ECON 2035 Exam 2(Chapters 5-9) Essay Questions

Suppose you invest $5,000 in a one-year Japanese bond that pays 1% interest. At the time of your purchase, 85 yen equals $1 while one year later, 80 yen equals $1. What will be the value of your investment in one year when measured in dollars?

A $5,000 investment equals 425,000 yen. After earning 1% interest, you have 429,250 yen. When converted back to dollars, you have $5,366.

Explain the difference between a credit swap and a credit default swap.

A credit swap is a contract in which interest-rate payments are exchanged, with the intention of reducing default risk. A credit default swap is a derivative that requires the seller to make payments to the buyer if the price of the underlying security declines in value. It is, in effect, a type of insurance.

A one-year bond has an interest rate of 0.2% and is expected to rise to 0.5% next year and 1.1% in two years. The term premium for a two-year bond is 0.1% and for a three-year bond is 0.25%. What are the interest rates on a two-year bond and three-year bond according to the liquidity premium theory?

A two-year bond will have an interest rate of (0.2 + 0.5) / 2 + 0.1% = 0.45%. A three- year bond will have an interest rate of (0.2 + 0.5 + 1.1) / 3 + 0.25% = 0.85%.

A one-year bond has an interest rate of 3% and is expected to fall to 2.5% next year and 2% in two years. The term premium for a two-year bond is 0.3% and for a three-year bond is 0.5%. What are the interest rates on a two-year bond and three-year bond according to the liquidity premium theory?

A two-year bond will have an interest rate of (3% + 2.5%) / 2 + 0.3% = 3.05%. A three-year bond will have an interest rate of (3% + 2.5% + 2%) / 3 + 0.5% = 3%.

What is the difference between adaptive expectations and rational expectations?

Adaptive expectations is when investors expectations of the price of a firm's stock depended only on past prices of the stock. With rational expectations, people make forecasts using all available information.

What are the economic implications of an inverted yield curve?

An inverted yield curve normally precedes a recession. An inverted yield curve reflects market expectations of an expected decline in future short-term interest rates, which typically occur during recessions.

What are the information costs associated with forward contracts?

As a result of counterparty risk, buyers and sellers of forward contracts will incur information costs when analyzing the creditworthiness of potential trading partners.

In 2009, global investors began to regain confidence in the financial system and reversed the flight to safety that had taken place during the depths of the financial crisis. Make use of a graph of the market for corporate bonds to show the impact on corporate bonds' prices and yields. (look at page 19 of chapter 5 for graph)

As investors regained confidence in the financial system, the demand for corporate bonds rose, leading to an increase in the price of bonds and a decline in yields.

Suppose a Nintendo Wii U has a price of 24,000 yen in Japan and the yen-dollar exchange rate changes from 80 yen to the dollar to 100 yen to the dollar. What happens to the price of the Wii U measured in dollars?

At 80 yen = $1, the dollar price of the Wii U is $300 while at 100 yen = $1, the dollar price of the Wii U is $240.

Why are forward contracts typically illiquid?

Because forward contracts usually contain terms specific to the particular buyer and seller involved in a transaction, selling the contract is difficult because a buyer would have to accept the same terms.

Shouldn't better informed investors be able to profit from the deviations from pricing efficiency caused by noise traders?

Better informed investors may be able to profit from the deviations from efficiency caused by noise traders. But the longer these deviations persist, the less likely it is that better informed investors will be able to profit.

Compare the rights and obligations of buyers and sellers of futures contracts with the rights of buyers and sellers of options contracts.

Buyers and sellers of futures contracts have symmetric rights. Buyers and sellers of options contracts have asymmetric rights. Options represent the right to buy or sell the underlying asset. This means that buyers have rights, but sellers have obligations.

What are the differences between common stock and preferred stock?

Common stockholders elect the members of the board of directors, but preferred stockholders are not eligible to vote in these elections. Preferred stockholders receive a fixed dividend set when the stock is issued while holders of common stock receive a dividend that fluctuates with the profitability of the corporation over time. Corporations suffering losses may decide to suspend paying dividends, but if the corporation does pay dividends, it must first pay the dividend promised to preferred stockholders before making any dividend payments to the common stockholders.

Explain what is meant by the "double taxation of dividends"?

Corporate profits are subject to the corporate profits tax, which companies pay before they distribute dividends to their stockholders. Individuals must pay individual income taxes on the dividends they receive.

