does not have as dramatic an impact
5. Briefly discuss the notion of substitutability among money market instruments. Address specifically the following three questions: a.) Why should we expect yields on money market instruments to move together and to typically differ only by small magnitudes? b.) Why are the yields on these instruments not identical? c.) Why do yield spreads among various money market instruments tend to widen during recessions and financial crises?
We should expect yields on money markets to move together and typically differ only by small magnitudes because of the high degree of substitutability among these securities. In particular, all money market instruments share the key characteristics of 1.) low default risk; 2.) short maturity; and 3.) high liquidity/marketability. Yields on money market instruments are not identical because differences among the securities do exist with respect to all three of the key characteristics. For example, US Treasury bill carries essentially no default risk, while there is some risk of default for other money market instruments such as commercial paper and CDs. Similarly, maturities among these instruments vary, as do liquidity conditions in secondary markets. For all of these reasons, the instruments typically trade at different yields with predictable relations (e.g., US Treasury bills typically trade at lower yields than comparable maturity commercial paper). During recessions and financial crises, differences in default risk and liquidity among the various money market instruments are magnified. This leads to wider spreads among these securities. For example, in the financial crisis of 2007-2009, financial commercial paper and CDs traded at a very wide spread (relative to historical norms) relative to US Treasury. This was driven both by the "flight to quality" effect of increases in demand for Treasuries, and also by relatively high perceived risk for commercial paper and CDs owing to financial institutions' exposure to the sub-prime mortgage crisis and its aftermath.
US Treasury bonds 2. (15 POINTS) Suppose that an on-the-run 6-month Treasury bill currently trades at $98.361 (per $100 of FV). In addition, an on-the-run 1-year Treasury note paying a 2.75% coupon semi-annually currently trades at $99.234. What is the most you can say about the current trading price of an on-the-run 52-week Treasury bill? Recall that the latter is a discount bond.
Write the PV of the 1-year Treasury note as , where DF(0.5) represents the discount factor for cash flows in six months (half-a-year) and DF(1) represents the discount factor for cash flows in one year. The market-based discount factor DF(0.5) is 0.98361. Now plug-in and solve for DF(1): So the 52-week T-bill should trade at $96.554. It might not trade at exactly this value, due to bid-ask spreads, etc., but it should trade very close to this value.
An increase in income tax rates
all of the above
Which among the following is a fiat currency? a.The US dollar b.The Euro c.The Yen d.All of the above
all of the above
2. Which segment of the commercial paper market grew most rapidly between 1990 and 2007? a. Asset-backed commercial paper b. Financial commercial paper c. Corporate commercial paper
asset-backed commercial paper
2. Consider a zero-coupon US Treasury bill. This bond will trade:
at a discount
1. Consider a US Treasury bond paying a coupon rate of 5% when the market yield is 5%. This bond will trade:
at par
1. Which of the following statements about bonds is NOT true? a. The greater the default risk, the greater the yield (all else equal). b. Bonds selling at premium are especially high quality. c. The less liquid a bond, the higher the yield (all else equal). d. Municipal bonds have lower yields than similar corporate bonds.
b. Bonds selling at premium are especially high quality.
3. You form an opinion regarding future stock prices for ABC Inc. and decide to take an option position on this stock. In this position, your potential losses are capped (bounded) irrespective of how high the stock price rises and you earn a profit if the stock price falls sufficiently. Which among the following is your option position? a. Bought a call option b. Bought a put option c. Written a put option d. Written a call option
b. Bought a put option
8. Which of the following statements is true?
b. Coupon rates are fixed at the time of issue.
3. Consider the position of a farmer in April of a certain year who will harvest grain in June. In order to hedge against fluctuations in the price of corn over the ensuing months, the farmer should : a. Go long futures contracts in corn b. Go short futures contracts in corn c. Go long S&P 500 index futures contracts
b. Go short futures contracts in corn
7. A reverse repurchase agreement calls for a. a firm to sell securities with the agreement to buy them back later at a higher price. b. a firm to buy securities with the agreement to sell them back later at a higher price. c. a firm to sell securities with the agreement to buy them back later at a lower price. d. a firm to buy securities with the agreement to sell them back later at a lower price.
b. a firm to buy securities with the agreement to sell them back later at a higher price.
