ECON 2035 Final LSU Arnold
Everything else held constant, suppose the federal government budget deficit increases. Trace through the effects of this action in the market for bonds.
Fed will issue more bonds, bond supply will shift right causing P* to fall and i* to rise in bond market
Collateral requirements lessen the consequences of __________ because the collateral reduces the lender's losses in the case of a loan default and it reduces ________ because the borrower has more to lose from a default.
Lessens the consequences of adverse selection to lender and moral hazard to borrower.
The Liquidity premium theory assumes
Long-term bonds and short-term bonds are substitutes; but, NOT perfect substitutes
Suppose that the money supply is increasing at a rate of 4% and real GDP is increasing at a rate of 2%. Assuming velocity is constant in the short run, what is the inflation rate?
M X V = P X Y %ΔM + %ΔV = %ΔP (rate of inflation) + %ΔY %ΔM + % ΔV = π + %ΔY 4% + 0 = π + 2% 4% - 2% = π 2% = π
Suppose you transfer $1,000 from your savings account to your checking account, which of the following statements is correct? a. M1 rises by $1,000 b. M2 falls by $1,000 c. M1 remains unchanged d. Both A & B e. Both B & C
M1 will rise by $1,000 M2 is a wash as it includes M1 M2=M1+Savings+CDs(sm denomination time note deposits)+money mrkt mutual funds shares+money mrkt accounts
Suppose that Google announces that its profits for the 3rd quarter of 2016 were $1.6b. As a result fo thiss announcement the price of Google's stock decreases. the best explanation of this is
Market participants expected Google's profits > $1.6b at 3rd quarter. If Google did worse than they thought the price is overvalued so they would sell ASAP.
Suppose market analysts predict that a stock's dividend will be $10 next year and that dividends will grow at a rate of 1% indefinitely. Max has a risk premium of 8%, Jerry has a risk premium of 5%, and Laura has a risk premium of 7%. The current interest rate on a safe asset is 2%. 1.What is the required return to equity for Max, Jerry, and Laura? 2. List the individuals from lowest willingness to pay to highest willingness to pay. 3. What can you say about the market price of this stock?
Max's re=10%(2%+8%) Jerry's re=7%(2%+5%) Laura's re=9%(2%+7%) Max < Laura < Jerry Laura < Mrkt P <= Jerry
Suppose Maya buys a government bond on January 1st 2015. The bond has an annual coupon payment of 4% and a face value of $1000. The bond is an asset for ________ and a liability for _____________.
Maya's asset, government's liability
Suppose the Fed conducts open market sales. This causes the money ________ curve to shift ________ and interest rates will _______.
Money supply curve will shift left and interest rates will rise.
Supposed you purchase a 10 yr coupon bond with a face value of $1000 and coupon rate of 10% for $950. In 5 years the bond holder would expect to receive a payment of ________ and in 10 years the bond holder would expect to receive a payment of ___________
$100; $1100
Suppose Maya buys a government bond on January 1st 2015. The bond has an annual coupon payment of 4% and a face value of $1000. What is annual coupon payment?
$40
Suppose that a slice of pepperoni pizza cost £1 in London and $2 in San Francisco. Suppose further that the current exchange rate is $2 per £1. The real exhange rate is ________ and pizza in San Francisco is _______ pizza in London
$1 is .5£ ($2 per 1£) £1/(x$ X .5£) = $2. $2/$2 is 1 so real exchange rate is 1. Pizza in San Francisco is same price as London.
Suppose Maya buys a government bond on January 1st 2015. The bond has an annual coupon payment of 4% and a face value of $1000. Suppose further that it has 2 yrs to maturity and a 4% YTM. What is the bond price?
$1,000 If YTM = Cpn rate PV=FV
Suppose Maya buys a government bond on January 1st 2015. The bond has an annual coupon payment of 4% and a face value of $1000. Suppose further that it has 2 yrs to maturity and a 2% YTM. What is the bond price?