How does the liquidity premium theory explain an upward-sloping yield curve during normal economic times?

During normal economic times, future short-term interest rates are not expected to differ much from current short-term interest rates. In this case, long-term interest rates will be higher than short-term interest rates due to a term premium since long-term interest rates reflect the average of current and expected short-term interest rates plus a term premium.

How do exchanges seek to reduce default risk in the futures market?

Exchanges require both the buyer and seller to place an initial deposit in a margin account. At the end of each trading day, exchanges carry out a daily settlement known as marking to market in which, depending on the closing price of the contract, funds are transferred from the buyer's account to the seller's account or vice versa.

How are financial intermediaries able to reduce transactions costs?

Financial intermediaries are able to take advantage of economies of scale, which refers to the reduction in average cost that results from an increase in the volume of a good or service produced.

Describe two useful purposes served by speculators in derivatives markets.

First, hedgers are able to transfer risk to speculators. In derivatives markets, as in other markets, there must be two parties to a transaction. Second, studies of derivatives markets have shown that speculators provide essential liquidity.

What are the three key features of the financial system that result from the existence of transactions and information costs?

First, loans from financial intermediaries are the most important external source of funds for small- to medium-sized firms. Second, the stock market is a less important source of external funds to corporations than is the bond market. Third, debt contracts usually require collateral or restrictive covenants.

What real-world complications keep purchasing power parity from being a complete explanation of exchange rates ?

First, not all goods are traded internationally. Second, products are differentiated, so they would not be expected to have the same price. Third, governments impose barriers to trade, preventing prices of goods from equalizing between nations.

What are the reasons why disclosure by the SEC does not eliminate the information costs of adverse selection?

First, some good firms may be too young to have much information for potential investors to evaluate. Second, lemon firms will try to present the information in the best possible light so that investors will overvalue their securities. Third, there can be legitimate differences of opinion about how to report some items on income statements and balance sheets. Finally, the interpretation of whether information is material can be tricky.

What are the effects of the double taxation of dividends?

First, the return investors receive from buying stocks is reduced, which reduces the incentive individuals have to save in the form of stock investments and increases the costs to firms of raising funds. Second, firms have an incentive to retain profits rather than to distribute them to stockholders. Finally, because firms can deduct from their profits the interest payments they make on loans and bonds, the double taxation of dividends gives firms an incentive to take on what may be an excessive level of debt rather than issue stock.

What are three reasons that the interest-rate parity condition may not always hold?

First, there may be differences in default risk and liquidity. Second, there are transactions costs which may prevent returns from being exactly equal. Third, it does not take into account exchange-rate risk.

Why may some investors prefer forward contracts to futures?

Forward contracts are more flexible than futures contracts.

In what ways do futures contracts differ from forward contracts?

Futures contracts are traded on exchanges. Futures contracts typically specify a quantity of the underlying asset to be delivered but do not fix what the price will be on the settlement date when the asset is delivered. Futures contracts are standardized in terms of the quantity of the underlying asset to be delivered and the settlement dates for the available contracts.

Suppose that short-term real interest rates fall in Japan. Is this likely to be good news or bad news for the tourism industry in Hawaii?

Good news, unless short-term real interest rates decline in the United States as well. If short-term real interest rates in Japan fall relative to short-term real interest rates in the United States, the value of the yen should decline relative to the dollar. This will lower the yen price of vacations in Hawaii.

Steve Forbes has run for president twice on a program of a "flat tax." Under a flat tax, there would be only one tax bracket for the federal income tax and most tax deductions and tax exemptions would be eliminated. Suppose that Forbes wins the 2020 presidential election. What would be the likely impact on the market for municipal bonds?

If interest on municipal bonds were no longer exempt from the federal income tax, the prices of municipal bonds would fall and their yields would rise. Reducing the marginal tax rate on high income tax payers—as would be done under most flat tax proposals—would reduce the incentive many high income people have for buying municipal bonds. This would also result in a decline in the prices of these bonds and a rise in their yields.

What should affect the fundamental value of a stock according to the efficient markets hypothesis?

If new information leads investors to change their opinions about the risk, liquidity, information costs, or tax treatment of the returns from owning the stock, the fundamental price of the stock will change.

In 2010, fears were growing that the dollar would experience a significant decline in value. What are the likely implications for the euro-dollar exchange rate?

