Rupayan Gupta

Money, Banking, and Financial Institutions (Econ 353)

Midterm Examination II, June 21 2004

Total points: 16.5×3 questions = 49.5 + 0.5 (for neatness) = 50

Time allotted: 1 hour

This is a closed-book, closed-notes exam. A one page (single-side) ‘cheat sheet’ is allowed. You may use calculators.

A ‘correct’ answer will not fetch you points if you do not demonstrate that you have understood the concept behind it.Remember that the length of your answer is not a substitute for clarity.

There are two sections to this exam. You have to answer three questions. You must compulsorily attempt one question from each section and choose a third from either of the sections. Do not mix questions. Please show all work if you want partial credit.

Part A

  1. (i). Using both the supply and demand for bonds and the liquidity preference frameworks, show what the effect is on interest rates when the riskiness of bonds rises. Are the results same in the two frameworks? ( You need to draw diagrams for both frameworks if you want to earn full credit on this question)

(10 points)

(ii). Predict what will happen to interest rates if prices in the bond market become more volatile. Explain your answer carefully.

(6.5 points)

  1. (i). Assuming that 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 for the following series of one-year interest rates over the next 5 years: 5%, 7%, 7%, 7%,7%.

If you were to draw a yield curve for this series, how would that yield curve change if people preferred shorter-term bonds over longer-term bonds?

(7 + 3 points)

(ii). Predict what would happen to the risk premiums on corporate bonds if brokerage commissions were lowered in the corporate bonds market. Explain your answer carefully.

(6.5 points)

  1. (i). 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 interest rates. Is your answer consistent with what you would expect to find with the liquidity preference framework? ( You need to draw diagrams for both frameworks if you want to earn full credit on this question)

(10 points)

(ii). If the yield curve suddenly becomes steeper, how would you revise your predictions of interest rates in the future. Explain your answer carefully.

(6.5 points)

PartB

  1. (i). After careful analysis, you have determined that a firm’s dividend should grow at 7% on the average in the foreseeable future. Its last dividend was $3. Compute the current price of this stock, assuming the required return is 18%.

(5.5 points)

(ii). “Forecasters’ predictions of inflation are notoriously inaccurate, so their expectations of inflation cannot be rational.” Is this statement true, false, or uncertain? Explain your answer.

(5.5 points)

(iii). “If stock prices did not follow a random walk, there would be unexploited profit opportunities in the market.” Is this statement true,false, or uncertain? Explain your answer.

(5.5 points)

  1. (i). Compute the price of a share of stock that pays a $1 per year dividend and you expect to be able to sell in one year for $20, assuming you require a 15% return.

(5.5 points)

(ii). Suppose that increases in the money supply lead to a rise in stock prices. Does this mean that when you see that the money supply has had a sharp rise in the past week, you should go out and buy stocks? Why or why not?

(5.5 points)

(iii). “An efficient market is one in which no one ever profits from having better information than the rest”. Is this statement true, false, or uncertain? Explain your answer.

(5.5 points)

  1. (i). Intel stock is currently selling for $50 per share today and pays $0.16 per year in dividends. You are satisfied to earn 12% return on investment if you buy Intel stock. The forecast for the share price of Intel is $60 next year. If you want to hold Intel stock for one year and then sell it, would you be making a right decision in buying this stock? Show your calculations fully.

(5.5 points)

(ii). If higher money growth is associated with higher future inflation and if announced money growth turns out to be extremely high, but is still less than what is expected by the market, what do you think would happen to long-term bond prices?

(5.5 points)

(iii). If the public expects a corporation to lose $5 a share this quarter and it actually loses $4, which is still the largest loss in the history of the company, what does the efficiency market hypothesis say will happen to the price of the stock when the $4 loss is announced?

(5.5 points)

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