$1,038.84 $40/1.02 + $1,040/1.02^2 When YTM falls PV rises and vice versa
What is the price of a coupon bond that has annual coupon payments of $75, a face value of $1,000, a yield to maturity of 5%, and a maturity of two years?
$1,046.49 $75/1.05 + $1000/1.05^2 + $75/1.05^2 $71.43 + 907.03 + 68.03 = $1,046.49 7.5% cpn > 5% YTM so P will be > FV (by a little)
Suppose Maya buys a government bond on January 1st 2015. The bond has an annual coupon payment of 4% and a face value of $1000. What will Maya receive in 2016 and 2017 respectively (with 2 yrs to maturity)?
$40 in 2016; $1,040 in 2017 (cpn + FV)
If you deposit $50 in the bank, the immediate impact on your bank's balance sheet will be a
$50 increase in reserves and a $50 increase in checkable deposits
If 1-year interest rates for the next four years are expected to be 5%, 4%, 2%, and 1%, respectively, then the expectations theory predicts that today's interest rate on a four-year bond is
(5%+4%+2%+1%)/4 = 12%/4 = 3%
What is the "the multiplier"
1/[1-marginal propensity to consume (mpc)] Any change in output = multiplier X change in AE
Suppose interest rates rise from 3% to 5%. Would you rather be holding a 10-year bond or a 30-year bond assuming both have a face value of $1000 & coupon rate of 3%? Why?
10-year bond as the coupon rate is < YTM , so a shorter term bond has lower risk when YTM changes
If 1-year interest rates for the next five years are expected to be 2%, 4%, 6%, 2%, and 1%, respectively, then the expectations theory predicts that today's interest rate on a two-year bond is
3% (2%+4%)/2 = 6%/2 = 3%
According to the quantity theory of money and assuming velocity is constant, if the long-run economic growth rate is 2.5%, by how much should the Fed increase the money supply if it wants inflation to be 2%?
4.5% (2% + 2.5%)
Which of the following is an example of adverse selection? a. Your brother-in-law borrows $20,000 from you to open a pizza parlor, but spends it gambling at the track b. A renter with a large renter's insurance policy doesn't lock her door when she leaves home c. A woman with a large life insurance policy takes up skydiving d. A man with a bad heart condition buys a large life insurance policy
A man with a bad heart condition buys a large life insurance policy Adverse selection happens *before* the transaction
Lenders may be reluctant to increase the interest rate they charge borrowers because these high interest rates may a. attract less creditworthy borrowers, increasing adverse selection b. attract more creditworthy borrowers, increasing adverse selection c. attract more creditworthy borrowers, decreasing adverse selection d. attract less creditworthy borrowers, decreasing adverse selection
A. Attract less creditworthy borrowers, increasing adverse selection
Suppose a bank has more interest rate sensitive liabilities than assets. A(n) _____ in interest rates will result in a(n) _________ in bank profit
An increase in interest rates will decrease bank profits as their liabilities may have a higher or lower interest rate than their assets
Everything else held constant, suppose the cost of acquiring bonds falls relative to other assets. Trace through the effects of this action in the market for bonds.
Bond demand will shift right, causing P* to rise and i* to fall in the bond market
If interest rates typically fall during a recession, what can you conclude about the impact of the recession on bond demand vs. bond supply?
Bond supply would have more effect on equilibrium price and interest of bonds in a recession
Suppose the US Government increases tax revenue and decreases government spending. ETHC, the government budget deficit is ________ and the _________ of bonds will shift _________.
Budget deficit is decreasing, supply of bonds will shift left
If a bank can use the same loan contract for multiple loans, thereby reducing the cost per loan, this is an example of ________ because __________
Economies of scale, because as production increases average cost decreases
A bond with a coupon of $50 that was purchased for $500 and sold on eyear later for $550 incurred a capital ___________ and the rate of return is ____________
Capital gain of 20% 50/500 + (550-500)/500 = 100/500 = 20%
When the economy enters a(n) _________ the demand for bonds may increase and the supply of bonds may _________. If the equilibrium interest rate ultimately ____, then the impact on supply was greater than the impact on demand.
