Page 1 of 6 Economics 176 2010 - Exam #1 Name_________________________

Print your name neatly. There are 4 pages and 100 points. The points for each question are given in brackets []. Read each question carefully. Answer using material only from class, the book, and special readings. There are two helpful formulas provided at the end. Fill in the blank / or circle the correct answer that BEST completes the statement or answers the question. 1) I purchase Bond A. Immediately after I make the purchase, interest rates fall. Thus, would I prefer that Bond A is a 10-year bond or a 5-year bond? __________________. (Assume a flat yield curve.) [5] 2) A 10-year coupon bond has a coupon rate of 15 percent and a face value of $1,000. 2a) In year 10, this bond makes a payment of _$1150________. [2] 2b) In year 5, this bond makes a payment of ___$150____________. [2] 2c) If the yield to maturity increases, however, then the coupon payment will ___remain the same_______________. [3] 2d) If this bond currently sells for $1,100, then the yield to maturity is [greater than 15% / less than 15% / equal to 15%]. [3] 3) The one-year rate of return on a 10% coupon bond with a face value of $5,000 that initially sells for $1,000 and sells for $500 one year later is: [5] (a) -10% (b) 0% (c) 10% (d) 100% (e) -100% 4) If the yield curve is inverted and the yield to maturity on a 5-year bond is 10%, then the yield to maturity on a 6-year bond is typically: [5] [greater than 10% / less than 10% / equal to 10%]. 5) The Federal Reserve entity that sets monetary policy strategy is the (no abbreviations) [5] ______ FOMC Federal Open Market Committee ________________________ . 6) Besides acting as the governments bank, facilitating the payments system, and conducting monetary policy, and two other functions of the Federal Reserve are ____________ financial stability and regulating banks ____________________. [5]

Page 2 of 6 (1) MULTIPLE CHOICE: Circle ALL true statements: [15] [3 points off for each one wrong, up to 15 since they are all basic bond type questions.] A) The longer a bond's maturity, the larger is a bonds duration, holding other factors constant. B) A bond with a larger coupon rate will have a shorter duration, holding other factors constant. C) Prices and returns for long-term bonds are more volatile than those for shorter-term bonds, holding other factors constant. {full credit for circled or not circled} D) A municipal bond typically has a higher yield to maturity than a Treasury bond. E) A municipal bonds yield to maturity will rise if its liquidity falls, holding other things constant. F) An inverted yield curve could be explained by an expected drop in inflation. G) An inverted yield curve could be explained by an expected recession 2) An open market sale of securities by the Fed to banks will [5] A) decrease liabilities of the Fed and not affect total assets of the banking system. B) decrease total assets of banks and decrease assets of the Fed. C) increase liabilities of the banking system and increase assets of the Fed. D) have no effect on assets of banks but increase liabilities of the Fed. E) decrease total assets of the banking system and increase assets of the Fed. 3) You expect two things to happen: First, you expect a reduction in inflation. Second, you expect greater risk of default on corporate bonds. When combining these two events, what do you expect to happen to the yield to maturity on treasury securities? [5] A) rise B) fall C) ambiguous

4) When there is an expected economic expansion, the demand curve for bonds shifts to the ________, the supply curve shifts to the __________, and (given these shift and what we actually saw in the data from class and the book) we expect the yield to maturity to ____________. [5] (A) right; left; falls, (B) right; left; rises, (C) left; left; falls, (D) right; right; rises, (E) right; right; falls, (F) left; left; rises 5) In year 0, a 10-year coupon bond has duration of 3. In year 1, the duration on the same bond will [5] A) be less than three. B) be more than three. C) cant tell without making additional assumptions.

Page 3 of 6 MULTIPLE CHOICE: Circle ALL that apply 1) The Fed conducts open market purchases of Treasury securities from banks. In normal times, we expect the following to occur. (Circle all that are true.) [5] A) Initially reserves will rise, but then they will fall as banks lend more through the discount window. B) Initially reserves will rise, but then they will fall as banks increase commercial lending. C) Interest rates on commercial loans will tend to fall. D) None of these statements is true. 2) Let: i1 be the yield to maturity on a one-year bond, i2 be the yield to maturity on a two-year bond, i3 be the yield to maturity on a three-year bond, 0i1 be the one year interest rate between year 0 and year 1, 1i2 be the one year interest rate between year 1 and year 2, and 2i3 be the one year interest rate between year 2 and year 3. Bond A is a one-year zero coupon bond with a face value of $1,000. Bond B is a two-year zero coupon bond with a face value of $9,000. Bond C is a three-year zero coupon bond with a face value of $27,000. All bonds currently, i.e. in year zero, sell for $1,000.
A)

