Exam #1

Exam #2

Econ 351

Fall 2017

Good Luck!

Name _____________________________________ Last 4 PSU ID __________

Please put the first two letters of your last name on the top right hand corner of this cover sheet. Also, ONLY NON-PROGRAMMABLE CALCULATORS ARE ALLOWED - THERE ARE NO SUBSTITUTES. THANKS FOR YOUR COOPERATION!

GOOD LUCK!!!

Total Points for exam = 315

Test time = 120 minutes

To help with time management if spreading time evenly - spend about 20 minutes on each question

Question #1 = 50 points

Question #2 = 60 points

Question #3 = 50 points

Question #4 = 55 points

Question #5 = 50 points

Question #6 = 50 points

1. (50 points) Use the table below to answer the following questions:

DATE

i on 1 year GS

i on 2 year GS

i on 3 year GS

12/31/15

.65%

1.06%

1.31%

2/8/16

.51%

.66%

.83%

3/11/16

.70%

.97%

1.16%

a) (5 points) Calculate what has happened to the one year interest rate expected one year from now (in year 2) (i12e) between December 31, 2015 and February 8, 2016. Please show all work.

b) (5 points) Now calculate what has happened to the one year interest rate expected two years from now (in year 3) (i13e) between December 31, 2015 and February 8, 2016. Please show all work.

c) (5 points) Name two possible real world reasons why these expected interest rates (parts a) and b)) changed the way they did.

d) (10 points) Suppose that you were bullish on bonds and bought one 3 year GS with a coupon rate of 2% on 12/31/2015 (data is in Table above). The face value of the bond is $1,000 as is normal. Suppose that you held the bond until 2/8/16 (a little over a month). Calculate the price of bond on 12/31/15 and then on 2/8/16. Calculate your profit / loss AND rate of return. (you did not receive any coupon payments during this short holding period) Please show all work.

e)(10 points) Your friend was also bullish on bonds but played the 2 year GS market instead. Same as above, your friend bought one 2 year GS on 12/31/15 and closed on 2/8/16. The coupon rate is the same as above = 2%, face value = $1,000 and you can ignore any coupon payments given the short holding period. Calculate the price of bond on 12/31/15 and then on 2/8/16. Calculate your profit / loss AND rate of return.

f)(10 points) So you and your friend are having lunch after you both closed your position(s) and your friend says, "I told you that my bet was less risky (safer) than your bet, I learned that in Chud's econ 351 class - you should take that class!" Is your friend correct? Why or why not? Explain the theory as to why your friend may be correct - this is worth 10 points!

g)(5 points) Without doing the math, would it have been better to wait to close the bullish bet on the 3 year GS on 3/11/16 rather than close it on 2/8/16? Explain.

2. (60 points total)

We now consider the behavior of the Treasury yield curve during the spring/summer of 1984. The table below provides the interest data. .

DATE

i on 3 month TBill

i on 10 year GS

March 1984

10.09%

12.53%

June 1984

10.31%

13.84%

August 1984

11.06%

12.79%

Plot these three yield curves on ONE diagram, labeling each with the appropriate dates

15 points for correct and completely labeled diagram

a) (10 points) What has happened to the slope of the yield curve as defined as the i on 10 year GS minus the i on 3 month T-bill from March 1984 to June 1984? Explain 3 reasons why the slope could have changed the way it did.

b) (10 points) What has happened to the slope of the yield curve as defined as the i on 10 year GS minus the i on 3 month T-bill from June 1984 and August 1984? Explain 3 reasons why the slope could have changed the way it did.

c)(10 points) Given your answers in a) and b) above, does this behavior of the yield curve remind you of a period we discussed during the Greenspan regime? Give some specifics about this period during the Greenspan regime - when it was, what was it called, and what happened exactly.

d) (10 points) Suppose you tell a friend that the Fed sometimes lowers interest rates by raising them. They are confused. Explain to them exactly what you mean using the pure expectations theory of the term structure and the fisher effect.

e) (5 points) As you can see by the numbers from 1984, both the short rate and the long rate were in the double digits, way higher than they are today - why were rates so high back then ? Explain

3. (50 points total)

Excerpts from WSJ article, October 20, 2017 titled "Yellen Says Fed May Need to Use Unconventional Policy Again Some Day"

Janet Yellen recently released remarks ahead of delivery to the National Economists Club. Ms. Yellen said officials “do not anticipate a jump in term premiums as our balance-sheet reduction plan gets under way.” The term premium is the extra yield investors demand for taking on the uncertainty that comes with longer-dated securities.

The Fed’s purchases of Treasury and mortgage securities were aimed at spurring household and business investment by driving longer-term interest rates and bond yields down.

a) (10 points) What would cause a jump in the term premium and why don't the (Fed) officials anticipate a jump?

b) (10 points) Provide an argument as to why the Fed would want the term premium to rise and then provide a counter argument why the Fed would not want it to rise.

c) (10 points) Explain the phrase: The term premium is the extra yield investors demand for taking on the uncertainty that comes with longer-dated securities. Using the graph we used in class (short and long term yields on vertical axis and time on horizontal axis), explain why there is extra uncertainty in longer term securities. What is this (extra) uncertainty called?

d) (5 points) When bond investors buy long term bonds, what are they most worried about: interest rates rising or interest rates falling? Explain.

e) (15 points) Using two graphs side by side (the corporate bond market on the left hand side and the US Treasury market on the , right hand side), explain this excerpt from the article: The Fed’s purchases of Treasury and mortgage securities were aimed at spurring household and business investment by driving longer-term interest rates and bond yields down. Explain, referring to your diagram. Be specific as to how this unconventional policy is supposed to work. We did this in class.