5. If purchasing power parity held exactly in foreign exchange rates, a. foreign exchange rates would remain constant. b. goods and services would cost the same in terms of dollars everywhere in the world. c. goods and services would cost the same in each local currency. d. high relative inflation rates would cause a country's currency to appreciate.
b. goods and services would cost the same in terms of dollars everywhere in the world.
13. An investor in a first-level CMO tranche with claims on a pool of mortgages is likely to a. have a much higher risk position than lower level tranches. b. have more certain returns and less default-risk exposure. c. wait until all tranches are paid before receiving a return. d. have lower risk but a much more varied return than lower level tranches.
b. have more certain returns and less default-risk exposure.
9. An investor in a first-level CMO tranche with claims on a pool of mortgages is likely to a. have a much higher risk position than lower level tranches. b. have more certain returns and less default-risk exposure. c. wait until all tranches are paid before receiving a return. d. have lower risk but a much more varied return than lower level tranches.
b. have more certain returns and less default-risk exposure.
16. Suppose that Dow Chemical stock currently trades at $33.42 / share. Meanwhile, a put option on Dow at a strike price of $32, expiring in May, trades for $0.87. Is the put option a. in-the-money b. out-of-the-money c. at the money
b. out-of-the-money
9. Which of the following risks will not affect zero coupon bonds?
b. reinvestment risk
4. The bid-ask spread for equity securities tends to be _______ for more frequently traded stocks and _______ for stocks which have more traders with inside information. a. smaller; smaller b. smaller; larger c. larger; smaller d. larger; larger
b. smaller; larger
9. Amortizing a mortgage loan means that a. the equity in the house declines as the loan is paid down. b. the loan is repaid in equal, consecutive payments. c. interest is paid first entirely, and then the principal. d. a long-term loan is converted to a short-term loan.
b. the loan is repaid in equal, consecutive payments.
17. According to the interest rate parity condition, if the nominal interest rate in the domestic country is higher than the nominal interest rate in the foreign country, then the foreign currency is expected a. to depreciate relative to the domestic currency b. to appreciate relative to the domestic currency c. to stay unchanged
b. to appreciate relative to the domestic currency
1. Shares of common stock for ABC Inc. currently trade at $47.50/share. The premium for a put option on ABC shares with a strike price of $49.00 and 3 months to maturity is $3.75. The intrinsic value of the put option is _____, and the time value of the option is ______. a. $0.00; $2.25 b. $0.00; $3.75 c. $1.50; $2.25 d. $1.50; $3.75 e. $3.75; $1.50
c. $1.50; $2.25
8. If a $10,000 par T-Bill has a 2.75% discount quote and a 180 day maturity, what is the price of the T-Bill to the nearest dollar? a. $9,625 b. $9,706 c. $9,863 d. $9,927
c. $9,863
7. If a $1000 par value bond has an 8% coupon (annual payments) rate, a 4-year maturity, and similar bonds are yielding 11%, what is the price of the bond?
c. $906.93
15. If you are the manager of a thrift institution and you expect interest rates to increase over the next 5 years, what type of mortgage would you most like to hold? a. A balloon mortgage with a maturity of ten years. b. An interest only mortgage. c. An adjustable-rate mortgage with monthly adjustment. d. A fixed-rate mortgage with a maturity of 15 years.
c. An adjustable-rate mortgage with monthly adjustment.
6. You manage a stock portfolio worth $5,000,000 with a beta of 1. To hedge the portfolio, you trade S&P 500 futures contracts. Each contract is worth $250 per index point. How many contracts do you need to buy or sell if the S&P 500 index is currently at 2,500? a. Sell 10 contracts. b. Buy 10 contracts. c. Sell 8 contracts. d. Buy 8 contracts. e. Buy 20 contracts.
c. Sell 8 contracts.
4. Privately placed securities a. have to be registered with SEC. b. never trade in the secondary market. c. can only be sold to large, sophisticated investors (e.g., financial institutions). d. cannot be originally sold to less than 35 investors. e. both c and d.
c. can only be sold to large, sophisticated investors (e.g., financial institutions).
