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School of Business

FNAN 421 Money and Capital Markets

Sample Midterm Examination

NAME: ___________________________________

G#: ________________________

(Answer all questions. Place your answer to each question on a separate sheet of paper. Please write your

name or initials on the top left corner of each page. Document your answers and show your work. Read each

question carefully and answer all parts. Your guess may turn out to be correct. The number in parentheses is

the point weight for the question. Please, turn in this exam with your answers.

(15)

(20)

1. What are the economic functions that financial intermediaries and markets perform that benefit

society? In your answer, discuss the relationships of financial intermediaries and financial markets

to the savings-investment process within an economy and to each other. In addition, provide in

your discussion an analysis of the differences in preferences among economic agents as an

explanation for the wide variety of primary and secondary securities found in financial markets and

the reasons for federal and state regulation of depository institutions and other financial

intermediaries. In this regard, consider what role asset-backed securities, securitization and the

secondary markets for these instruments play in the efficiency of the financial intermediation

process. For example, the mortgage-backed securities secondary markets development and the

funds flows to finance home ownership. In this discussion consider the role of interest rates in

determining the demand for current and future consumption and the relationship of this to

individual and aggregate saving.

2. Using the graph and definitions below of the supply of loanable funds, SLF, and the demand for

loanable funds, DLF, discuss the following:

a.

b.

Illustrate and discuss how an autonomous increase in the expected rate of inflation will

change the equilibrium nominal interest rate. Express your discussion in terms of the effect on

the supply and demand for loanable funds. Consider an initial real rate of interest of 3 percent

and an expected inflation rate of 3 percent. If the expected rate of inflation rises to 4 percent

with the real interest rate constant, what would the resulting nominal interest rate become in

equilibrium using the Fisher relationship? Assume that investors believe the rise in the expected

rate of inflation will remain at the higher level indefinitely.

1

c.

Starting from an equilibrium position as in 1.a, discuss the effects of a tightening monetary

policy if the markets believe that a Fed tightening will lower future (next period) inflation. How

might a recession occur under this scenario?

HINTS: Recall the Fisher relationship where (1+i) = (1+r)(1+pe), where i is the nominal interest

rate, r is the required real rate of return before taxes, and pe is the expected rate of inflation.

DLF = I + G - T + NX

I = investment in real assets;

NX = net exports

G - T = the government deficit (excess of government spending over tax revenues).

SLF = S + Ms - H

S = private savings

H = desired hoarding

Ms = change in the money supply (under Federal Reserve discretionary control).

(15)

3(a).

Discuss the relationship of a coupon bond's price, duration, and convexity of the price-yield

relationship with respect to changes in the bond's maturity, coupon rate, and the market yield to

maturity. Define your terms, state assumptions, and clearly identify the algebraic sign (positive or

negative) in the relationships discussed. You may use diagrams to explain your answer, but

describe clearly each diagram.

3(b)

Compare the interest rate risk of a noncallable 10-year Treasury coupon bearing bond with a

mortgage-backed pass-through security with prepayments related to the level of interest rates

lower market interest rates raise the rate of prepayments. Discuss how the changes in cash flows,

arising from prepayments, on a mortgage-backed security affect the duration of such securities.

HINT: consider the coupon effect on duration.

Macaulay Duration Measure:

M

tC

MF

t

P (1 y )

(1 y ) (1 y ) M

DM

, For a coupon bearing bond : DM tM1

C

F

y P

t

(1 y ) M

t 1 (1 y )

A more complete approximation to the proportional change in price of a bond with respect to a change

in yield to maturity takes into account the convexity of the price-yield relationship for the bond:

dP

P 1

1 2P 1 2

dy

dy

P

y P

2 y 2 P

where P = Price, C = coupon, F = Face value, y = Yield to maturity, M = maturity (years), t = time (year), dP

is the total change in price, and

P

y

maturity. The second term, excluding the dy2, is the convexity effect.

(20)

4.

There are a number of theories of the term structure of interest rates including the unbiased

expectations hypothesis, preferred habitat hypothesis, and market segmentation hypothesis.