If people expect the dollar to decline in value, ΔEXe will be negative, thus increasing the expected foreign return on assets. This should lead to an appreciation of the euro relative to the dollar.

What does it mean to "cover a short"?

If the price of an asset in which an investor has a short position rises, the investor will incur losses by having to buy back the asset at a higher price than what it was sold for.

Suppose the private bond rating agencies ceased to exist. What would be the impact on the bond market?

If the private bond rating agencies ceased to exist, the information available to investors on the default risk of bond's would decline. The risk premium would increase, bond yields would rise, and some firms might find they were unable to raise funds on the bond market.

What is an advantage of using options instead of forward contracts when speculating on exchange rates?

If the value of the currency moves in the opposite direction to the one the speculator hopes, the speculator with an options contract doesn't have to exercise the option.

Why must the spot price equal the futures price on the settlement date?

If there were differences in prices, there would be opportunity for arbitrage.

What are the information costs faced by savers?

Information costs are the costs that savers incur to determine the creditworthiness of borrowers and to monitor how they use the acquired funds.

Explain how a bubble can develop in the market for an asset.

Investors imitating each other can help to fuel a speculative bubble. In a bubble, the price of an asset rises above its fundamental value. Once a bubble begins, investors may buy assets not to hold them but to resell them quickly at a profit, even if the investors know that the prices are greater than the assets' fundamental values. This increased demand for the asset causes its price to further exceed the fundamental value.

Why do some economists think that taxing capital gains results in a locked-in effect?

Investors may be reluctant to sell stocks that have substantial capital gains.

How does adverse selection affect the economic efficiency of the used car market?

Since potential buyers have a difficult time distinguishing good cars from lemons, the prices of good cars decline to below their true values.

How do high interest rates increase the risk of adverse selection in the bond market?

Investors often reason that as interest rates on bonds rise, a larger fraction of the firms willing to pay the high interest rates are lemon firms. After all, the managers of a firm facing bankruptcy may well be willing to pay very high interest rates to borrow funds that can be used to finance risky investments.

Briefly explain how a U.S. company that exports to Europe can hedge against exchange rate risk.

It can sell euros forward for dollars at the current forward rate or have its bank carry out the transaction for a fee.

In what way do owners of stocks have limited liability?

Limited liability is the legal provision that shields owners of a corporation from losing more than they have invested in the firm.

Why does the segmented markets theory suggest that bonds of different maturities are NOT perfect substitutes for each other?

Long-term bonds are subject to greater interest-rate risk than short-term bonds. and long-term bonds are less liquid than short-term bonds.

Suppose the Federal Reserve reduces interest rates while interest rates in Europe do not change. Make use of a graph of the foreign exchange market to show how this will affect the value of the dollar.(Look at page 37 in Chapter 8 to see graph)

Lower interest rates in the U.S. will reduce the demand for dollars as foreign investors buy fewer U.S. financial assets.

How does adverse selection affect the participation of small- and medium-sized firms in the stock market?

Many small- and medium-sized firms will be unwilling to issue shares of stock for a price below its true value. Many will be unable to find investors who will be willing to purchase their stock due to fears about adverse selection.

If the expectations theory of the term structure is correct, would a reduction in the supply of thirty-year Treasury bonds affect their yields?

No. According to the expectations theory, Treasury bonds of different maturities are perfect substitutes. If expectations of the future path of short-term rates remain unchanged, then a reduction in the supply of thirty-year bonds will not affect their yields.

Suppose that the one-year Treasury bill rate in the United States is 6%, the one-year government bond rate in Canada is 4%, and investors expect the U.S. dollar to depreciate against the Canadian dollar by 4% over the coming year. Is the nominal interest rate parity condition violated?

Not if investors have a preference for U.S. securities over Canadian securities. In this example there is an implied currency premium of 2%.

What is an advantage of using forward contracts instead of options to hedge against exchange-rate risk?

Option prices are higher than the fees associated with forward contracts.

What is an advantage of using options instead of forward contracts when hedging against exchange-rate risk?

Options contracts have the advantage to hedgers that if the price moves in the opposite direction to the one being hedged against, the hedger can decline to exercise the option and instead can gain from the favorable price movement.

How can restrictive covenants help to reduce moral hazard in bond markets?

