university of toronto department of economics
UNIVERSITY OF TORONTO DEPARTMENT OF ECONOMICS Money, Banking & Financial Markets ECO349H5F (LEC0101) MICHAEL HO MID-TERM TEST – SOLUTIONS DURATION: 90 MINUTES OCTOBER 16, 2013 IMPORTANT: (i) (ii) (iii) (iv) (v) (vi)
This test should be answered in ballpoint pen and any part done in pencil will not be eligible for re-assessment. You must put all your answers to Part A in the table provided on page 2 or a 10-mark penalty will be imposed. Answer all Part B questions in point form and only in the designated pages. Answer every part of all the questions and clearly label each part of your answer. Please ensure your handwriting is legible. Only non-programmable calculators are allowed. A 10-mark penalty will be imposed if any page is separated from this test.
Student Name (Print Clearly):
Student ID#:
Part A
Part B
Question
A1 – A25
B1
B2
B3
Total
Marks
50
20
16
14
100
(a)
15 50
(b) Score Version B
10 16
5 50
20
4 16
100
14 Page 1 of 8
PART A (50 Marks): Answer all twenty-five multiple-choice questions and write each answer only in the table below or a 10-mark penalty will be imposed. Part A – Answers A1
A2
A3
A4
A5
A6
A7
A8
A9
A10
B
C
A
A
C
A
A
B
B
A
A11
A12
A13
A14
A15
A16
A17
A18
A19
A20
A
D
A
A
C
A
A
A
B
A
A21
A22
A23
A24
A25
A
A
A
B
D
A1. (A) (B) (C) (D)
Changes in stock prices ________. do not affect people's wealth and their willingness to spend affect firms' decisions to sell stock to finance investment spending are predictable are unimportant to decision makers
A2. (A) (B) (C) (D)
A sharp increase in the growth of the money supply is likely followed by ________. a recession a depression an increase in the inflation rate no change in the economy
A3. (A) (B) (C) (D)
Which of the following can be described as involving direct finance? A corporation issues new shares of stock. People buy shares in a mutual fund. A pension fund manager buys a short-term corporate security in the secondary market. An insurance company buys shares of common stock in the over-the-counter markets.
A4. (A) (B) (C) (D)
Prices of money market instruments undergo the least price fluctuations because of ________. the short terms to maturity for the securities the heavy regulations in the industry the price ceiling imposed by government regulators the lack of competition in the market
A5.
Asymmetric information is a universal problem. This would suggest that financial regulations ________. in industrial countries are an unqualified failure differ significantly around the world in industrialized nations are similar are unnecessary
(A) (B) (C) (D)
Version B
Page 2 of 8
A6. (A) (B) (C) (D)
In a barter economy the number of prices in an economy with N goods is ________. [N(N - 1)]/2 N(N/2) 2N N(N/2) - 1
A7.
People hold money even during inflationary episodes when other assets prove to be better stores of value. This can be explained by the fact that money is all of the following except ________. perfectly liquid a unique good for which there are no substitutes the only thing accepted in economic exchange backed by gold
(A) (B) (C) (D) A8. (A) (B) (C) (D) A9. (A) (B) (C) (D)
A10.
There is no single precise measure of money or the money supply for economists because ________. the government considers money supply statistics to be confidential and refuses to publish them deciding what is generally accepted in payment for goods and services or in the repayment of debt is difficult to determine economists cannot agree if currency should be considered money definitions change all the time During hyperinflations, ________. the value of money rises rapidly money no longer functions as a good store of value and people may resort to barter transactions on a much larger scale middle-class savers benefit as prices rise money's value remains fixed to the price level; that is, if prices double so does the value of money
(A) (B) (C) (D)
Introduction of cheques into the payments system reduced the costs of exchanging goods and services. Another advantage of cheques is that ________. they provide convenient receipts for purchases they can never be stolen they are more widely accepted than currency the funds from a deposited cheque are available for use immediately
A11. (A) (B) (C) (D)
The measures of money supply used by the Bank of Canada are ________ indices. simple-sum complex multiplicative accurate
A12.