Economy enters an expansion, supply of bonds may increase. If the equilibrium interest rate ultimately rises, supply impact was greater.
When the treasury bond market becomes more liquid, other things equal, the demand curve for corporate bonds shifts to the _________ and the demand curve for Treasury bonds shifts to the __________ and the interest rate on corporate bonds ______ relative to the interest rate on Treasury bonds.
D curve for corporate bonds shifts left D curve for T-bonds shifts right i on corporate bonds rises (becuase P is falling)
According to the Gordon growth model, which of the following can cause the value of a stock to increase? a. decrease in current dividend b. lower expected growth rate of dividends c. increased required return on equity d. decreased risk premium
Decreased risk premium will lower re (re=i+risk premium) which causes P0 to rise
Suppose, everything else held constant, the cost of acquiring information about corporate bonds rises relative to municipal bonds. In the market for corporate bonds, this will cause the ________ curve to shift ________, equilibrium price to ________, and equilibrium interest rates to ________ . In the market for municipal bonds, the ________ curve will shift ________ , equilibrium price will ________ , and equilibrium interest rate will ________.
Demand curve will shift left, P* will fall, i* will rise in market for corporate bonds. Demand curve will shift right, P* will rise, i* will fall in market for municipal bonds
All else being equal, an increase in the foreign demand for US goods causes the demand for dollars to ____________ and the dollar will _________ relative to foreign currencies.
Demand for dollars to increase and the dollar will appreciate against foreign currencies.
When banks borrow from the Fed this is referred to as a __________; when banks borrow from other banks this is referred to as _________
Discount lending from Fed; borrowing in the fed funds market from other banks
If the exchange rate changes from 1.4 dollars per euro to 1.3 dollars per euro, the euro has ____ against the dollar and American goods are _____ expensive in Europe.
Euro has depreciated against $ and American goods are more expensive in Europe
Suppose Charlie, Dillon, and Evan are considering buying stock XYZ. Analysts project the dividend payment next year to be $2 and the company to grow 3%, and current interest rates on a safe asset are 3%. Suppose further that Charlie has a required return on equity of 9%, Dillon has a required return to equity of 13%, and Evan has a required return to equity of 15%. Rank Charlie, Dillon, and Evan from highest risk premium to lowest risk premium.
Evan - risk premium = 15%-3% = 12% Dillon - risk premium = 13%-3% = 10% Charlie - risk premium = 9%-3% = 6%
The FDIC _________ short-term borrowing by shadow banks, and shadow banks are normally _____ to receive loans from the Fed when they suffer liquidity problems
FDIC does not insure shadow banks and Fed does not normally loan to shadow banks
Suppose Charlie, Dillon, and Evan are considering buying stock XYZ. Analysts project the dividend payment next year to be $2 and the company to grow 3%, and current interest rates on a safe asset are 3%. Suppose further that Charlie has a required return on equity of 9%, Dillon has a required return to equity of 13%, and Evan has a required return to equity of 15%. The market price of the stock will be:
Greater than Dillon's willingness to pay, but no greater than Charlie's as Charlie is willing to pay the most (think of it like an auction)
Which of the following will result in a decrease in the price of an existing corporate bond? a. increased default risk b. lower expectations of inflation c. new bonds issued at a lower interest rate d. all of the above
Increase default risk as will raise interest and when interest goes up P goes down
Which of the following will lead to a higher interest rate on a loan? a. reduced likelihood of borrower not paying the loan b. lower opportunity cost c. increased perceived risk of default d. lower inflation
Increased perceived rise of default re=i-πe return on equity = interest - expected inflation
Which of the following is NOT true of moral hazard? a. It describes a lender's problem of distinguishing the good-risk applicants from the bad-risk applicants b. It describes a lender's problem in verifying borrowers are using their funds as intended c. It arises because borrowers typically know more than lenders d. It would not exist in a world of perfect information
It describes a lender's problem of distinguishing the good-risk applicants from the bad-risk applicants as this is a adverse selection
According to the rational expectations theory, if you are always 5 minutes late when it rains then you should: a. always leave 5 minutes earlier b. leave 5 minutes earlier when it's raining c. leave 5 minutes later when it's not raining d. do the same thing all the time
Leave 5 minutes earlier when it's raining Rational expectations theory: use ALL information (whether you know about it or not)
How might a recession impact the supply of bonds? What impact would this have on equilibrium price of bonds & interest rates?
