Practice Exam I

Econ 353

Fall 2004

For problems 1-10, circle the correct answer (if multiple choice) or do the calculations.  Show your work on the calculations if you wish to receive partial credit.  Problems 1-10 are worth 5 points each.  Answers in BOLD

1.  Rank the following from least liquid to most liquid

a.  bonds                                  c.  real estate

b.  cash                                    b. bonds

c.  real estate                           d. savings deposits

d.  savings deposits                 b. cash

2.  Which of the following statements is NOT consistent with the efficient market

hypothesis:

A.  Stock price movements are unpredictable.

B.  Financial analysts that have recommended successful stocks in the past

will probably recommend successful stocks in the future.

C.  Unexploited profit opportunities will be eliminated.

D.  A positive announcement from a corporation (such as higher profits) doesn’t

necessarily lead to a higher price for that corporation’s stock

3.  Financial futures contracts are different from forward contracts in that:

A.  They specify a future date at which a financial transaction will occur.

B.  The price at which the transaction will occur is decided when the contract

C.  The contract is between the investor and the exchange, thus

eliminating the risk of default.

D.  They are used to hedge.

4.  Which feature of the term structure is effectively explained by the segmented markets theory (assuming people prefer bonds of short maturity)?

A.  Yield curves usually slope upward

B.  When short term interest rates are low, yield curves are likely to slope upward

C.  The yield curve contains a liquidity premium.

D.  Interest rates on bonds of different maturities move together over time.

6.  Calculate the yield to maturity of a coupon bond with face value \$1000 and coupon rate of 10% that matures in one year and whose current price is \$600.

Use the principle that the price of a security today is equal to the present value of its future payments.     Thus,

\$600 = \$1000 / (1+i)

Solving this equation for i yields i = 5/6 or 83.3%

7.  Calculate the current yield on the bond in the problem 6.

Current yield is the amount of a coupon payment divided by the face value.  Each coupon payment is

\$1000 * .10 = \$100, so the current yield is .10.

8.  The table below provides the current yield for one-year bonds today, and the expected yield on these bonds for the next four years.

 Time Period Expected yield Today it 8.2% One year from now iet+1 7.0% Two years from now iet+2 4.8% Three years from now iet+3 4.0% Four years from now iet+4 3.1%

Calculate the current yield for a three-year bond according to the expectations theory of the term structure of interest rates.

The expectations theory of interest rates says that the interest rate on a three year bond is the average of the expected one-year rates from today until three years from now.  That is,

By plugging in the appropriate numbers from the table, one finds that i3t is 20/3% (6.67%)

9.  If pencils serve as a medium of exchange, a store of wealth and a unit of account, pencils have the same functions as:

A.  a checking account

B.  shares of stock

C.  money

D.  reserves

10.   Which of the following is a transaction involving indirect finance

A.  Issue of new shares of stock by a corporation

B.  Purchase of a corporate bond by an individual

C.  Loan to a corporation by a bank

D.  Purchase of a Eurobond by a corporation

Questions 11-15 require short answers.  They are worth 10 points each.

11.  Suppose that due to problems with oil distribution caused by the hurricanes in Florida, oil prices increase, which leads to higher expected inflation.  How will this affect interest rates? (You might want to use graphs)

An increase in expected inflation reduces the demand for bonds because the expected returns on real assets, such as real estate and cars rise.  A lower bond price and higher interest rates are the result.  Also, the increase in expected inflation reduces the real costs of borrowing, making borrowing more attractive.  Thus, businesses will issue more bonds, increasing the supply for bonds.  This effect will further reduce the bond price and, therefore, cause interest rates to rise even further.

12.  Why might you be willing to make a loan to your neighbor whom you don’t know very well by putting money into a savings account and having the bank issue her a loan instead of directly loaning her the money?

If you don’t know your neighbor well, you may not know if she’ll pay you back or not.  A bank posseses (or can possess) information about your neighbor that you cannot which gives the bank a better idea of whether she’ll pay back the loan.

13.  Suppose that due to unstable business conditions stocks become more risky relative to bonds.  How will this affect interest rates? (You may want to use a graph)

The increased relative risk of stocks will make bonds relatively less risky, which will increase the demand for bonds, resulting in a higher bond price and, therefore, lower interest rates.

14.   Can someone with rational expectations expect the price of Microsoft stock to increase by 5% during the next month?  Why or why not?

It depends.  If this price increase does not imply returns above (or below) the equilibrium return, then then answer is yes.  Note that a 5% monthly increase in the stock price implies an almost 80% annual return, not considering dividends, so this is likely higher than the equilibrium.  If the price increase implies returns above the equilibrium return then the market price of the stock will fall until equilibrium returns are restored, so that a rational person would not expect such a price increase to be possible.

15.  Suppose you have a long position on U.S. Treasury bonds with face value \$100,000 selling at par that mature in 2024.  How could you hedge the interest-rate risk you face by using futures contracts that sell for \$1,000 each that expire in 2 years?

You could sell futures contracts (i.e., take a short position on these contracts).  You would have to sell \$100,000 / \$1000 = 100 futures contracts to completely hedge the interest rate risk.   In 2 years, the bonds will have a certain value, call it V2.  Thus, in the 2 years you will have lost (or gained) V2-\$100,000 by holding the bonds.  On the other hand you will gain (or lose) \$100,000-V2 when you deliver the bonds to the purchaser of the futures contract.  Thus, your net gain is zero.