The price of a coupon bond and the yield to maturity are ________ related; that is, as the yield to maturity ________, the price of the bond ________. positively; rises; rises negatively; falls; falls positively; rises; falls negatively; rises; falls
(A) (B) (C) (D)
Version B
Page 3 of 8
A13. (A) (B) (C) (D) A14. (A) (B) (C) (D) A15. (A) (B) (C) (D) A16. (A) (B) (C) (D) A17. (A) (B) (C) (D) A18.
(A) (B) (C) (D) A19. (A) (B) (C) (D) Version B
Which of the following is generally true of bonds? The only bond whose return equals the initial yield to maturity is one whose time to maturity is the same as the holding period. A rise in interest rates is associated with a fall in bond prices, resulting in capital gains on bonds whose terms to maturity are longer than the holding periods. The longer a bond's maturity, the smaller is the size of the price change associated with an interest rate change. Prices and returns for short-term bonds are more volatile than those for longer-term bonds. The nominal interest rate minus the expected rate of inflation ________. defines the real interest rate is a less accurate measure of the incentives to borrow and lend than is the nominal interest rate is a less accurate indicator of the tightness of credit market conditions than is the nominal interest rate defines the bank rate Risk premiums on corporate bonds tend to ________ during business cycle expansions and ________ during recessions, everything else held constant. increase; increase increase; decrease decrease; increase decrease; decrease A business cycle expansion increases income, causing money demand to ________ and interest rates to ________, everything else held constant. increase; increase increase; decrease decrease; decrease decrease; increase When stock prices become more volatile, the ________ curve for gold shifts right and gold prices ________, everything else held constant. demand; increase demand; decrease supply; increase supply; decrease Everything else held constant, if the expected return on bonds falls from 10 to 5 percent and the expected return on GE stock rises from 7 to 8 percent, then the expected return of holding GE stock ________ relative to bonds and the demand for GE stock ________. rises; rises rises; falls falls; rises falls; falls When the inflation rate is expected to increase, the ________ for bonds falls, while the ________ curve shifts to the right, everything else held constant. demand; demand demand; supply supply; demand supply; supply Page 4 of 8
A20. (A) (B) (C) (D)
When talking about a coupon bond, face value and ________ mean the same thing. par value coupon value amortized value discount value
A21. (A) (B) (C) (D)
Bonds whose term-to-maturity is longer than the holding period are subject to ________. interest rate risk exchange-rate risk inflation deflation
A22.
If a corporation begins to suffer large losses, then the default risk on the corporate bond will ________. increase and the bond's return will become more uncertain, meaning the expected return on the corporate bond will fall increase and the bond's return will become less uncertain, meaning the expected return on the corporate bond will fall decrease and the bond's return will become less uncertain, meaning the expected return on the corporate bond will fall decrease and the bond's return will become less uncertain, meaning the expected return on the corporate bond will rise
(A) (B) (C) (D)
A23. (A) (B) (C) (D)
A24. (A) (B) (C) (D)
A25. (A) (B) (C) (D) Version B
Which of the following statements is true? Because coupon payments on tax-exempt bonds are exempt from federal income tax, the expected after-tax return on them will be higher for individuals in higher income tax brackets. An increase in tax rates will decrease the demand for tax-exempt bonds, lowering their interest rates. Interest rates on tax-exempt bonds will be higher than comparable bonds without the tax exemption. Because coupon payments on tax-exempt are exempt from federal income tax, the expected after-tax return on them will be lower for individuals in higher income tax brackets. According to the liquidity premium theory of the term structure ________. because buyers of bonds may prefer bonds of one maturity over another, interest rates on bonds of different maturities do not move together over time the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a term premium because of the positive term premium, the yield curve will not be observed to be downward sloping the interest rate for each maturity bond is determined by supply and demand for that maturity bond According to the expectations theory of the term structure ________. when the yield curve is steeply upward sloping, short-term interest rates are expected to remain relatively stable in the future when the yield curve is downward sloping, short-term interest rates are expected to remain relatively stable in the future investors have strong preferences for short-term relative to long-term bonds, explaining why yield curves typically slope upward yield curves should be equally likely to slope downward as slope upward Page 5 of 8
B1.