Restrictive covenants either place limits on the uses of the funds the borrower receives or require that the borrower pay off the bond if the borrower's net worth drops below a certain level.

How can stock prices affect spending by businesses and households?

Rising stock prices make it easier for corporations to raise funds. Since stocks make up a significant portion of household wealth, changes in stock prices can affect wealth and thus household spending. Changes in stock prices can also affect consumer and business expectations. For example, declining stock prices may make households more uncertain about their jobs and income, leading to less spending.

How does adverse selection affect the willingness of corporations to issue stock?

Since adverse selection reduces the price of the stock of a good corporation below its true value, corporations will be less likely to issue shares of stock.

Why did some economists and policymakers think ratings agencies had a conflict of interest leading up to the Financial Crisis of 2007-2009?

Since ratings agencies earn income by charging firms for their services, they may have an incentive to maintain higher ratings than justified in order to keep a firm's business

Southwest Airlines relies on jet fuel to operate its planes. If it chooses to hedge against future changes in fuel prices, what positions (long or short) will it take in the spot and futures markets?

Southwest will take a short position in the spot market and a long position in the futures markets.

What are the various ways that financial intermediaries can take advantage of economies of scale?

Standardized legal contracts enable the cost of writing contracts to be spread over many loans. Bank loan officers are able to process loans efficiently by specializing in evaluating and processing loans. Fees for high-dollar purchases of financial assets do not differ much from fees for low-dollar purchases. Financial intermediaries can use sophisticated computers to provide financial services.

Discuss what happened to the market prices on corporate securities relative to government securities during the Great Recession.

The Great Recession was accompanied by a financial crisis. There was a flight to quality by investors. The market prices of corporate securities fell significantly relative to the market prices of government securities.

Which bond would someone in a 35% tax bracket choose to buy: a municipal bond with an interest rate of 7% or a corporate bond with an interest rate of 10%?

The corporate bond returns 6.5% after taxes (0.65 × 10%). Thus, the investor is likely to choose the municipal bond since it offers a higher after-tax return.

How would proponents of the efficient markets hypothesis use the Gordon growth model to explain the movement of stock prices during the financial crisis of 2007-2009?

The decline in stock prices, though, may have been consistent with substantial changes in the expectations of investors with respect to both the future growth rate of dividends and the degree of risk involved in investing in stocks. The Gordon growth model indicates that an increase in rE and a decrease in g will cause a decline in stock prices.

Why do futures have lower information costs and higher liquidity than forward contracts?

The exchange stands as a counterparty to each trade, thus reducing counterparty risk and information costs. The reduced risk and information costs, along with the standardization of contract terms, increase the willingness of investors to buy and sell futures contracts. The large number of buyers and sellers results in increased liquidity.

Suppose interest rates in the U.S. are 3% while interest rates on comparable bonds in Japan are 1%. By how much is the exchange rate between the yen and dollar expected to change according to the interest-rate parity condition?

The expected change in the value of the dollar is 1%-3% = -2%, implying an expected 2% depreciation in the value of the dollar.

Suppose you buy a stock that sells for $20. It's expected annual dividend is $2 and you expect its price to be $25 in one year. What is your expected rate of return on the stock?

The expected rate of return is $2 / $20 + ($25 - $20) / $20 = 35%.

Briefly explain what was done in the early years of George Washington's administration that helped the United States develop a modern financial system.

The federal government paid off the bonds issued by the Continental Congress and state governments, which reassured investors that they could buy bonds with a reduced risk of default. Congress also established a central bank, the Bank of the United States, which with its branches in several states made loans more widely available to businesses and inspired state governments to allow other private banks to be established. Stock and bond markets were established in New York, Boston, and Philadelphia, and once these financial markets were organized, they provided corporations with a way to raise funds and investors with a way to participate in the growth of the economy by buying part ownership of corporations.

According to the expectations theory, what will be the interest rate on a three-year bond if a one-year bond has an interest rate of 2% and is expected to have an interest rate of 3% next year and 5% in two year? Report your answer using a percentage with two decimal places.

The interest rate on a three-year bond will equal (2 + 3 + 5) / 3 = 3.33%.

Suppose you purchase a call option to buy IBM common stock at $35 per share in September. The current price of IBM is $37 and the option premium is $4. What is the intrinsic value of the option? As the expiration date on the option approaches, what will happen to the size of the option premium?