Need to borrow increases, so bond supply shifts left causing P to rise and interest falls. Ambiguous to equilibrium without knowing which (demand or supply) affects more.
ETHC, when the bank has to write off the value for a loan, the corresponding reduction in a liability entry would be
Net worth (bank capital) is reduced by the amount of the decline in the value of the loan
Suppose you use past performance of a company to predict that a company's profit will rise by 5%. If the companies profits actually rise by 5%, was your estimate formed using rational expectations?
No, didn't use all information available, so Adaptive assumption used
In which of the following situations would you prefer to be the borrower? a. Nominal interest rates are 7% and inflation if 8% b. Nominal interest rates are 1% and inflation is 1% c. Nominal interest rates are 5% and inflation is 2% d. Nominal interest rates are 16% and inflation is 3%
Nominal interest rates are 7% and inflation is 8% as re=i-πe so lower i the better
Which of the following is NOT significant cost that a barter system imposes on an economy? a. Only agricultural goods may be traded b. Specialization of labor is hindered c. The costs arising from the problem of finding two people who each want what the other produces d. Many prices must be maintained for each good
Only agricultural goods may be traded
An open market __________ of bonds could cause stock prices to increase due to a __________ in the dividend growth rate and a _____ in the required return to equity.
Open market purchase due to an increase in the dividend growth rate and a decrease in the required return to equity. This is because an open market purchase will lower i which lowers re (re=i+risk prem) which can raise dividend growth rate
An open market _______ results in a decrease in Money Supply and a __________ nominal interest rate
Open market sales decrease Ms and a higher nominal i
Suppose the Fed conducts open market sales. What might happen to the required return to equity? Dividend growth rate? Stock prices?
Open market sales will raise i, which will increase re (re=i+risk prem), lowering dividend growth rate (businesses have less money to spend), lowering stock prices (less bang for buck)
When nominal interest rates on financial assets are low, the opportunity cost of holding money is _________, so the quantity of money demanded by households and firms will be __________.
Opportunity cost of holding money is low, so quantity demanded by households and firms is high
If growth rises then
P0 will also rise
If re rises what happens to P0?
P0 will fall
If current dividend rises what happens to P0?
P0 will rise
Expectations premium theory assumes long-term bonds and short-terms bonds are
PERFECT substitutes
In 2016, investors became more concerned with the default risk of bonds issued by the government of Greece relative to the default risk on bonds issued by the government of France. The price of bonds issued by France would have most likely ________ and the interest rate on those bonds would have most likely __________.
Price of French bonds increased and interest on French bonds decreased (because P is rising)
How to calculate ROR (rate of return)
R = CPN PMT / Price paid + (New price-Old Price)/Price paid CAN HAVE NEGATIVE ROR!!!
Suppose Charlie purchased a bond last year for $800. The coupon rate on the bond was 8% and the face value was $1000. Suppose, again, the bond is expected to sell for $1000 this year. Calculate Charlie's expected rate of return under this scenario.
R = cpn pmt/P + ΔP/P R = $80/$800 + ($1000-$800)/$800 R = .1 + .25 = .35 or 35%
Suppose a professional athlete signs a contract with his team that has a clause forbidding him from engaging in extra-curricular sporting events, such as snowboarding. This is an example of a _______________ that is meant to reduce ____________
Restrictive covenant to reduce moral hazard
If Venezuelan investors are becoming concerned that Venezuelan investments are at an increased risk of default, these investors would be inclined to ______Venezuelan bolivars, _________ the value of the Venezuelan bolivar relative to other currencies.