Assume a bond has three years to maturity in which one coupon payment of $160 will be received at the end of each year, and a face value of $1,000. Suppose the current interest rate is 16% (Year 1). There are only two possible scenarios with equal probability: Scenario A – interest rate will rise 3% every year in Year 2 and Year 3; and Scenario B – interest rate will drop 3% every year in Year 2 and Year 3. Your investment strategy is to buy the bond and hold it for only one year. The timeline below helps you visualize the timing of cash flows. (a) Complete the table below. Show your calculation or a zero will be given. (15 marks) (b) What is the maximum price that you should pay for this bond? Briefly explain why you might be more determined to invest in this bond when it is sold at par in the market if Scenario B has a higher probability than Scenario A. (5 marks)
(a) Scenario A
Scenario B
Coupon payment received in Year 2 and discounted to the beginning of Year 2
134.45
141.59
Coupon payment received in Year 3 and discounted to the beginning of Year 2
110.21
128.72
Face value received in Year 3 and discounted to the beginning of Year 2
688.80
804.51
Bond price at the beginning of Year 2
933.46
1,074.82
Present value of coupon payment received in Year 1
137.93
137.93
Present value of all cash flows
942.64
1,064.50
Weighted Outcome
471.32
532.25
Expected present value of all cash flows (b)
Version B
1,003.57
Since the expected present value of all cash flows worth $1,003.57, which is the maximum price that you should pay for this bond. Scenario B represents favourable outcome to existing bondholders when interest rate falls 3% each year in Year 2 and Year 3 as interest rate and bond price move in opposite direction, which helps to boost the expected bond price above par at the beginning of Year 2 ($1004.14, which is the weighted outcome of $933.46 and $1,074.82). If the bond is sold at par in the market, the expected present value of profit is only $3.57, which is quite insignificant. A higher probability for Scenario B (favourable outcome) will definitely boost the expected present value of all cash flows more significantly above par and make you more determined in favour of buying the bond.
Page 6 of 8
B2.
Explain the factors that shift the demand and supply of money curves in Keynes’s liquidity preference analysis. (16 marks)
Income and price level are the factors causing the demand curve for money to shift in Keynes’s liquidity preference analysis. Income would affect the demand for money because: (i)
As an economy expands and income rises, wealth increases and people will want to hold more money as a store of value.
(ii)
As the economy expands and income rises, people will want to carry out more transactions using money, with the result that they will also want to hold more money. A higher level of income causes the demand for money to increase and the demand curve to shift to the right.
Keynes took the view that people care about the amount of money they hold in real terms. When the price level rises, the same nominal quantity of money is no longer as valuable, it cannot be used to purchase as many real goods and services. To restore their holdings of money in real terms to their former level, people will want to hold a greater nominal quantity of money, so a rise in the price level causes the demand for money to increase and the demand curve to shift to the right. It is assumed that the supply of money is completely controlled by the central bank (Bank of Canada), an increase in the money supply engineered by the Bank will shift the supply curve for money to the right.
Version B
Page 7 of 8
B3.
(a) (b)
(a)
What are the impacts of rising interest rates on bonds with different maturities when all bonds are purchased at par? (10 marks) Why some people are puzzled by these observed phenomena? (4 marks)
The only bond whose return equal the initial yield to maturity is one whose time to maturity is the same as the holding period. A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds whose terms to maturity are longer than the holding period. The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest-rate change. The more distant a bond’s maturity, the lower the rate of return that occurs as a result of the increase in interest rate. Even though a bond has a substantial initial interest rate, its return can turn out to be negative if interest rate rises.
