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BA 4345
Spring 2005
Quiz 1
Name:
Questions 1-3 below refer to a November 11, 2004 WSJ article entitled “Fed
Raises Short-Term Rate to 2%”.
Summary: For the fourth time this year, the Federal Reserve (Fed) raised the
federal funds (fed funds) rate. The target on the short term rate stands at 2%,
and the Fed has indicated that it might raise rates again in December. During
the past two years, the real fed funds rate has been negative. Now that the
federal funds rate is above the inflation rate, the interest rate “path is expected to
become more data dependent”.
1. What is the federal funds rate? Who can lend at this rate? Who borrows
at this rate? The fed funds rate is the inter-bank loan rate. Banks borrow
and lend from each other at this rate to maintain their required amount of
reserves.
2. The article states that the Federal Reserve raised its “short-term target”.
When the Fed raises the fed funds rate, it actually raises a target on a
rate, rather than raising the rate directly. How does the Federal Reserve
operate to “hit” the target that they set? The Fed buys and sells shortterm government bonds. They buy to lower the rate and sell to raise the
rate.
3. How is an expectation of inflation built into an interest rate? The article
notes that the “real” fed funds rate was negative until recently. How would
this happen? Why is the “real” rate not negative now? The nominal rate
is the real rate plus the inflation rate. The real rate is negative if the
inflation rate is above the nominal rate. The nominal rate has increased in
recent weeks and is now above the inflation rate.
Questions 4-5 refer to an April 15, 2004 WSJ article entitled “Bond Rates
are Rising on Fears That Growth is Spurring Inflation”.
Summary: The likelihood of an improving economy has implications for the bond
market. An improving economy could result in increased inflation. As a result,
fixed income investors will demand higher rates to compensate for erosion in the
expected purchasing power of their fixed future payoffs. It is also likely that the
Federal Reserve Bank will target short-term rates to rein in the economy and
damp down inflation.
4. How do changes in interest rates affect bond prices? What has happened
to bond markets over the last few months? Bond prices and interest rates
move in opposite directions. Bond yields are up on short term bonds and
prices of those bonds are down. Bond yields are down on long term
bonds and prices of those bonds are up.
5. What is the yield curve? What is a flattening of the yield curve? Why
does an increase in the fed funds rate cause a flattening in the yield
curve? The yield curve is a graph of government bond yields versus their
term to maturity. The yield curve has flattened recently with short yields
up and long yields down. The increase in the fed funds rate affects the
short term rates.
6. Suppose you bought a 10-year zero-coupon bond for $400. The face
value of the bond is $1,000. What is the yield to maturity on the bond?
After 5 years, you decide to sell the bond. Market rates at that time are
12%. What is your annual return?
 YTM = 9.6%: FV=1000, PV=-400, n=20, i=?
 Price at time 5 = 567.43. FV = 567.43, PV=-400, n=5, i=7.24%=return.
 Or (567.43-400)/400 = 0.4186. (1.4186)(1/5)=1.0724. 1.0724-1 = 7.24%
7. Suppose the yield to maturity on a one-year pure discount bond is 5%.
The yield to maturity on a two-year pure discount bond is 7%. According
to the pure expectations theory, what is the expected one-year rate for
year 2? 7% = (5%+x)/2
x = 9%
8. What is the primary difference between the money and the capital
markets? Give two examples of financial instruments in each. Money
market instruments have an original maturity of less than one year.
Examples are: T-bills, Commercial paper, Large CDs, etc.
Capital market instruments have an original maturity of more than one
year. Examples are: Corporate bonds, municipal bonds, stocks.
9. Describe the three functions that money serves in the economy. Medium
of Exchange – can be exchanged for goods. Store of Value – people can
accumulate savings and holds value. Unit of Account – prices of other
goods are expressed in terms of money.
10. When interest rates rise there is a tendency for people to switch their
money out of demand deposits and other checkable deposits into money
market deposit accounts and money market mutual funds. How does this
affect the money supply as defined by M1? As defined by M2? M1
decreases and M2 stays the same (in the short run). M2 would increase
in the long run if the reserve requirements on the money market accounts
was less than on demand deposits.