Green – easy

Orange – intermediate

Red - difficult

Mid-Term questions – October 3rd

  1. A money market mutual fund is a common type of financial intermediary.
  2. What advantages does a money market mutual fund provide over individual investments in the money markets?
  3. In September 2008 the reserve fund broke the buck? What does this mean and why was it important to investors?
  4. Explain the difference between moral hazard and adverse selection. Give an example of both and explain how a financial intermediary might mitigate these issues.
  5. 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.
  6. What are the two primary drivers in cost-push inflation?
  7. The following chart shows the relationship between the British Pound (GBP) and the Euro (EUR).
  8. If 1 GBP is worth more than one EUR what units is the following graph in.
  9. In what month would an English family have preferred to travel to Europe?
  10. 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)?

  1. What is the difference between interest rate risk and reinvestment risk?
  2. What is the difference between nominal and real interest rates? Which is a better indication of the incentives to borrow? Why? Are short-term real interest rates positive or negative currently?
  3. Name three factors that affect the supply of bonds. Explain how changes in each will affect the market equilibrium for bonds?
  4. What are the three criteria by which we analyzed term structure theories of interest rates?Which criteria does the liquidity premium theory of interests explain which the expectations theory?
  5. Assuming the expectations theory of interest rates if the 52W T-bill rates is 4.5% and 10 year treasury bond rateis 3% would you expect the 1 year forward 9 year treasury price to be higher or lower than par? Explain your answer.
  6. Assume that the expectations theory of interest rates is correct.
  7. If the quote on a 13W T-bill is 1.5% and the quote on a 26W T-bill is 2% then what is the expected quote on a 13W T-bill in 13 weeks time?
  8. If this quote were 5% what would be the expected investment rate?
  9. Assume that the liquidity premium theory of interest rates is correct. If the quote on a 13W T-bill is 1.5% and the quote on a 26W T-bill is 2% then what is the implied liquidity premium if the expected rate on a 13W T-bill in 13 weeks time is 1.5%?
  10. 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?
  11. A recently issued 2-year T-note has a quoted rate of 3.1% and a coupon rate of3%.
  12. What is its present value?
  13. What is its duration?
  14. If its quote moved to 41 basis points would you expect its duration to increase or decrease? Why?
  15. I purchase a 3-year bond with a face value of 100, an annual coupon of 3% for 100. Assume that coupons are reinvested with a 3% rate. Assume that the forward yield to maturity of this bond has a distribution of:

Rate / Probability
3% / 25%
4% / 50%
5% / 25%

a)What is the expected return on this bond assuming I sell it in 2 years?

b)What is the standard deviation of returns after 2 years?

c)If the distribution of returns changes to be as follows would I expect demand for this bond to increase or decrease? What effect should this have on the price of the bond?

Rate / Probability
3% / 30%
4% / 40%
5% / 30%
  1. 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:
  1. Draw supply and demand curves for short-term treasuries.
  2. 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.
  3. 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.
  4. 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).
  1. 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?
  2. The current 1 year interest rate is 3%. The forecast for one-year interest rates are 3.5%, 4%, 4% and 5% for years 2, 3, 4 and 5.
  3. Complete the following table.

Cashflow / Maturity / Present Value
50 / 1
50 / 2
1050 / 3
  1. 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
50 / 2
1050 / 3