6. If market interest rates fall after a bond is issued, the
c. market value of the bond is increasing.
14. Mortgages with government or private mortgage insurance __________. a. typically sell at lower prices than comparable conventional mortgages b. are less likely to default that conventional mortgages c. offer the investor less default risk than conventional mortgages d. are written under the credit standards of the originator, and not the standards of the government agency or insurance company
c. offer the investor less default risk than conventional mortgages
10. If three-year securities are yielding 6% and two-year securities are yielding 5.5%, future short-term rates are expected to _____, and outstanding security prices are expected to _____.
c. rise; fall.
4. Suppose a corporation wants to hedge against an increase in the cost of debt associated with financing a future investment project. The most appropriate action would be to a. sell T-bill futures for when the funds were needed. b. buy T-bill futures for when the funds were needed. c. sell T-bond futures for when the funds were needed d. buy T-bond futures for when the funds were needed.
c. sell T-bond futures for when the funds were needed
12. A savings and loan writing ARMs and expecting mortgage interest rates to decrease in the future would want a. an interest rate "cap" on their loans. b. second mortgage on the home. c. to lengthen the "adjusting" time period. d. no limits on the variability of the rates.
c. to lengthen the "adjusting" time period.
8. A savings and loan writing ARMs and expecting mortgage interest rates to decrease in the future would want a. an interest rate "cap" on their loans. b. second mortgage on the home. c. to lengthen the "adjusting" time period. d. no limits on the variability of the rates.
c. to lengthen the "adjusting" time period.
2. An American firm sells farm equipment to a British company for ₤250,000 to be paid in 180 days. The spot exchange rate is $1.96/₤. The exporter hedges by buying a put option on ₤250,000 with a strike of $1.92/₤. The put, expiring in 180 days, costs the firm $5,000. What is the dollar amount the American firm will net on its transaction if the exchange rate is $1.90/₤ in 180 days? a. $490,000 b. $485,000 c. $480,000 d. $475,000 e. $470,000
d. $475,000
19. A firm enters into a contract to invest $100m in one year for one year. Assume that the current 12-month STRIP rate is 0.16% and the current 24-month STRIP rate is 0.25%. What should be the forward rate in this contract? a. 0.28% b. 0.30% c. 0.32% d. 0.34%
d. 0.34%
5. Which statement about Treasury bills is NOT true? a. They have maturities less than one year. b. Most are sold by "book-entry" method. c. They are sold at a discount. d. Interest on T-bills is tax-deductible for federal income tax purposes.
d. Interest on T-bills is tax-deductible for federal income tax purposes.
A feature of forward contracts not shared by futures contracts is: a. Delivery occurs in the future b. The price is specified in the contract c. Contracts are marked-to-market each day d. Terms can be customized
d. Terms can be customized
6. Which of the following is not a reasonable expectation for investors in pass-through mortgage securities? a. The securities are readily marketable. b. They have little default risk. c. The investor receives cash flows in proportion to his/her ownership proportion. d. The timing of the cash flow return from the securities is quite predictable.
d. The timing of the cash flow return from the securities is quite predictable.
18. Gains and losses are unlimited with a. forward contracts b. futures contracts c. option contracts d. a. and b. e. a and c.
d. a. and b.
4. If the coupon rate on a bond increases, all else equal, the price volatility of the bond:
decreases
. Relative to the British pound, the US dollar has ____________ over the past 12 months. a. appreciated b. depreciated c. neither appreciated nor depreciated
depreciated
2. Investors in the money markets are generally willing to take which of the following risks?
e. None of the above
_______ real rates are almost always positive; _______ real rates may be negative
expected; realized
"Issuance of commercial paper typically requires registration under the Securities Act of 1933." This statement is: a. True b. False
false
4. "Dealers bring buyers and sellers together; brokers make a market." This statement is:
false
The secondary market for commercial paper is highly liquid." This statement is: a. True b. False
false
.Entities that facilitate the flow of funds from savers to borrowers are called: a.Fiat currencies b.Financial intermediaries c.Regulatory agencies d.Initial public offerings
financial intermediaries
1. Which of the following are exchange-traded contracts? a. Futures contracts b. Forward contracts
futures
3. Suppose that the yield on a bond falls during the course of a trading day. What does this imply about the bond price?
it increases
1. TIPS have less _____ risk than "regular" Treasury securities of the same maturity. a. default b. price c. liquidity d. foreign exchange
price
. If the Fed chooses to raise the federal funds rate using open market operations, it will ___________________.
sell treasury bills
A decrease in the money stock by the Federal Reserve
shifts the supply of loanable funds to the left, increasing interest rates.
