Money and Banking Quiz 2

Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations: your wealth falls

less willing your wealth falls and you have less money to invest. incentive to spend money/invest decreases

Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations: prices in the bond market become more volatile

more willing it becomes less risky to hold stock relative to bonds.

in 2010 and 2011, the government of Greece risked defaulting on its debt due to a severe budget crisis. using bond market graphs, compare the effects on the risk premium between U.S. treasury debt and comparable-maturity greek debt.

As the risk of default by the Greek government increased, this reduced the demand for Greek bonds relative to US bonds. The result was lower prices and higher yields of Greek debt relative to US debt look at notes

in the aftermath of the global economic crisis, that started to take hold in 2008, U.S. government budget deficits increased dramatically, yet interest rates on U.S. treasury debt fell sharply and stayed low for some time. does this make sense? why or why not?

At first, no, because when there is a bigger government deficit, the government issues more bonds and the supply increases (Bs shifts to the right) which would typically lower prices and increase interest rate. however some economists believe that the increased supply would also increase the demand. this make it more ambiguous wether the prices/interest rates will rise or fall. if the demand curve shifts to the right more than the supply curve, the price might increase which would lend to a decrease in interest rates.

if the yield curve suddenly became steeper, how would you revise your predictions of interest rates in the future?

I would expect interest rates to increase in the future. a steep upward-slope to the yield curve indicates that market participants are expecting interest rates to increase in the future.

what will happen in the bond market if the government imposes a limit on the amount of daily transactions? which characteristic of an asset would be affected?

Liquidity of bonds relative to other assets will​ decrease, increasing the interest rate and lowering​ bond's prices.

During 2008, the difference in the yield (the yield spread) between three-month AA-rated financial commercial paper and three-month AA-rated non-financial commercial paper steadily increased from its usual level of close to zero, spiking to over a full percentage points at its peak in October 2008. What explains this sudden increase?

The global financial crisis hit financial companies very suddenly and very hard, creating much uncertainty about the soundness of the financial system, and doubt about the soundness of the healthiest banks and financial companies. As a result, there was a sharp decrease in demand for the financial commercial paper relative to the seemingly safer non-financial commercial paper. this resulted in a spike in the yield spread between the two, reflecting the greater risk of financial company investments.

In the fall of 2008, AIG, the largest insurance company in the world at the time, was at risk of defaulting due to the severity of the global financial crisis. As a result, the U.S. government stepped in to support AIG with the large capital injections and an ownership stake. How would this affect, if at all, the yield and risk premium on AIG corporate debt?

The risk of default would significantly decrease demand for AIG corporate debt, resulting in a much higher yield. After the announcement that the government would provide extraordinary assistance to support AIG and keep it from failing, demand for its corporate debt would rise, and yields would fall.

will there be an effect on interest rates if brokerage commissions on stocks fall? explain your answer.

Yes, interest rates will rise. When brokerage commissions on stocks falls, they become more liquid. the demand for bonds will decrease and the demand curve Bd will shift to the left. the equilibrium bond price falls and the interest rate rises.

If the income tax exemption on municipal bonds were abolished, what would happen to the interest rates on these bonds? what effect would the change have on interest rates on U.S. treasury securities?

abolishing the tax-exempt feature of municipal bonds would make them less desirable relative to Treasury bonds. the resulting decline in the demand for municipal bonds would increase interest rates on the municipal bonds. and the resulting increase in demand for treasury securities would decrease interest rates on treasury bonds.

The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.

do on notebook

Risk premiums on corporate bonds are usually anticyclical (or countercyclical); that is, they decrease during business cycle expansions and increase during recessions. Why is this so?

during business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. during recessions, default risk on corporate bonds increases and the risk premium increases. the risk premium on corporate bonds is thus anti-cyclical, rising during recessions and falling during booms

Assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years, and plot the resulting yield curves for the following paths of one-year interest rates over the next five years: NOTEBOOK. how would your yield curve change if people preferred shorter-term bonds to longer term bonds?

if people preferred short term bonds, their demand would increase relative to long term bonds. this would make short term bond prices increase and their rates decrease. this would drop the long term bond rates as well because they are a simple average of the expected future short term interest rates The upward- and then downward sloping yield curve in (A) would tend to be even more upward sloping if people preferred short-term bonds over long-term bonds because long-term bonds would then have a positive risk premium. The downward- and then upward-sloping yield curve in (B) also would tend to be more upward sloping because of the positive risk premium for long-term bonds.

if the yield curves, on average, were flat, what would this say about the liquidity (term) premiums in the term structure? would you be more or less willing to accept the expectations theory?

if yield curves on average were flat, this would suggest that the risk premium on long-term relative to short-term bonds would equal zero and we would be more willing to accept the expectations theory.

how might a sudden increase in peoples expectations for future real estate prices affect interest rates?

interest rates would rise. a sudden increase in people's expectations of future real estate prices raises the expected return on real estate relative to bonds, so the demand for bonds fall. the demand curve Bd shifts to the left, and the equilibrium price falls, so the interest rate rises.