Discuss the implications of the unbiased expectations hypothesis within the context of the

following problem. Problem 1: For a two-year, default-free, zero coupon security, compute its

yield to maturity and draw the respective yield curves assuming two different expectations of

inflation employing the Fisher Effect and the data below: (a) 4 percent one year from now, and

(b) 2 percent one year from now. In addition, define and compute the implied forward yield on

a one-year security one year from now, assuming the current two-year yield is 6.0 percent.

Discuss the assumptions underlying this calculation and how it can be used to evaluate the

implied forward yield on a 1-year loan, next year. (c) What is the implied expected rate of

inflation if the real rate remains at 3 percent?

Use the following definitions and values:

2

(a)

(b)

1y1

e

2y1

1y2

R

p1

p2e

p2e

=

=

=

=

=

=

=

0.02 (period 1 rate of inflation)

0.04 (expected period 2 rate of inflation)

0.02 (expected period 2 rate of inflation)

current yield on one-year securities

Expected period 2 yield on one-year securities

current yield to maturity on two-year securities

In general, (1 + 1ym) = [(1 + 1y1)(1 + 2y1e). . .(1 + my1e)]1/m and jy1e = the forward rate, jf1.

Fisher Relationship: (1 + jy1) = (1 + jR1)(1+ jp1e ), where jp1e is the expected rate of inflation for period j for 1

year, and jR1 is the real rate of interest for period j for 1 year.

Specifically, (1 + 1y2) = [(1 + 1y1)(1 + 2y1e)]1/2 and

(1 1 y 2 ) 2

e

.

The expected future 1-year yield factor is: 1 2 y1

(1 1 y1 )

Dont forget to draw the yield curves under assumptions (a) and (b), above, for each of the expected rates of

inflation. Give the reasons for the shapes of these yield curves (HINT: are forward rates on future

short-term securities equal to, greater than, or less than current short-term interest rates).

(20)

5.

2 1

Consider the following bank balance sheet (fixed rates and pure discount securities unless

indicated otherwise). Interest rates on liabilities (yL)are 4 percent and on assets (yA) are 6

percent.

Duration

($millions)

(years)

Super Now Checking Accounts (rates set daily)

$200

1.0

6-Month Certificates of Deposit

80

.5

3-Year Certificates of Deposit

100

3.0

Total Liabilities

380

?

Net Worth

20

-Total Liabilities and Net Worth

400

?

Prime-Rate Loans (rates set daily)

100

2.0

2-Year Auto Loans

130

1.0

30-Year Mortgages

170

7.0

Total Assets

400

?

a.

b.

The bank will (benefit)/(be hurt) if all interest rates rise. Define your terms and state

clearly your assumptions.

DA

L DL

E y

A

(1 y A ) A (1 y L )

3

DA

L DL

1 y A A 1 y L

E

DA

DL

L

A

y

=

=

=

=

=

=

duration of assets,

duration of liabilities,

market value of liabilities,

market value of assets, and

change in interest rates.

c. What is the duration of assets that would be necessary to immunize the market value of

equity from interest rate changes for this banks portfolio holding the DL constant?

(10) 6. Data on weekly stock prices for Microsoft Corporation, Exxon Mobil Corporation and the S&P

500 Index were used to compute the following historical volatility and expected return. Using these results,

answer the following questions:

The historical returns volatility (standard deviation of returns) at an annualized rate for each stock are:

MSFT= 0.182, XOM= 0.120 and S&P500 = 0.108. The expected return for each stock and the index at an

annual rate for MSFT, XOM and S&P500 is respectively:

0.136

0.308

0.105

a. Using the computed (beta) of 0.997 for MSFT and 0.508 for XOM and expected return for

each stock and the S&P 500 index over the past year, draw the Securities Market Line (SML)

using a risk-free rate of 5.37 percent based on the 3-month Libor rate at the time. Do each of the

stocks fall on the SML? Analyze their relative position and which stock is the best buy and why.

HINT: Use the average return of the S&P 500 stock index provided above as the expected

return for the market.

b. Using the data in above and in a. and assuming the average return on the S&P 500 index is a

representation of market expected return and risk, compute the slope of the Capital Market Line

(CML) when the risk-free rate is approximated by the Libor rate given in a. From your results,

what is the market price of risk?

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