(b)
Version B
Most students are puzzled by the fact that a rise in interest rates can mean that a bond has been a poor investment, it is important for them to recognize that a rise in the interest rate means that the price of a bond has fallen and hence a capital loss, which can be significant to make a bond poor investment.
Page 8 of 8
This test should be answered in ballpoint pen and any part done in pencil will not be eligible for re-assessment. You must put all your answers to Part A in the table provided on page 2 or a 10-mark penalty will be imposed. Answer all Part B questions in point form and only in the designated pages. Answer every part of all the questions and clearly label each part of your answer. Please ensure your handwriting is legible. Only non-programmable calculators are allowed. A 10-mark penalty will be imposed if any page is separated from this test.
Student Name (Print Clearly):
Student ID#:
Part A
Part B
Question
A1 – A25
B1
B2
B3
Total
Marks
50
20
16
14
100
(a)
15 50
(b) Score Version B
10 16
5 50
20
4 16
100
14 Page 1 of 8
PART A (50 Marks): Answer all twenty-five multiple-choice questions and write each answer only in the table below or a 10-mark penalty will be imposed. Part A – Answers A1
A2
A3
A4
A5
A6
A7
A8
A9
A10
B
C
A
A
C
A
A
B
B
A
A11
A12
A13
A14
A15
A16
A17
A18
A19
A20
A
D
A
A
C
A
A
A
B
A
A21
A22
A23
A24
A25
A
A
A
B
D
A1. (A) (B) (C) (D)
Changes in stock prices ________. do not affect people's wealth and their willingness to spend affect firms' decisions to sell stock to finance investment spending are predictable are unimportant to decision makers
A2. (A) (B) (C) (D)
A sharp increase in the growth of the money supply is likely followed by ________. a recession a depression an increase in the inflation rate no change in the economy
A3. (A) (B) (C) (D)
Which of the following can be described as involving direct finance? A corporation issues new shares of stock. People buy shares in a mutual fund. A pension fund manager buys a short-term corporate security in the secondary market. An insurance company buys shares of common stock in the over-the-counter markets.
A4. (A) (B) (C) (D)
Prices of money market instruments undergo the least price fluctuations because of ________. the short terms to maturity for the securities the heavy regulations in the industry the price ceiling imposed by government regulators the lack of competition in the market
A5.
Asymmetric information is a universal problem. This would suggest that financial regulations ________. in industrial countries are an unqualified failure differ significantly around the world in industrialized nations are similar are unnecessary
(A) (B) (C) (D)
Version B
Page 2 of 8
A6. (A) (B) (C) (D)
In a barter economy the number of prices in an economy with N goods is ________. [N(N - 1)]/2 N(N/2) 2N N(N/2) - 1
A7.
People hold money even during inflationary episodes when other assets prove to be better stores of value. This can be explained by the fact that money is all of the following except ________. perfectly liquid a unique good for which there are no substitutes the only thing accepted in economic exchange backed by gold
(A) (B) (C) (D) A8. (A) (B) (C) (D) A9. (A) (B) (C) (D)
A10.
There is no single precise measure of money or the money supply for economists because ________. the government considers money supply statistics to be confidential and refuses to publish them deciding what is generally accepted in payment for goods and services or in the repayment of debt is difficult to determine economists cannot agree if currency should be considered money definitions change all the time During hyperinflations, ________. the value of money rises rapidly money no longer functions as a good store of value and people may resort to barter transactions on a much larger scale middle-class savers benefit as prices rise money's value remains fixed to the price level; that is, if prices double so does the value of money
(A) (B) (C) (D)
Introduction of cheques into the payments system reduced the costs of exchanging goods and services. Another advantage of cheques is that ________. they provide convenient receipts for purchases they can never be stolen they are more widely accepted than currency the funds from a deposited cheque are available for use immediately
A11. (A) (B) (C) (D)
The measures of money supply used by the Bank of Canada are ________ indices. simple-sum complex multiplicative accurate
A12.
