Download Midterm Exam Answer Key

Mid-term Examination
Economics 333
Money and Banking
Thursday, October 18 2001
I. Multiple Choice [5 Points Each]
1. Which of the following statements is true about monetary aggregates in Hong
Kong?
c. Demand deposits at commercial banks are part of M2; and time deposits at
restricted license banks are part of M3.
.
2. A manufacturing corporation needs to borrow $1,000,000 funds to build a factory.
The corporation’s chief financial officer visits an investment bank. The bank calls
one of its regular customers, which agrees to exchange $1,000,000 for the new
bond. The market for this bond could be described as:
d.. An over-the-counter market and a primary market.
3. A coupon bond pays a coupon of $100,000 and has a face value of $1,000,000.
You calculate the yield to maturity of the bond as 12%. The bond has an
a. Initial price less than $1,000,000 and a current yield greater than 10%
4. Your company owns a factory in Malaysia that will be estimated to generate
1,000,000 Malaysian ringit in revenue after 1 year. You call a foreign exchange
dealer at your bank and make an agreement. You will deliver 1,000,000 ringit at
the end of one year and your foreign exchange dealer will deliver HK$2,000,000
to you at that time.
.
d. An over-the-counter market and a derivative market.
5. You buy a discount bond with a maturity date of two years and put it in a safe for
1 year. The initial yield to maturity of the bond was 10%. At the end of 1 year’s
time, the yield to maturity is now 5%. The price of the bond has:
a. Definitely risen over the course of the year.
II. Short Answer Questions
6. (10 points) There are free capital markets between Elbonia and Kneedonia. The
only bond selling in Elbonia is a 1-year discount bond with a face value of
100,000 Elbonian Dollars and a price of 80,000 Elbonian Dollars. The only bond
selling in Kneedonia is a 1-year discount bond with a face value of 100,000
Kneedonian Yen and a price of 75,000 Kneedonian Yen. Assume that the two
bonds have the same risk, information, and liquidity properties. Treating Elbonia
as the domestic country, what is the market’s forecast of the growth rate of the
exchange rate over the course of the year?
FACE 100000

 1.25  i  .25 . The yield
The yield on Elbonian bonds is 1  i 
PRICE 80000
FACE 100000

 1.33  i f  .33 . Interest parity
on Kneedonian bonds is 1  i f 
PRICE
75000
EX 1
EX 1
says i  i f 

 i f  i  .3333  .25  .0833 .
EX
EX
7. (10 points) You buy a coupon bond with a face value of $1,000,000 and a coupon
of $100,000 and a yield to maturity of 10%. After 1 year, the price of the bond
changes. You use the new price to calculate a current yield (which is different
from the yield to maturity) of 12.5%. What is your total return on the bond
(including both the coupon rate and the capital gain rate) for the year?
The coupon rate is 10%. If the coupon rate is equal to the yield to maturity, then price
equals face value: P=1,000,000. Current yield is the coupon divided by the price. If
after 1 year, the current yield is .125, the P+1 = 800,000. The total return is the
C P P
800000  1000000
coupon yield + the capital gain  1
 .10 
 .1  .2  .1 .
P
P
1000000
8. (10 points) You are the mortgage loan officer at Hang Seng bank. You offer 30
year fixed payment loans to creditworthy homebuyers at a yield to maturity of
4%. You arrange a loan of HK$2,000,000. What fixed payment will generate a
yield to maturity of 4% for this loan?
i
.04
The payment is C  LOAN 
 2000000 
 $115,160.19
T
  1  
  1  30 
 
 
1  
1  
  1  i  
  1.04  
9. (10 points) Over the course of the 1990’s, the average growth rate of the real
exchange rate between Hong Kong and Japan has been 5%. The average Hong
Kong inflation rate has been 5%. The average Japan inflation rate has been –
2.4%. Assuming that Japanese bonds have the same risk, information and
liquidity properties as Hong Kong bonds, should we expect Japanese bond yields
to be greater or less than Hong Kong bond yields. What is the difference in yields
that we should expect to see, measured in basis points?
EX r EX
EX EX r

 (   f ) 

 (   f )  .05  .05  .024  .024
EX r
EX
EX
EX r
EX 1
. Given the interest parity condition,  .024 
 i f i
EX
III. Graph Exercises 6. (10 points) The bond market perspective represents bond markets with a supply
curve for bonds (representing issuers of bonds) and a demand curve for bonds
(representing portfolio holders). Certain events will affect the behavior of both
bond issuers and portfolio holders and shift both curves. Draw a graph of the
effect of these events from the Bond Market Perspective of a large country bond
market like the US dollar market. Report whether the event increases the price of
bonds, decreases the price of bonds, or has an ambiguous effect on the price of
bonds. Report whether the event increases the quantity of bonds, reduces the
quantity of bonds, or has an ambiguous effect on the quantity of bonds.
a. Due to political events in the oil producing regions of the world, there is a
sharp rise in oil prices. The rise in oil prices dramatically reduces the
productivity of capital equipment that requires energy to operate. The rise
in gasoline prices also has a negative impact on the wealth of savers.
P
S
D
B
Price: Ambiguous, Quantity falls.
b. A government that has never borrowed before sets up a market for
government bonds. The government issues bonds to finance a new deficit.
The new government bond market sets up a benchmark standard for riskfree debt, giving bond buyers cheaper information. This makes all bonds
in this market more attractive to portfolio holders
P
S
D
B
c. Price: Ambiguous; Quantity: Greater
7. (10 points) Use the Loanable Funds perspective to analyze some events occurring
in the HK$ bond market. Remember, Hong Kong, has a fixed exchange rate vs.
the US. Draw a graph that demonstrates the effect of the event on the bond market
using the Loanable Funds perspective. Report the effect of each event on both the
yield and the quantity of HK loanable funds.
a. The government sets up a new auction market for bonds. This improves
the liquidity characteristics of the representative HK dollar bond relative
to a US dollar bond.
S
i
S’
iUS
iUS-hf,d
D
LF
Yield: Drop in interest rates, increase in supply of funds to HK$ bond market.
b. The Hong Kong government announces that it will cut the corporate
profits tax beginning in one years’ time.
S
i
iUS
iUS-hf,d
D
LF
Yield: No Change; Loanable Funds increase.
(15 points) Consider the effect of the following temporary events on the current
exchange rate between the HK dollar and the Japanese Yen. Draw a graph that shows
the relationship between the HK$-¥ exchange rate and the HK$ returns of Hong Kong
and Japanese bonds. Draw graphs that analyze the effect of these events on the
current level of the exchange rate (treating Hong Kong as the domestic economy).
Report whether the event should cause a rise or fall in the current exchange rate.
Report whether the event should imply an expected future appreciation or
depreciation of the exchange rate over the life of the bonds. These events have no
effect on forecasts of future exchange rates.
a. The Japanese government runs a large temporary budget deficit to
finance the construction of soccer stadiums for the 2002 World
Cup games.
Japanese if increases
i
EX
if-
EX e
EX
R
Current Exchange Rate Depreciates; Expected Appreciation over the life of the bond.
b. There is an increase in uncertainty in economic conditions that
leads to a temporary worsening of the risk properties of Hong
Kong bonds.
EX e
 h f ,d
EX
There is a rise in the domestic country risk premium. If interest rates stay the same
i if 
EX
if-
EX e
-hfd
EX
R
Current Exchange Rate Depreciates; Expected Appreciation over the life of the bond.