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- Midterm exam will cover the following chapters: 2, 3, 4 and 5 to the extent covered in class.
- The exam will be given in the form of: multiple choice questions (20), true /false questions (4), short-answer questions (3) problems solving and graphing (3) from the questions given below which are the exam question, therefore answers to the exam questions are not given
- Multiple choice questions are not included in the study guide but they will cover chapters indicated below.
- The following chapters will be covered by the exam:
Chapter 3: What is Money?
- Meaning of money.
- What does money do? Functions of money
- Why money is the most liquid asset?
- The form of money: commodity money and fiat money
- Why do we measure changes in money supply?
- Monetary aggregates and their components
- M1 and its components
- M2 and its components
- How changes in money supply are related to change in interest rates, economic growth and inflation?
- Why are currency and checkable deposits money?
- The link between the quantity of money and the price level: quantity theory of money.
- The link between growth in the money supply and the inflation rate: the quantity theory of money
Chapter 2: An overview of the financial system
An overview of the financial markets
- Defining financial markets: direct finance
- Bond market: what is traded?
- Stock market: what is traded?
- How do activities in financial markets affect: individual wealth, businesses and the economy?
- Derivatives market
- Foreign exchange market
- Financial markets functions: information asymmetry in the financial markets
- An adverse selection: Who is affected?
- Moral hazard: Who is affected?
- Categorizing financial markets
- According to the type of financial instruments they sell
- According to the way they trade
- According to newly issued instruments and existing financial instruments
- According to the maturity of financial instruments
An overview of financial institutions
- Primary function of financial institutions.
- Other functions of financial institutions.
- Lowering transaction cost.
- Lowering information cost.
- Adverse Selection
- Moral Hazard
- Risk sharing.
- Types of Financial Institutions.
- Reasons for the Financial System Regulation.
- Why does deposit insurance lead to a moral hazard?
Chapter 4: Understanding interest rates
- Determining an asset price: The present value concept
- Factors that determine the present value of expected income
- Size of expected income (future income)
- Number of years when income will be received
- Interest rate
- Determining the price of the following bonds
- Price of a coupon bond
- Price of a zero-coupon bond
- Price of a bond with perpetual stream of payments: console
- Relationship between price of a bond and a change in interest rate on a bond
- Change in interest rate and its effect on the price of the short-term and the long-term bonds
- Interest rates calculation
- Yield to maturity. What does it measure and how?
- Yield to maturity on a coupon bond
- Change in the bond price and its effect on the yield to maturity
- Yield on a zero-coupon bond
- Change in the bond price and its effect on the yield to maturity on zero-coupon bond
- Current yield. What does it measure and how?
- Holding period return on a bond
- Why does holding period return differ from the yield to maturity?
- Holding period rate of return on coupon bond
- Nominal and real interest rate: Fisher equation
- Nominal interest rate: What does it measure?
- Real interest rate: What does it measure?
- Relationship between nominal interest rate and expected inflation
- Nominal and real interest rates behavior
- Inflation-indexed bonds
Chapter 5: The Bond Market and Determination of Interest Rates
- The demand side of the bond market: bond demand curve
- Relationship between the price and quantity of bond demanded.
- Change in quantity demanded of bond: movement along the demand curve
- Why quantity demanded of a bond goes up when price of bond goes down?
- Change in a demand for bond: shift in the demand curve
- Factors that change demand for a bond
- The supply side of the bond market
- Market bond supply curve
- Relationship between the price of the bond and quantity supplied.
- Change in quantity supplied of the bond: movement along the bond supply curve
- Why quantity supplied of the bond goes up when price of the bond goes up?
- Equilibrium price and interest rate determination
- Excess supply in the bond market
- Excess demand in the bond market
- How does the bond market eliminate surpluses and shortage?
- Change in equilibrium price and interest rate.
- Interest rates behavior
- Why are interest rates increasing during economic expansion?
- Why are interest rates falling during recession?