3. Which of the following terms is not commonly associated with municipal bonds? a. inflation-protected bonds b. serial bonds c. general obligation bonds d. revenue bonds
a. inflation-protected bonds
4. Issuers of commercial paper tend to be a. large financial and nonfinancial firms b. firms with high credit risk c. small banks d. wealthy individuals e. both a and b
a. large financial and nonfinancial firms
8. A contract designed to use the equity in a home for retirement income without any required payments is called a(n) a. reverse annuity mortgage b. adjustable-rate mortgage c. home equity loan
a. reverse annuity mortgage
4. Define default risk. How does the default risk premium vary over the business cycle? Briefly explain.
Default risk reflects the risk that a bondholder will not receive part or all of promised bond cash flows. Defaults reduce the realized yields/returns to an investor, owing to delays or failure to collect the contracted amount of interest and/or principal promised by the borrower. The risk of default is priced in to bonds ex ante, in the form of higher yields ("default risk premium"). The default risk premium becomes larger during economic recessions. This occurs because default events are related to the financial position and the operating performance of firms and households who borrow. In "good times" borrowers' financial positions tend to be stronger, and the likelihood of default falls on average. In contrast, during recessions, or when recessions loom on the horizon, borrowers' financial positions tend to erode and defaults are more likely. This leads to an increase in the default risk premium.
2. Suppose Fargood Corporation engages in a repurchase agreement with The National Bank of Nebraska. In the agreement, Fargood sells $9,987,950 worth of Treasury securities to the bank and agrees to repurchase the securities in 30 days for $10,000,000. Who is effectively the 'borrower' and who is the 'lender' in this repo transaction? Describe the collateralization in this agreement: What is the collateral and who holds this collateral during the term of the agreement? What interest rate (or yield) is earned by the lender?
Fargood is the borrower, since they receive cash up front (at time 0), while National Bank of Nebraska is the lender. The Treasury securities are the collateral in the agreement. These are held by National Bank of Nebraska during the term of the agreement. 1.448%
7. A portfolio manager is concerned that a potential drop in interest rates is going to lower the yield on the $1,000,000 of T-Bills she plans to buy in 3 months. She can hedge this potential interest rate risk by a. buying a call option on 3-month T-bill futures. b. buying a put option on 3-month T-bill futures. c. taking a short position in 3-month T-bill futures. d. paying the fixed leg and receiving the variable leg in an interest rate swap. e. either a or d
a. buying a call option on 3-month T-bill futures.
2. Default risk premiums vary _______ with the ________ of the security. a. directly; default risk b. inversely; default risk c. inversely; maturity d. directly; marketability
a. directly; default risk
1. A commercial bank made a five-year term loan at 13 percent. The bank's economics department forecasts that one and three years in the future, the two-year interest rate will be 12 percent and 14 percent, respectively. The current one-year rate is 7 percent. Given that the bank's forecast is reliable, has the bank set the five-year rate correctly?
Consider the following investment strategy for a total 5-year holding period: invest in a one-year security, then roll over the proceeds into a two-year security one year in the future, and then roll over the proceeds again into a two-year security three years in the future. Assuming that expectations prove to be correct, the (annualized) interest rate is: This is lower than the 13% rate on the 5-year loan. Before we conclude that the 5-year rate is incorrect; however, we should acknowledge that the long-term and short-term strategies outlined above may not be equivalent. In particular, the default risk borne over a 5-year term is likely higher than that borne over a one- or two-year term. Short term loans permit the bank to re-evaluate credit risk on a more regular basis. Perhaps the higher 5-year rate reflects compensation for bearing greater default risk on the loan.