4) (55 points total)

a) (10 points) We discussed the conundrum in quite a bit of detail. When the Penn State Economics Association visited the Fed Boardroom for the first time in March of 2005, we were in the midst of the conundrum. I argue that we might be in the midst of conundrum number 2 (as in right now). How would one determine if we were in the midst of conundrum number 2? What data would you use to assess whether we are in conundrum number 2?

b)(10 points) If you were to make a presentation to Janet Yellen about this possible conundrum number 2, what arguments would you make to convince her that the existence conundrum number 2 is very probable moving forward. Please refer to whether the arguments that explained conundrum number 1 applies today.

c)(5 points) If the we were to enter into conundrum number 2, is there anything the Fed could do or say that would get us out of conundrum number 2?

d)(10 points) Another episode in interest rate history was the taper tantrum. What exactly is meant by the term taper tantrum.... that is, what does the word taper apply to and why was this event associated with a tantrum??? When did the taper tantrum occur? Be very specific.

(20 points total for this part) - use the data below to answer parts e) through h)

e)(5 points) Calculate the current year earnings.

f) (5 points) Calculate the Market Cap.

g)(5 points) Calculate the P/E ratio using the Market Cap:

h) (5 points) Now calculate the P/E ratio using the EPS (earnings

5) (45 points total)

a) (10 points) The graphic below is from stock trak and shows the numbers for a 2 year treasury bond - face value = $1000 and the coupon rate is 3.375 %. The current interest rate on a 2 year T-note is 1.6%.

Calculate the price of this bond and show that it is close to the price quote in stock trak .

b) (10 points) Suppose that you purchased a 3 year government security (face value = $1000) where the interest rate was 1.31% with the coupon rate = 3%. You held on to the security for one year and sold it, a two year bond now, when the interest rate was .83% Calculate your profit or loss and rate of return.

c)(5 points) Calculate the price of a 2 year government security with face value of $1000 where the interest rate is 4% and the coupon payment is also 4%.

d)(20 points) We discussed the Magnetar trade in quite a bit of detail. Explain what the Magnetar trade was. To get full credit you must use the following words/terms in your essay.. Please circle each time you use the terms to help us with the grading.

CDS..........Structure it like cows .........Bet against the American dream...... triple A rating.... rating agencies... equity tray.......CDO manager

6. Merck Problem. (50 points total) Pretend that you are hired by Merck to do some research on the behavior of their stock price. The CEO wants you to develop a report investigating two rumors that she has been hearing about Merck stock: 1) The behavior of Merck stock is consistent with the efficient market theory and 2) Changes in Merck stock, just like any other stock, are impossible to predict. That is, Merck stock follows a random walk.

In this problem, you are going to prepare the report. I will help!

To begin, I went to Yahoo finance and copied a picture depicting the behavior of Merck’s stock for the week of (10/31/05 – 11/04/05). I also went to the WSJ online and copied and pasted an excerpt from “Merck and Qualcomm Gain, But ImClone, Guidant Decline”

By KAREN TALLEY, DOW JONES NEWSWIRES November 4, 2005.

Excerpt

“Merck was the best percentage gainer among the Dow industrials, rising $1.07, or 3.8%, to $29.48. The drug maker scored a court victory in its second Vioxx liability case; thousands of cases lie ahead.”

Answer the following questions:

a) (5 POINTS) To begin this “make believe” report (the CEO treasures completeness), explain exactly what determines stock prices. Write out our general formula of stock price determination, explaining exactly what each term means, and the intuition underlying the formula itself.

Now discuss some of the factors that could influence the terms of your expression above.

b) (5 POINTS) Now use your expression above to explain the movement in Merck stock on Thursday, November 3. Be specific as to the cause of the movement as well as well the movement itself, i.e., the duration.

c) (5 POINTS) Use the expression in a) above to explain the behavior of Merck stock on Tuesday, November 1, the day the FOMC raised their target for the federal funds rate. Again, be very specific as to the cause of this behavior, using your expression in a). Below is an excerpt from the official statement from the 11/1 meeting.

Release Date: November 1, 2005

For immediate release

The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 4 percent.

Write your answer for part c) here.

d) (10 POINTS) Are your results consistent with the efficient market theory? Begin your answer with explaining exactly what the efficient market theory is making sure you refer to the best investment advice assuming that markets are efficient. Apply your definition of the efficient market theory to your answers on both b) and c) above. Be very specific and be sure to use the term NEWS numerous times in your explanations.

We now move on to addressing whether or not changes in Merck stock are predictable. Begin with a little notation. Let MRKt be the current spot price of Merck at time t (right now; today) and let MRKet+1 be the spot price of Merck expected tomorrow.

Of course the information set available to you is Ωt and includes all information, relevant or not, that is available up until time t (right now!).

e) (10 POINTS) According to the efficient market theory (along with our class discussion), what is the best forecasting model that you can come up with to predict MRKt+1 (the price of Merck stock tomorrow)? Be very specific and justify the choice of your forecasting model (i.e., justify why your model is the best of all the possible choices, being sure to identify some of the other possible forecasting models! (hint – redundant variables everywhere!!)).

f) (15 POINTS TOTAL, 5 FOR EACH EQUATION WITH SOLID ACCOMPANYING DISCUSSION) We are now ready to test whether or not Merck (stock) follows a random walk. Using the forecasting model above, explain exactly how we would test whether or not Merck follows a random walk. Be sure to identify the expected empirical results using all the equations that we set up in class. There are a minimum of three equations to set up and discuss. Be sure to continuously refer to the efficient market theory and the random walk properties of Merck throughout your discussion.

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