The price of a coupon bond and the yield to maturity are ________ related; that is, as the yield to maturity ________, the price of the bond ________. positively; rises; rises negatively; falls; falls positively; rises; falls negatively; rises; falls
(A) (B) (C) (D)
Version B
Page 3 of 8
A13. (A) (B) (C) (D) A14. (A) (B) (C) (D) A15. (A) (B) (C) (D) A16. (A) (B) (C) (D) A17. (A) (B) (C) (D) A18.
(A) (B) (C) (D) A19. (A) (B) (C) (D) Version B
Which of the following is generally true of bonds? The only bond whose return equals the initial yield to maturity is one whose time to maturity is the same as the holding period. A rise in interest rates is associated with a fall in bond prices, resulting in capital gains on bonds whose terms to maturity are longer than the holding periods. The longer a bond's maturity, the smaller is the size of the price change associated with an interest rate change. Prices and returns for short-term bonds are more volatile than those for longer-term bonds. The nominal interest rate minus the expected rate of inflation ________. defines the real interest rate is a less accurate measure of the incentives to borrow and lend than is the nominal interest rate is a less accurate indicator of the tightness of credit market conditions than is the nominal interest rate defines the bank rate Risk premiums on corporate bonds tend to ________ during business cycle expansions and ________ during recessions, everything else held constant. increase; increase increase; decrease decrease; increase decrease; decrease A business cycle expansion increases income, causing money demand to ________ and interest rates to ________, everything else held constant. increase; increase increase; decrease decrease; decrease decrease; increase When stock prices become more volatile, the ________ curve for gold shifts right and gold prices ________, everything else held constant. demand; increase demand; decrease supply; increase supply; decrease Everything else held constant, if the expected return on bonds falls from 10 to 5 percent and the expected return on GE stock rises from 7 to 8 percent, then the expected return of holding GE stock ________ relative to bonds and the demand for GE stock ________. rises; rises rises; falls falls; rises falls; falls When the inflation rate is expected to increase, the ________ for bonds falls, while the ________ curve shifts to the right, everything else held constant. demand; demand demand; supply supply; demand supply; supply Page 4 of 8
A20. (A) (B) (C) (D)
When talking about a coupon bond, face value and ________ mean the same thing. par value coupon value amortized value discount value
A21. (A) (B) (C) (D)
Bonds whose term-to-maturity is longer than the holding period are subject to ________. interest rate risk exchange-rate risk inflation deflation
A22.
If a corporation begins to suffer large losses, then the default risk on the corporate bond will ________. increase and the bond's return will become more uncertain, meaning the expected return on the corporate bond will fall increase and the bond's return will become less uncertain, meaning the expected return on the corporate bond will fall decrease and the bond's return will become less uncertain, meaning the expected return on the corporate bond will fall decrease and the bond's return will become less uncertain, meaning the expected return on the corporate bond will rise
(A) (B) (C) (D)
A23. (A) (B) (C) (D)
A24. (A) (B) (C) (D)
A25. (A) (B) (C) (D) Version B
Which of the following statements is true? Because coupon payments on tax-exempt bonds are exempt from federal income tax, the expected after-tax return on them will be higher for individuals in higher income tax brackets. An increase in tax rates will decrease the demand for tax-exempt bonds, lowering their interest rates. Interest rates on tax-exempt bonds will be higher than comparable bonds without the tax exemption. Because coupon payments on tax-exempt are exempt from federal income tax, the expected after-tax return on them will be lower for individuals in higher income tax brackets. According to the liquidity premium theory of the term structure ________. because buyers of bonds may prefer bonds of one maturity over another, interest rates on bonds of different maturities do not move together over time the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a term premium because of the positive term premium, the yield curve will not be observed to be downward sloping the interest rate for each maturity bond is determined by supply and demand for that maturity bond According to the expectations theory of the term structure ________. when the yield curve is steeply upward sloping, short-term interest rates are expected to remain relatively stable in the future when the yield curve is downward sloping, short-term interest rates are expected to remain relatively stable in the future investors have strong preferences for short-term relative to long-term bonds, explaining why yield curves typically slope upward yield curves should be equally likely to slope downward as slope upward Page 5 of 8
B1.