7. Which of the following is true about GNMA pass-through securities? a. Interest and principal from borrowers are passed through to investors. b. Federally insured implies mortgage loans are guaranteed by the FHA, VA, and other authorized federal agencies. c. GNMA pass-throughs are secured by mortgage pools originated by mortgage banks, commercial banks, or other mortgage lending institutions. d. All of the above are true.
D
3. (15 points) You work as an analyst at a bond investment fund. The following table summarizes current yields for on-the-run (recently issued) US Treasury debt at various maturities: Maturity Yield 3 Months 0.04% 1 Year 0.26% 2 Years 0.63% 3 Years 0.97% 10 Years 2.01% a) What do these data imply about future short term (1 Year) interest rates? Explain your reasoning.
It is not clear. Under the expectations theory, an increasing yield curve implies that future short term interest rates will rise. However, the expectations theory has been critiqued in various directions (assumes risk-neutral investors, inconsistent with data, etc.). The liquidity/risk premium hypothesis implies that the yield curve will be upward sloped even if short term rates are expected to remain constant. This is due to the premium investors' demand in order to hold longer maturity securities under the theory. This premium derives from 1) greater duration and interest rate risk associated with longer maturities; and 2) a more illiquid secondary market relative to short term Treasuries. Theoretically, it is possible that the increase yields at longer maturities reflect these components. In practice, this seems doubtful because much of the future expected increases are occurring in the first 2-3 years.
3. How has the development of secondary mortgage markets allowed mortgage issuers to attract additional funds from the capital markets?
Many mortgage-backed securities have characteristics similar to government bonds. Pass-throughs, participation certificates, and collateralized mortgage obligations are sold in standard denominations. Also, because they are guaranteed, they can be resold easily if desired. Further, mortgage-backed bonds and CMOs are not only of standard denomination, these also provide guaranteed repayment schedules. Because these securities exhibit characteristics similar to bonds, they become more readily interchangeable with bonds in investors' portfolios. As a result, they can compete more effectively with bonds for investors' funds.
1. Briefly explain the differences between the "money markets" and the "capital markets." Which would General motors use to finance a new vehicle assembly plant?
Money markets are markets for liquidity, whether borrowed to finance current operations or lent to avoid holding idle cash in the short term. Money markets tend to be wholesale OTC markets made by dealers. Capital markets are where real assets or "capital goods" are permanently financed, and involve a variety of wholesale and retail arrangements, both on organized exchanges and in OTC markets. GM would finance its new plant by issuing bonds or stock in the capital market. Investors would purchase those securities to build wealth over the long term, not to store liquidity. GMAC, the finance company subsidiary of GM, would finance its loan receivables both in the money market (commercial paper) and in the capital market (notes and bonds). GM would use the money market to "store" cash in money market securities, which are generally, safe, liquid, and short-term.
2. Explain why mortgage investors demand a higher yield for investing in securities with prepayment risk. Why would a mortgage investor view mortgage prepayments negatively?
Prepayment risk is of concern to investors because of its impact on mortgage valuations. Unlike non-callable bonds, which increase in value at an increasing rate when yields fall and decrease in value at a decreasing rate when yields rise, mortgage portfolios increase in value at a decreasing rate when yields fall (because mortgage borrowers refinance more to take advantage of lower rates) and decrease in value at an increasing rate when yields rise (because very few mortgage borrowers refinance, and investors receive cash flows based on mortgage rates that are below the current rates).
1. (15 points) You are in charge of risk management at a major commercial bank. The bank holds a large portfolio of US Treasury bonds, as well as a large portfolio of loans. Bank analysts recently determined that the duration of the bank's portfolio of Treasuries and loans equals approximately 7.75. During your meeting with a bank regulator, you are asked to provide estimates of the percentage gain or loss that the bank's portfolio will experience in the following two scenarios: 1) interest rates increase by 10 basis points; 2) interest rates increase by 70 basis points. Assume the yield curve is currently flat at 6%.