- Interest rates and expected inflation: Fisher effect
- Interest rates and deflation
- True/false questions. Briefly explain your choice to receive full credit.
- Financial instruments used primarily to transfer risk include bonds, bank loans, mortgages and stocks.
- Financial instruments are used primarily as stores of value and means of trading risk. They are less likely to be used as means of payment.
- In the world without information and transaction costs, financial intermediaries would not exist.
- Corporations raise funds only in secondary markets.
- The most important characteristic an asset must have to serve the function of medium of exchange is its portability.
6.Credit cards make a difference in how much money people hold, but they are not money
- Fiat money, the kind of money used today is accepted as a medium of exchange because of its intrinsic value.
- M1 is the component of the money supply that consists of M2 plus other relatively liquid assets.
- If during 2013 the money supply increases by 4%, the inflation rate is 2%, and the growth of the Real GDP is 3%, then the value of velocity must fall by 1%.
- If the money supply in a country increases, the velocity constant, then the nominal GDP in that country must also increase
- If interest rates rise, bonds become more attractive to investors, so bond prices rise.
- If there is a decline in interest rates, you would rather be holding short-term bonds than long-term bonds
- When the price of the bond is above its face value, the coupon rate is less than yield to maturity.
- The holding period return on a bond is the same as an interest rate on a bond.
- If you own a bond and market interest rates increase, you will experience capital gain.
- The prices of long-term bonds are less volatile than those of short-term bonds because long-term bonds respond less strongly to changes in interest rates.
- The yield to maturity shows the earnings from holding the bond a year and then selling it.
- A rise in expected asset income raises asset price, while decrease in interest rate reduces asset price.
- The demand for bonds rises when expected inflation rises
- I Short-answer questions. Briefly explain your answer to receive full credit.
- Is money the only store of value? If not, give some other examples of stores of value. Must money be a store of value to serve its function as a medium of exchange? No money is not the only store of value, some other store of value include: stocks, bonds, land, houses, art or jewelry.
No, money is only one of the many assets that can be used to store value.
- Imagine that you have just received $4,000 that you have to hold as either an M1 asset or M2 asset. What are the costs and benefits of holding the $4,000 as an M1 asset rather than as an M2 asset? Explain.
- An article in the Economist magazine observes: One big reason to tie money to a commodity standard would be to limit its growth in order to protect against runaway inflation.
- Why would tying money to a commodity limit the growth of the money supply?
- Would doing so limit inflation? Explain
Source: on Gold and Golden Ages. Economist, September 11, 2012
- It is sometimes suggested that the Fed should try to achieve zero inflation rate. If we assume that velocity is constant, does the zero- inflation goal require that the rate of money growth equal zero? If yes, explain why. If not, explain what the rate of money growth should be?
- On January 1, 2002, Germany officially adopted the euro as its currency, and deutsche mark stopped being legal tender. According to the Article in the Wall Street Journal, even 10 years later many stores in Germany continued to accept it. Briefly explain how possible for people to continue to use a currency when government replaced it with another currency.
Source: Who needs the euro When You Can Pay with Deutsche Marks? Wall Street Journal July, 2012.
6 .Rating agencies such a Moodys and Standard &Poors study corporations that issue bonds. They publish ratings for the bonds- evaluation of the likelihood of default. Suppose these rating companies went out the business. What effect would this have on the bond market? What effect would it have on banks?
- National credit bureaus collect information on peoples credit histories. They are likely to know whether you ever defaulted on a loan. Suppose that a new privacy law makes it illegal for credit bureaus to collect information. What effect would this have on the banks? Explain
- Consider two bonds; one matures in 1 year and the other matures in 30 years. What do you expect to happen to the price of each bond when the interest rate falls? When the interest rate increases? In which case do you expect the price of the bond to increase or decrease by greater percentage and why?