Assume a bond has three years to maturity in which one coupon payment of $160 will be received at the end of each year, and a face value of $1,000. Suppose the current interest rate is 16% (Year 1). There are only two possible scenarios with equal probability: Scenario A – interest rate will rise 3% every year in Year 2 and Year 3; and Scenario B – interest rate will drop 3% every year in Year 2 and Year 3. Your investment strategy is to buy the bond and hold it for only one year. The timeline below helps you visualize the timing of cash flows. (a) Complete the table below. Show your calculation or a zero will be given. (15 marks) (b) What is the maximum price that you should pay for this bond? Briefly explain why you might be more determined to invest in this bond when it is sold at par in the market if Scenario B has a higher probability than Scenario A. (5 marks)
(a) Scenario A
Scenario B
Coupon payment received in Year 2 and discounted to the beginning of Year 2
134.45
141.59
Coupon payment received in Year 3 and discounted to the beginning of Year 2
110.21
128.72
Face value received in Year 3 and discounted to the beginning of Year 2
688.80
804.51
Bond price at the beginning of Year 2
933.46
1,074.82
Present value of coupon payment received in Year 1
137.93
137.93
Present value of all cash flows
942.64
1,064.50
Weighted Outcome
471.32
532.25
Expected present value of all cash flows (b)
Version B
1,003.57
Since the expected present value of all cash flows worth $1,003.57, which is the maximum price that you should pay for this bond. Scenario B represents favourable outcome to existing bondholders when interest rate falls 3% each year in Year 2 and Year 3 as interest rate and bond price move in opposite direction, which helps to boost the expected bond price above par at the beginning of Year 2 ($1004.14, which is the weighted outcome of $933.46 and $1,074.82). If the bond is sold at par in the market, the expected present value of profit is only $3.57, which is quite insignificant. A higher probability for Scenario B (favourable outcome) will definitely boost the expected present value of all cash flows more significantly above par and make you more determined in favour of buying the bond.
Page 6 of 8
B2.
Explain the factors that shift the demand and supply of money curves in Keynes’s liquidity preference analysis. (16 marks)
Income and price level are the factors causing the demand curve for money to shift in Keynes’s liquidity preference analysis. Income would affect the demand for money because: (i)
As an economy expands and income rises, wealth increases and people will want to hold more money as a store of value.
(ii)
As the economy expands and income rises, people will want to carry out more transactions using money, with the result that they will also want to hold more money. A higher level of income causes the demand for money to increase and the demand curve to shift to the right.
Keynes took the view that people care about the amount of money they hold in real terms. When the price level rises, the same nominal quantity of money is no longer as valuable, it cannot be used to purchase as many real goods and services. To restore their holdings of money in real terms to their former level, people will want to hold a greater nominal quantity of money, so a rise in the price level causes the demand for money to increase and the demand curve to shift to the right. It is assumed that the supply of money is completely controlled by the central bank (Bank of Canada), an increase in the money supply engineered by the Bank will shift the supply curve for money to the right.
Version B
Page 7 of 8
B3.
(a) (b)
(a)
What are the impacts of rising interest rates on bonds with different maturities when all bonds are purchased at par? (10 marks) Why some people are puzzled by these observed phenomena? (4 marks)
The only bond whose return equal the initial yield to maturity is one whose time to maturity is the same as the holding period. A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds whose terms to maturity are longer than the holding period. The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest-rate change. The more distant a bond’s maturity, the lower the rate of return that occurs as a result of the increase in interest rate. Even though a bond has a substantial initial interest rate, its return can turn out to be negative if interest rate rises.
(b)
Version B
Most students are puzzled by the fact that a rise in interest rates can mean that a bond has been a poor investment, it is important for them to recognize that a rise in the interest rate means that the price of a bond has fallen and hence a capital loss, which can be significant to make a bond poor investment.
Page 8 of 8