a) Provide your estimates: + 10 basis points: -0.73% ; +70 basis points: -5.12% Both follow from the formula b) Which estimate is more accurate? Explain in one or two sentences (maximum). The +10 basis point estimate is more accurate. This is due to the convexity of the bond price-yield relation and the associated pattern of approximation errors. c) If interest rates do rise rapidly, what will happen to the duration of the bank's portfolio, assuming the holdings in the portfolio remain constant? The duration of the bank's portfolio will fall, because earlier cash flows will represent a greater proportion of the value of the portfolio. (see slides on duration) d) Suppose the regulator informs the bank that its current duration is too high and must be reduced. Explain one way that the bank might do this. There are various possible strategies, but a very simple one is to swap out long duration bonds for shorter duration bonds.
20. An item costs $5.00 in the U.S. and 525 yen in Japan. If purchasing power parity holds, what is the yen/dollar exchange rate? a. 105 yen/dollar b. 525 yen/dollar c. 100 yen/dollar d. 125 yen/dollar e. .0095 yen/dollar
a. 105 yen/dollar
11. A two-year interest rate is 7% and a one-year forward rate one year from now is 8%. According to the expectations theory, what is the current one-year rate?
a. 6.0%
3. A bond with 3 years to maturity and a coupon of 6.25% is currently selling at $932.24. Assume annual coupon payments. a) What is its yield to maturity? b) Compute the duration of the bond. c) If interest rates are expected to decrease by 50 basis points, what is the expected dollar change in price? Percentage change in price?
a. Calculator (or Excel): FV=$1,000 N=3 PV = -$932.24. PMT=62.50 y = 8.92% [Note: it is implicit that the FV = $1,000 here] b. Use the yield determined in Part a and plug this into the duration formula from class: c. Using the equation on slide #12 from class ("BondDuration" slides): %ΔPB ≈ (-2.82)(-0.005/1.0892)(100) = 1.29%. Based on the initial will be price of $932.24, the dollar change in price is 1.29% of $932.24, or $12.03, and the new price is $944.27. This is an approximation. The actual new price will be $944.50: Calculator: 1,000 FV 3 N I = 8.42 62.50 PMT PV = 944.50. This represents a $12.26, or a 1.31%, increase in the bond price.
3. Which of the following may be a liability of a non-financial business corporation?
a. Commercial paper
6. Which of the following money market rates is studied closely for indicators of changes in Federal Reserve monetary policy? a. Federal Funds b. Treasury bills c. commercial paper d. banker's acceptances
a. Federal Funds
3. Privately Issued Pass-Throughs (PIPs) are issued by a. Private institutions or mortgage bankers b. Ginnie Mae c. Freddie Mac d. All of the above
a. Private institutions or mortgage bankers
3. Which of the following statements about the money markets is true? a. The money markets are a dealer market linked by efficient communications systems. b. Money market transactions are seldom over $1 million. c. Money market transactions include more "primary market" trades for a security than secondary market trades. d. Most money market transactions are conducted by mail. e. All of the above statements are true.
a. The money markets are a dealer market linked by efficient communications systems.
5. Which one of the following is not true about privately issued passthroughs (PIP): a. They are similar to "Ginnie Maes" in that they are backed by mortgages that qualify for FHA or VA guarantees. b. PIPs are issued by private institutions or mortgage bankers. c. They are similar to "Ginnie Maes" except that they are backed by conventional mortgages that do not qualify for FHA or VA guarantees. d. They are typically used to securitize large, non-conforming mortgage loans called jumbo loans.
a. They are similar to "Ginnie Maes" in that they are backed by mortgages that qualify for FHA or VA guarantees.
"Ginnie Mae pass-throughs are essentially free of default risk." This statement is: a. True b. False
a. True
1. Which of the following is not considered a money market security?
a. US Treasury bonds
Which of the following is not a mortgage-backed security? a. a jumbo mortgage b. a Ginnie Mae pass-through c. a private label pass-through d. Freddie Mac participation certificates
a. a jumbo mortgage
.In our characterization of financial systems, "SSUs" represent: a.Standardized security units b.Synthetic spending units c.Special security umbrellas d.Surplus spending units
surplus spending units
which among the following is least likely to affect the supply of loanable funds?
the investment opportunities in the economy