The intrinsic value of the option is the difference between the current market price of IBM and the strike price. In this case, the intrinsic value would be $2. As the expiration date approaches, the size of the option premium will approach its intrinsic value.

Suppose you are considering buying shares of a stock to hold for one year. The stock has an expected annual dividend of $2 and an expected price at the end of the year of $25. If your required rate of return is 10%, what is the most that you should be willing to pay for the stock? Round off to the nearest cent.

The present value of the stock is $27 / 1.1 = $24.55. You should pay no more than $24.55 for a share of the stock.

Suppose you buy 100 shares of 3M at $86 a share and sell all shares one year later for $99 a share. During the year, you earned a dividend of $2.10 a share. What was your rate of return? Report your answer in percentages with one decimal point.

The rate of return is $2.10 / $86 + ($99 - $86) / $86 = 17.6%.

If the six-month Treasury bill has an interest rate of 0.5%, the ten-year Treasury bond has an interest rate of 1.6%, and a ten-year bond issued by Dell has an interest rate of 4%, what is the risk premium on Dell's bond?

The risk premium is 4% - 1.6% = 2.4%.

If the three-month Treasury bill has an interest rate of 0.2%, the ten-year Treasury bond has an interest rate of 2.75%, and a ten-year bond issued by Time Warner has an interest rate of 6%, what is the risk premium on Time Warner's bond?

The risk premium is 6% - 2.75% = 3.25%.

How is the lemons problem in the used car market an example of asymmetric information?

The seller of a used car has more information about the quality of the car than the potential buyer.

How does the principal-agent problem increase the possibility of moral hazard?

The shareholders, as owners of the firm, are the principals, while the top managers, who are hired to carry out the owner's wishes, are the agents. Although the shareholders are interested in the managers running the firm so as to maximize the value of the shareholders' investment, the managers may have other objectives. Some top managers are accused of being "empire builders" who are interested in making the firm as large as possible through growth and the acquisition of other firms, even if the firm would be more profitable if it were smaller. Other top managers seem more concerned with using corporate jets and holding meetings in expensive vacation spots than with the firm's profits. Managers even have an incentive to underreport profits so that they can reduce the dividends they owe to shareholders and retain the use of the funds.

Suppose 3M pays a dividend of $2 per share which the investor is expected to receive immediately. The dividend is expected to grow by 5% per year and the investor has a required rate of return of 8%. What should be the current price of the stock according to the Gordon growth model?

The stock price should equal $2 × (1.05 / .08-.05) = $70.

What would happen to the value of the dollar if prices in the United States increased more rapidly relative to prices in other countries?

The value of the dollar will decline otherwise the competitiveness of U.S. goods will decline in the global marketplace.

Suppose that investors perceive a higher risk of investing in Europe as a result of a sovereign debt crisis. Make use of a graph of the foreign exchange market to show how this will affect the value of the euro.(Look at page 38 in Chapter 8 to see graph)

There will be reduced demand for euros as foreign investors buy fewer European financial assets.

How do ratings agencies earn income?

They primarily earn income by charging firms and governments for their services.

How do car dealers help reduce adverse selection?

To maintain their reputations with buyers, dealers are less willing to take advantage of private information about the quality of the used cars that they are selling than are individual sellers.

How does the use of collateral and net worth help reduce the problem of adverse selection?

To make it more costly for firms to take advantage of their asymmetric information, lenders often require borrowers to pledge some of their assets as collateral, which the lender claims if the borrower defaults. When the firm's net worth is high, the firm's managers have more to lose by using borrowed money for high-risk investments.

Describe the facts found in the bond market about the relationship between interest rates on bonds of different maturities.

Typically, long-term interest rates are higher than short-term interest rates. Also, interest rates on bonds of different maturities tend to move together.

How does adverse selection in financial markets affect the method by which firms raise funds?

When investors have difficulty obtaining information on good firms, the cost of raising funds for those firms increases. This situation forces many firms to grow primarily through investment of internal funds.

What are the steps involved in using options for a short sale of a stock?

With a short sale, you borrow the stock from your broker and sell it now, with the plan of buying it back—and repaying your broker—after the stock declines in price.

Suppose you purchase a call option with a strike price of $85 for an options price of $10 How much profit will you earn if you exercise it when the price is $100?

You will earn $15 minus the options price of $10 for a profit of $5.