Sell the bolivar, decreasing the value relative to other currencies.
Suppose you take out an auto loan and pay monthly payments of $299. Used in this way, money is fulfilling which of the following functions? a. Store of value b. Medium of exchange c. Unit of account d. Standard of deferred payment
Standard of deferred payment
Suppose the US Government increases tax revenue and decreases government spending. ETHC, what impact would this have on the equilibrium interest rates & equilibrium bond prices?
The equilibrium interest rate will fall and the equilibrium bond price will rise as supply of bonds will shift left due to budget deficit decreasing
According to the equation of exchange, if the quantity of money decreases and the velocity of money remains constant, then
The level of nominal GDP must decrease M X V = P X Y (i.e., Nominal GDP) %ΔM (falling) X %ΔV (0) = Nominal GDP (falling)
If the price level in the US increases more rapidly than the price level in Canada, ETHC, we would expect
US $ to depreciate against Canadian $
Suppose, everything else held constant, that the Fed conducts open market purchases. This will cause the interest rate on US assets to ________ relative to European assets. The demand for dollars will shift _________. The US dollar will ______________ against the euro and the euro will _______________ against the dollar.
US assets' i will fall relative to European assets. The demand for $ will shift left and the $ will depreciate against the € causing the € to appreciate against the $.
ETHC, suppose the Fed conducts open market sales, causing interest rate to ______ in the US compared to Japan. This will cause the ______ for/of dollars to shift right and the __ for/of dollars to shift left. The dollar will _________ against the yen.
US interest rate will rise, cause the demand for $ will rise, supply of $ will fall, US$ will appreciate against the yen.
Suppose the U.S. is experiencing a 5% rate of inflation and the Japan is experiencing a 2% rate of inflation. Prices in the US are ___________ compared to prices in Japan. According to the theory of purchasing power parity, the dollar will eventually _____________ by ______% against the yen.
US prices are more expensive compared to Japan prices. The $ will eventually fall by 3% against the ¥. %ΔE(¥>$)=π¥-π$ %ΔE=2%-5%=-3% so fall by 3%
Suppose in searching for a new TV you compare prices from Best Buy, Amazon, and Wal-Mart. In this scenario, money i serving which of the following functions? a. Store of value b. Medium of exchange c. Unit of account d. Standard of deferred payment
Unit of account A unit of account is something that can be used to value goods and services, record debts, and make calculations.
Suppose the economy enters a recession. What effect is this likely to have on the demand for bonds? What impact would this have on the equilibrium price of bonds & interest rate?
Wealth falls, so Bonds demanded falls causing P to fall and i to rise. Ambiguous to equilibrium without knowing which (demand or supply) affects more.
Suppose Charlie purchased a bond last year for $800. The coupon rate on the bond was 8% and the face value was $1000. Suppose the bond is expected to sell for $1000 this year. What can you say about the (expected) yield to maturity this year?
YTM = 8% (cpn rate)
Suppose Charlie purchased a bond last year for $800. The coupon rate on the bond was 8% and the face value was $1000. What can you say about the yield to maturity when Charlie bought the bond last year?