What are i1, i2, and i3? [5]

1. For Bond A
PV = CPt /(1 + i ) t
t =1

1000 = 1000 1 /(1 + i1 )1

1 = (1 +i1 ) i1 = 0%

2. For Bond B
1000 = 9000 2 /(1 + i2 ) 2 1 / 9 = 1 /(1 + i2 ) 2 9 = (1 + i2 ) 2 3 = (1 + i2 ) i2 = 200 %

3. For Bond C
1000 = 27000 3 /(1 + i3 ) 3 1 / 27 = 1 /(1 + i3 ) 3 27 = (1 + i3 ) 3 3 = (1 + i3 ) i3 = 200 %

B)

What are 0i1, 1i2, and 2i3? [5]

Page 4 of 6
1.

To value of 0i1 is the same as the interest rate on a one year Bond which was calculated above to be 0% For 1i2 we can use the Bond B to calculate its value.
9000 2 (1+0 i1 )(1+ i2 ) 1

2.

1000 = 1/ 9 =

1 (1+0 i1 )(1+ i2 ) 1
1 (1)(1+ i2 ) 1

Since we already know 0i1 we can plug this value into the equation and solve for 1i2
1/ 9 =

9 =(1+ i2 ) 1 8= i2 1

For 1i2 we can use Bond C to calculate its value. 27000 3 1000 = (1+0 i1 )(1+1 i2 )(1+2 i3 ) Plugging in the values we already determined we get:
3.

1000 =

27000 3 (1)( 9)(1+2 i3 )

1 1 = 3 (1+2 i3 ) 3 = (1+2 i3 ) 2=2 i3

3) Ruths Financial Institution has $200 billion in assets, owes $100 billion to debt holders, and therefore has a net worth of $100 billion. The assets have duration equal to 2. Ruth wants to select the duration of the debt so that the net worth does not change when interest rates change. What should she set the duration of debt equal to? [5] (1) DURgap = DURA DURL*L/A Set this to zero to make the banks net worth immune to interest rate changes DURgap = DURA DURL*L/A = 0 0= 2 - DURL*100/200 *DURL=2 DURL=4 4) During the recent crisis, the FEDs balance changed dramatically. What was the biggest change on (a) the liabilities side and (b) the asset side of the FEDs balance sheet (provide the specific items)? [5]

Page 5 of 6 A. There was an increase in reserves. B. The FED added Mortgage Backed Securities and added a significant amount of them. Quantitative Problem Consider Adam Smith Bank Corporation. At time zero, it has four assets. Asset A is a three-year coupon bond with a face value of $100 and a coupon rate of 100%. Asset B is a one-year discount bond with a face value of $100. Asset C is two-year discount bond with a face value of $100. Asset D is a three-year discount bond with a face value of $200. The yield to maturity is 100%. The yield curve is flat and does not change. (1) What is the total value of Adam Smith Bank Corps four assets at time zero? [5]
PV = CPt /(1 + i ) t
t =1

Time Bond A:CP(t) Bond B:CP(t) Bond C:CP(t) Bond D:CP(t) Sum of all CP (1+i)t PV of CP(t) = CPt /(1 + i ) t

1 $100 $100 $0 $0 $200 2 $100

2 $100 $0 $100 $0 $200 4 $50

3 $200 $0 $0 $200 $400 8 $50

Sum

$200

Therefore the PV of all of the banks assets at time zero is $200. (2) What is the duration of Adam Smith Bank Corps assets at time zero? [5] Time 1 t PV of CP(t) = CPt /(1 + i ) t*[PV of CP(t)] = t * CPt /(1 + i ) t $100 2 $100 $100
t

3 $50 $150 $50

Sum $200 $350

n tCP (t ) DURloan 2 = t t =1 (1 + i )

CP(t ) /(1 + i) =$350/$200=7/4=1.75

t =1

(3) On the liabilities side of Adam Smith Bank Corps balance sheet, the only non-equity (i.e., non-net worth) liabilities are bonds. Adam Smith Bank wants to choose the duration of these bonds, so that the net worth of the bank is immune to interest rate changes The Banks net worth at time zero is $100. What would it set the duration of the bonds to be? [5]

Page 6 of 6

NW=Assets-Liabilities $100=$200-Liabilities Liabilities=$100 DURgap = DURA DURL*L/A Set this to zero to make the banks net worth immune to interest rate changes 0=7/4- DURL *100/200 DURL =(7/4)*(2)=(7/2)=3.5 The Bank should set the duration of bonds equal to 3.5 years.

These might be useful:

P / P = i DUR (1 + i )

n tCP (t ) DUR = t t =1 (1 + i )

CP (t ) /(1 + i)
t =1