- Consider bond J and bond K. Bond. Bond J is a 5% coupon and bond K is 10% coupon bond. Both bonds have 10 years to maturity .If the interest rates suddenly fall by 2 percent, what do you expect to happen to the price of each bond? Price of which bond increases or falls by greater percentage? Which bond has more interest rate risk?
- A student says: The interest rate on the one-year Treasury bill is currently 0.29%, while the interest rate on the 30-year Treasury bond is currently 3.1%. Why are any investors buying Treasury bill when they can receive a much higher yield by buying the Treasury- bond? Provide answer to the student question.
- At the dinner table, your father is extolling the benefits of investing in bonds. He insists that as a conservative investor he will make only investments that are safe, and what could be safer that a bond, especially a U.S Treasury long-term bond? What accounts for his view of bonds? Explain why you think he is wrong?
- An article in the New York Times notes that rising bond yields can ..signal the threat of inflation. Briefly explain why, if investors expect inflation to be higher, the yield on bonds will rise.
- Writing in the wall Street Journal, two economists made the following prediction: We believe that when investors awake from their depressed state, they will realize that they do not have to lend the U.S. government money for the 10 years at a negative real yield. By negative real yield did they mean that the nominal interest rate on 10-year Treasury notes was negative?
- In 2012, an article in the Economist magazine recommended to investors that if economic growth and inflation are low in the United States, investors should buy bonds. But if inflation accelerated rapidly, investors should buy commodities, especially gold. Why would bonds be a poor investment in a period of high inflation? Explain .Why would bonds be a good investment in the time of low inflation? Explain
- Consider a bond with a coupon rate 3% and the yield to maturity 5%. Which of the two interest rates is a better measure of return for someone who holds the bond until its maturity?
- A Wall Street Journal offered the following opinion of the bond market in September 2012, when inflation rate was about 2%: Someone buying long-term bonds yielding 1.5% or 2% and then seeing consumer price inflation of 4%, will be on the loosing end of the bet.
- Explain verbally and illustrate what will happen to the price of bonds if expected inflation increases to 4% from 2%.
- Explain why someone buying long-term bonds yielding 1.5% and then seeing consumer price inflation of 4%, will be on the losing end of the bet.
- If expected inflation is increasing, would you have made a worse investment if you had invested in long-run bonds than if you had invested in short-term bonds?
- The president of the United States announces in a press conference that he will fight the higher inflation rate with a new anti-inflationary program. Predict what will happen to the interest rate and the bond prices if the public believes him.
- Assume that forecasts for the U.S. economy have taken sudden turn for the worse. Everyone had expected healthy growth of 3 to 4 percent in the coming year, but now a recession set in with output contracting by as much as 4 percent. Officials expect unemployment to rise and corporate profits to plummet. Describe the consequences for the market demand and supply for corporate bonds
- Suppose that you own a long-term bond and you expect a greater increase in inflation than do others investors, but you do not expect that the increase to occur until 2017. Should you wait until 2017 to sell your bond? Briefly explain
III. Problems and graphing. All underlying work must be shown to receive full credit
- 1. Which function of money is demonstrated in each of the following cases?
- You pay $10 for a movie ticket.
- You deposit your tax refund check in your saving account.
- A restaurant manager sets the prices of meals she serves in dollars.
- A restaurant manager reports $5,000 worth of wine in the cellar.
- McDonalds announces that a Big-Mac now costs only $1.00.
- Bill Gates net worth is around $50 billion.
- Suppose that this years the money supply is $400 billion, nominal GDP is $12 trillion, and Real GDP is $6 trillion. Assume that velocity of money is constant and the economys output of goods and services (Real GDP) rises by 5 percent each year. Use the data to answer the following questions:
All underlying work must be shown
- What is the price level in the economy?
- What is the money velocity in the economy?
- What will happen to nominal GDP and the price level the next year if the Fed keeps the money supply constant?
- What will happen to nominal GDP and the price level if the Fed increases the money supply from 400 billion to 500 billion? What would be the inflation rate?
- How many billions in the money supply should the Fed set the next year if wants to keep inflation rate from part d?
