A Money Market Mutual Fund Is a Common Type of Financial Intermediary

FNCE 4070 – Midterm 1 – October 3

A money market mutual fund is a common type of financial intermediary.
What advantages does a money market mutual fund provide over individual investments in the money markets?
In late 2007 several money market funds found themselves in difficulties and had to be bailed out by their parent companies over what type of commercial paper?
In September 2008 the reserve fund broke the buck? What does this mean and why was it important to investors?

Assume the expectations theory of interest rates. If the 52W T-bill rates is 4.5% and 10 year treasury bond rate is 2% would you expect the 1 year forward 9- year treasury price to be higher or lower than par? Explain your answer.

Mutual savings banks are financial intermediaries that take deposits and primarily use these to fund mortgages.
Give an example of moral hazard for which these institutions might alleviate this asymmetric information risk.

Give an example of adverse selection for which these institutions might alleviate this asymmetric information risks.

The ECB recently announced a bond-buying program for three-year government bonds if the country requests and accepts the conditions for a bailout. If immediately prior to this announcement the Spanish government had sold a 3-yearannual coupon bond for 100 EUR with a face amount of 100 EUR and a coupon of 7.5% and the 3-yearyield to maturity changed to 7% after the announcement, how much would a holder of one of these bonds make in EUR.

The following chart shows the relationship between the British Pound (GBP) and the Euro (EUR).
If 1 Euro is worth less than one Pound then in what units is the following graph?
In what month would an English family have preferred to travel to Europe?
Does an exchange rate of 1.34 represent a strengthening of the EUR vs the GBP or weakening relative to the exchange rate on September 18th, 2012 (the last date on this graph)?

What is the difference between interest rate risk and reinvestment risk? Phrase differently. What is IR risk? What is reinvestment risk?

Currently are short-term (less than one year)real interest rates positive or negative? Why?

Name three factors that affect the supply of bonds. Explain how changes in each will affect the market equilibrium for bonds?

Consider the theories of the term structure of interest rates.
By what three criteria did we use to analyze the expectations theory, the premium liquidity theory and the market segmentation theory?

Which of these criteria does the liquidity premium theory of interest rates explain which the expectations theory does not?

We have a 13W T-bill with a quote of 1.5% and a 26W T-bill with a quote of 2%.
Assume that the expectations theory of interest rates is correct. What is the expected quote on a 13W T-bill in 13 weeks time?

Assume I have two portfolios of bonds, one with a present value of $20m and aduration of 2 years and the other with a present value of $40m and a duration of 5 years. What is the duration of the combined portfolio?

A bond has 3-year to maturity, pays an annual coupon of 3%, has a par value of $100 and a yield of 3.5%.
What is its present value?

If its yield to maturity moved to 3.75% would you expect its duration to increase or decrease? Why?

Imagine a 3-yearannual coupon bond with a par value of 100 andacoupon rate of 3%.
I buy the bond today for 100. I will hold the bond for two years. If I assume that reinvestment rate on cashflows is 4% and the yield to maturity on the bond when I sell it is 4% then what will my return on the bond be.

Probability / Return
25% / 2%
50% / 3%
25% / 4%

If my distribution of returns changes to

Probability / Return
30% / 2%
40% / 3%
30% / 4%

What has happened to the riskiness of the bond?

If I see the behavior as suggested in (b) would I expect demand for this bond to increase or decrease? Explain.

Assume the Market Segmentation Theory of the term structure of interest rates. Assume that there are 4 investable markets for bonds – short-term corporates, short-term Treasuries, long-term corporates and long-term Treasuries. Assume that the initial corporate yield curve looks like:

Draw supply and demand curves for short-term treasuries.
The Federal Reserve has embarked on an open market operation where they are buying long-term treasuries. Draw supply and demand curves for short-term and long-term treasuries.
In addition to the operation described in (b) the Federal Reserve embarks on an open market operation where they sell short-term treasuries. Draw the supply and demand curves for short-term and long-term treasuries.
Copy the graph of the corporate yield curve before the Fed has embarked on any open market operations. On the same graph draw the expected corporate yield curve after the operation described in (b). On the same graph draw the expected corporate yield curve after the operation described in (c).

Which instrument is worth more today? A 26W T-bill with a quote of 25 basis points or a 182 piece of commercial paper with an investment rate of 25 basis points and a par value of 100?

The current 1 year interest rate is 3%. Economists forecast one-year interests of3.5%, 4%, 4% and 5% for years 2, 3, 4 and 5. These are all annualized interest rates.
Complete the following table.

Cashflow / Maturity / Present Value
50 / 1
1050 / 3

Now assume the liquidity premium theory for interest rates. If the liquidity premium for two years is 0.20% and for 3 years is 0.30% then complete the following table:

Cashflow / Maturity / Present Value
50 / 1
1050 / 3

From December 1979 to June 1981 the Fed Funds rate was raised by Paul Volker, the chairman of the Federal Reserve, from 12% to a peak of 20%. Why did he do this? Why did he expect this to be an effective strategy?