Explain why you would be more or less willing to buy long-term AT&T bonds under the following circumstances. you expect interest rates to rise

less willing when interest rates rise, the price for bonds fall. therefore, the demand for bonds BEFORE rates go up will fall. this causes prices to fall and rates to rise

Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations: the bond market becomes more liquid

less willing stocks become less liquid relative to bonds

Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations: you expect gold to appreciate in value

less willing you would rather be holding gold which is appreciating ceteris paribus. the return on gold relative to stocks has improved

using both the liquidity preference framework and the supply and demand for bonds framework, show why interest rates are pro-cyclical (rising when the economy is expanding and falling during recessions).

liquidity preference frame work: when the economy booms, the demand for money increases (people need more money to carry out an increased amount of transactions AND their wealth has risen) the demand curve, Md, shifts to the right and the price of money rises (aka the interest rate rises). the opposite is true at the time of recession. bond of supply and demand framework: when the economy booms, the demand for bonds increases (public's wealth has risen) and the supply increases (firms have more attractive investment opportunities). therefore Bd and Bs both shift to the right. But it has been seen that the demand curve shifts less than the supply curve so the price falls and interest rate rises. in a recession, both curves shift to the left, but the demand curve shifts less than the supply curve so the bond prices rise and interest rate falls.

Explain why you would be more or less willing to buy long-term AT&T bonds under the following circumstances. trading in these bond increases, making them easier to sell

more willing bonds have become more liquid and more desirable - increases demand, increases price, lowers interest rate on bond

Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations: you expect the stock to appreciate in value

more willing its relative expected value increases and you would be able to have a greater capital gain

Explain why you would be more or less willing to buy long-term AT&T bonds under the following circumstances. you expect a bear market in stocks (stock prices are expected to decline)

more willing the expected return on the bonds have risen relative to stocks investors will shift from equities to bonds. this increase in the demand for bonds, which increases the price lowers interest rate

Explain why you would be more or less willing to buy long-term AT&T bonds under the following circumstances. brokerage commissions on bonds fall

more willing they have become more liquid stocks are now cheaper for investors to buy. this decreases the demand for bonds, which decrease the price and raises the interest rate

Following a policy meeting on March​ 19, 2009, the Federal Reserve made an announcement that it would purchase up to​ $300 billion of​ longer-term Treasury securities over the following six months. What effect might this policy have on the yield​ curve?

purchase of long term maturities make the price rise and yield fall. the yield curve will become flatter or possibly slope downward.

The U.S. Treasury offers some of its debt as Treasury Inflation Protected Securities, or TIPS, in which the price of bonds is adjusted for inflation over the life of the debt instrument. TIPS bonds are traded on a smaller scale than nominal U.S. Treasury bonds of equivalent maturity. What can you conclude about the liquidity premiums of TIPS versus nominal U.S. bonds

since TIPS bonds are traded much more lightly than their nominal counterparts, demand for these bonds is somewhat lower than comparable U.S. treasuries; hence the higher yield (controlling for the effects of inflation) represents a liquidity premium. because the liquidity effect is relatively small, inflation compensation will generally be larger than the liquidity premium, implying that nominal bonds have overall higher yields than TIPS of comparable maturity.

Which should have the higher risk premium on its interest rates, a corporate bond with a Moody's Baa rating or a corporate bond with a C rating? Why?

the bond with a C rating should have a higher risk premium because it has a higher default risk, which reduces its demand and raises interest rates relative to that of the Baa bond

Predict what will happen to interest rates on a corporation's bonds if the federal government guarantees that it will pay creditors if the corporation goes bankrupt in the future. what will happen to the interest rates on Treasury securities?

the government guarantee will reduce the default risk on corporate bonds, making them more desirable relative to Treasury securities. the increased demand for corporate bonds and decreased demand for Treasury securities will lower interest rates on corporate bonds and raise them on Treasury bonds.

if the expectations of future short-term interest rates suddenly fell, what would happen to the slope of the yield curve?

the yield curve should flatten or slope downward. a flat yield curve means that interest rates are expected to fall slightly. a downward-sloping yield curve means that interest rates are expected to fall significantly in the future

An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public. Using a supply and demand analysis for bonds, show what effect this action has on the interest rates. Is your answer consistent with what you would expect to find with the liquidity preference framework?

when the fed sells bonds to the public, it increases the supply of bonds, shifting the supply curve to the right. this decreases the price of bonds and increases the interest rate. in the liquidity preference framework, the decrease in the money supply shifts the money supply curve to the left and the equilibrium interest rate rises. the answer from bond supply and demand analysis is consistent with the answer from the liquidity preference framework.