- How many billions in the money supply should the Fed set next year if it wants an inflation of 3 percent?
- Consider the following $10,000 face -value bonds.
Bond Coupon rate Selling price Coupon payment Yield to maturity Current yield
A 10 percent $9,000 _____ ______ ________
B 7 percent $10,000 _____ ______ _________
C 9 percent $10,000 _____ ______ ________
D 10 percent $8,500 ______ _______ ________
- Compute and enter in the space provided in the table coupon payment on each bond
- Estimate the yield to maturity on each bond (you cannot calculate the yield since the years to maturity are not given)
- Which bond has the lowest yield to maturity? Which bond has highest yield to maturity? Explain why in each case?
- Calculate and enter in the space provided in the table current yield from each bond
- Which bond would you prefer to buy and why?
- Refer to the bond B. If the selling price of this bond falls to$9,500, what will happen to the yield to maturity on this bond, the current yield?
- On January 29th , 2015 you buy a bond that matures on January 29th, 2017. The face value of this bond is $1000, the coupon rate of 4% and the market rates 4%.
- How much did you pay for this bond on January 29th, 2015? Explain your answer
You receive one coupon payment and sell the bond after 1 year following the decrease in the market interest rate from 4% to 2%.
- What was the selling price of this bond?
- What was the yield to maturity on this bond?
- What was your holding period rate of return from this bond?
- If inflation was 2%, what was your real rate of return for one-year holding period the bond?
- If the bond you sold were longer maturity would your rate of return for one-year holding period return be higher or lower? Explain
Suppose that instead selling the bond after one year, you hold the band until its maturity
- What would be your annual return from this bond
- Suppose that on January 1, 2016, you purchased a bond with the following characteristics
Face value: $1,000
Maturity date: January 1, 2018
Current yield: 8.5%
All underlying work must be shown
- What was the coupon payment on this bond?
- What was the coupon rate?
- What was your annual return from this bond?
- Calculate the yield to maturity on this bond. Was the yield to maturity greater or less than the coupon rate? Why?
- If you sold the bond on January 1, 2017, while market interest rates were 5%, what was your holding period rate of return from this bond?
- If the bond you sold on January1, 2017 were longer maturity, would you have received higher or lower holding period return? Explain
- Suppose that instead selling the bond, you hold the bond until its maturity. What would be your rate of return form this bond? How does it compare to the holding period rate of return?
- Suppose that on January 1, 2016, the price of a one- year Treasury bill is $970.87. Investors expect the inflation rate to be 2% during 2016, but at the end of the year, the inflation rate turns out to have been 1%.
- What is the nominal interest rate on this bond?
- What is the annual return on this bond?
- What is the excepted real interest rate on this bond?
- What is the real interest rate on this bond?
- Do the expected real interest rate and the real interest rate differ? Explain your answer
- Who is better off at the end of the year, lender or borrower? Explain why
- Use a demand and supply graph for bonds to illustrate each of the following situations. Be sure that your graph shows any shifts in demand or supply curves, the original equilibrium price, interest rate and equilibrium quantity as well as the new equilibrium price, interest rate and quantity. Also be sure to explain what is happening on your graph. For each event use a separate graph.
- The Fed publishes a forecast that inflation rate will average 5% over the next five years. Previously, the Fed had been forecasting an inflation rate of 3%.
- The economy experiences a period of rapid growth, with rising corporate profits
- Investors believe that the level of risk in the stock market has decline.
- The federal government imposes a tax of $10 per bond on bond sales and purchases
- Interest rates are expected to fall.
- Use the supply and demand in the bond market to explain verbally and illustrate graphically the effect of each of the following event on the equilibrium price and interest rate in the bond market. Use a separate graph for each event.
- You expect inflation to increase
- You lost $100,000 in the stock market
- Interest rates are expected to fall
- Prices in the stock market become more volatile.
- Illiquidity is crippling bond world
- The economy enters recession
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