YTM > 8% (cpn rate)
Suppose a coupon bond with a face value of $1,000 is currently priced at $950 and has a coupon of $40. Which of the following is TRUE? a. Coupon rate has risen b. Yield to maturity >4% c. Coupon rate has declined d. Yield to maturity <4%
Yield to maturity is >4% Because P<FV, i must be >cpn. If i>$40, and $40 is 4% ($1,000x4%=$40), then i (or YTM) > 4%
Which of the following is an example of an intermediate-term debt? a. a six month loan from a finance company b. a sixty-month car loan c. a stock issued by a large corporation d. a thirty-year U.S. Treasury bond
b. a sixty-month car loan
A decrease in real GDP will result in a(n) __________ in the demand for money and cause the nominal interest rate to _________
decrease demand for money and decrease the nominal interest rate
All else being equal, an increase in the US demand for Japanese goods causes the ________ for/of yen to __________ and the yen will ________ against the dollar
demand of yen will rise and yen will appreciate against the US $
According to the expectations theory, a U-shaped yield curve with an equal beginning and end point and small fall in the middle, indicates that short-term interest rates are expected to: Yield to | maturity | | . . | . . | . . . . . . . . . |_________________________________ Term to maturity
fall moderately in the near-term and rise later on
If an investor is certain that market interest rates will decline in the future, which of the following will she be most likely to purchase and why? a. sixty-month government bill b. two-year government note c. ten-year government bond d. fifty-year government bond
fifty-year government bond because as i falls P rises and certain so longer l/t is better
What always moves together in the fisher equation
i and πe
If the interest rate on a U.S. one-year bond is 2%, the interest rate on a Brazilian one-year bond is 8%, and you prefer US assets and have a currency premium of 3%, what is the expected rate of appreciation of the U.S. dollar according to interest-rate parity?
idomestic=iforeign-expectedappreciationdomestic-currency premium 2%=8%-expectedappreciationdomestic-3% 2%=5%-expectedappreciationdomestic Expected Appreciation Domestic=3%
In order to reduce the likelihood of excessive leverage in the banking system, governments have traditionally:
imposed capital requirements on commercial banks.
If you deposit $500 in your bank and the rr=10%, your bank will have _________ in RR and ________ in ER.
increase in RR of $50 and an increase in ER of $450
If you buy a bond issued by Apple, the bond is a(n)
liability to Apple and an asset to you
Suppose the current market interest rate is 5% and the expected rate of inflation is 2%. What is the expected real interest rate? . If inflation turns out to be 4%, what is the actual real interest rate?
ra=i-πa ra=5%-4% ra=1%
As a result of adverse selection in the financial market, banks may ___________
ration credit (give out very few loans and only to perfect borrowers - worsens an already bad economy)
Fisher equation
re=i-πe
Suppose the current market interest rate is 5% and the expected rate of inflation is 2%. What is the expected real interest rate?
re=i-πe re=5%-2% re=3%
r=
real interest rate
If the government were to simultaneously cut the personal income tax and corporate profits tax, the equilibrium interest rate on corporate bonds would
rise, fall, or not change because no information was provided on which was (if was) more affected, so effect on P* and i* is ambiguous
You own a 2007 Ford Explorer. Although it has high mileage, you have maintained it very well. You want to sell it, but after checking the prices other owners of 2007 Ford Explorers are able to get for their cars in the used car market, you decide the prices are too low and you decide not to sell. This is an example of
the "Lemons Problem" Bad pushing out good - lemon problem
According to the liquidity premium theory of the term structure
the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the lift of the long-term bonds plus a term (liquidity) premium
If there is an excess demand at a given price of bonds, then
the interest rate will fall
In the bond market, the buyer is considered to be
the lender
In the many-period valuation model, the future sales price of a stock does not affect the current stock price because
the present value of the future selling price is negligible
Suppose, everything else held constant, British goods become popular in Europe. This will cause the demand for British pound to shift _________. The British pound will ____________ against the euro and the euro will _______ against the pound.
£ demanded will shift right. The £ will appreciate against the € and the € will depreciate against the £.
When velocity is constant
π = %ΔM - %ΔY
When %ΔM > %ΔY
π > 0
Everything else held constant, suppose that the expected rate of inflation rises. What impact does this have on the demand for bonds? Supply of bonds? Equilibrium bond prices & interest rates?
πe is rising so P is falling and i is rising. More bonds supplied and less demanded as re is falling.
Suppose the exchange rate changes from 50 yen per euro to 45 yen per euro. The euro has ________________ against the yen and the yen has ________________ against the euro. Japanese goods are ________________ expensive in Europe and European goods are ________________ expensive in Japan.
€ has depreciated against the ¥ and the ¥ has appreciated against the €. Japanese goods are more expensive in Europe and European goods are less expensive in Japan.