Practice Midterm Solutions
.pdf
School
University of Toronto**We aren't endorsed by this school
Course
ECO 349
Subject
Economics
Date
Dec 16, 2024
Pages
5
Uploaded by CommodorePower11558
Section 1(A) [5 points] In Canada, what type of financial asset is responsible for the majority of firm financing?Most firm financing in Canada comes from indirect finance using bank loans.(B) [5 points] Within the adaptive expectations framework, what parameter controls the rate at which past realizations are included into future forecasts?Past realizations/shocks are weighted by (1 β πΎ)π, where iis the distance between the current period and the shock.(C) [5 points] We observed several data series that supported the theory of secular stagnation. Name one of the variables we studied and describe its trend over time.The decline in the growth rate of productivity (TFP)(D) [5 points] Historically, the growth rate of the money supply tends to ______ during recessions. Increase(E) [5 points] What is the main implication of the efficient market hypothesis?Main implication is that you canβt beat the market because stock prices reflect all the relevant information already. (F) [5 points] The market for money predicts that an increase in the money supply will lead to a decrease in the interest rate, known as the liquidity effect. However, there were three additional general equilibrium forces that were relevant. Name one of these forces and describe its impact on interest rates following a rise in the money supply. Expectations on inflation, an increase in the money supply leads to higher inflation expectations which leads to higher interest rates. (income effect and price level effect is also acceptable)(G) [5 points] What types of financial assets are most susceptible to interest rate risk?Any answer is acceptable as long as you can explain why itβs susceptible to interest rate risk.(H) [5 points] According to the data we saw in class, in which forecasting horizon were inflation expectations the most strongly anchored to the central bankβs target rate? (Choose from one-year ahead, one-quarter ahead, or the current year) One-year ahead forecasts.(I) [5 points] What market force would cause someone to sell a bond for less than its face value?If interest rates rise and the value of bond decreases, they might want to sell their bond in favour of more desirable investments.(J) [5 points] According to the Modigliani-Miller theorem, what happens to the value of a firmβs equity if it issues more debt? Assume the conditions necessary for the theorem are true.Value of firmβs equity decreases because of a higher probability of default and a decrease in cashflows that go towards equity holders.
Section 2(A) [20 points] Your friend Reyn has forgotten to pay his bills several times in the past, and as a result he has a low credit score. He complains that credit scores only exist to punish consumers and make extra profit for banks. He thinks the economy would function better without them. Explain to him the economic problem solved by credit scores, and how credit scores can improve consumer access to credit.Credit scores help solve the problem of information asymmetries in lending markets. All lenders face uncertainty with regards to borrowersβ creditworthiness to the extent that they canβt observe some of the borrowersβ characteristics and actions. Credit scores allow banks/financial institutions to gain information about a borrowerβs creditworthiness. This allows them to filter out riskier borrowers with lower credit scores, who may have a lower likelihood of paying back their loans. At the same time, banks are more willing to lend to individuals/firms with strong credit scores at lower interest rates.(B) [30 points]In class we discussed four facts regarding the term structure of interest rates. Explain how the liquidity premium theory successfully explains all four of these facts, and why the expectations theory and segmented markets theory both fail to explain all of the facts. Your answer should clearly identify each fact and connect it to a specific feature of all three theories.Fact 1: Yield curve takes different shapes due to expectations of future path for short-term rates.Fact 2: interest rates comove due to long-term rates being composed of expected short-term rates.Fact 3: yield curve slopes upward when short-term rates are low due to expectations that short-term rates will return to normal high levels in the future.Fact 4: yield curves tend to slope upwards because investors prefer short-term bonds, and demand a rising term premium to purchase bonds with higher maturities.Neither of the theories can explain why yield curve slopes upward and why the interest rates on bonds of different maturities comove. The expectation theory canβt explain the 4thfact because we know investors require a liquidity premium to hold long-term bonds. Hence why the yield curve slopes upwards. The segmented markets theory fails to explain facts 2 & 3 because it treats different maturities as separate markets. If this was true, interest rates should not comove. The segmented market theory also assumes thereβs no connection between short-term and long-term rates. If this was true, the yield curve wouldnβt slope upward.
(C) [30 points] As a result of asteroid mining, the U.S. government suddenly receives a windfall of resources which it chooses to distribute to all citizens in the form of stimulus checks. At the same time, the advances in space flight have created new profitable ventures for private firms to explore. Describe the likely impact this will have on the bond market. Carefully describe the forces that will affect the supply and demand for bonds, and clearly show what will happen to the interest rate. You are free to assume relative strengths if there are competing forces, but be clear in your assumptions.The U.S. government distributes stimulus checks which increases national income/wealth. This will cause the bond demand curve to shift to the right. At the same time, private firms realize there are new profitability investment opportunities, so they are looking to issue debt which shifts the bond supply curve to the right. Depending on the strength of each of these events, the equilibrium interest rate may be higher or lower.You could argue for higher inflation expectations in a booming economy. Higher national income -> higher tax revenues, reducing the govt. deficit. As long as your arguments are clear and make sense you will get credit.
Section 3(A) [5 points] Suppose you pay $956.54 for a bond maturing in two years with face value of $1000. If the market interest rate is 4.5%, what must the coupon rate on your bond be?956.54 =?1.045+?(1.045)2+1000(1.045)240.81 = 1.873?? = 21.79 β π????? ?π?π π? ~2.2%[B] The current interest rate on a one-year government Treasury bill is 1.1%, while a three-year Treasury has an interest rate of 4.3%. Suppose you expect the forward rates over the next two years to be the same, so ie1t+1 = ie 1t+2. If the liquidity premium on a three-year Treasury bond is 1.8%, what must be the value of next yearβs forward rate?π3,π‘=π1,π‘+ π1,π‘+1π+ π1,π‘+2π3+ ?3,π‘Since π1,π‘+1π= π1,π‘+2π, we can rewrite the above as:π3,π‘=π1,π‘+ 2π1,π‘+1π3+ ?3,π‘4.3 =1.1 + 2π1,π‘+1π3+ 1.8π1,π‘+1π= 3.2[C] A stock just paid $1.05 in dividends, which are expected to grow at a constant 2% every year. If the current price is $114.38, what is the expected rate of return on this stock?Recall the dividend growth formula, where ?1= ?0(1 + π)=> ?1= 1.071π0=?1?πβ π114.38 =1.071?πβ 0.02?πβ 3%
[D] Suppose the current interest rate on one-year government Treasury bills 24.1%, but we don't know its face value. The supply and demand curves for this asset are given below:?π
= π?? β ????π= ??? + ???Suppose the central bank removes 100 bonds from circulation. What will be the new price and quantity on one-year government Treasury bills?Find the equilibrium price of 1Y T-bills priorto CB operations: 840 β 25π = 260 + 15π β π = 14.5Given the interest rate of 24.1%, the face value of the 1Y T-bill is 14.5 β 1.241 = 18A drop in the supply of 1Y T-bills lowers the intercept of the supply curve, so our new equilibrium is:840 β 25π = 160 + 15π β π = 17The interest rate is 17 =18(1+π)β π β 5.9%