Name: __________________________________________________

FNCE 4070 – Final Exam1. In the following question we are going to discuss a bond with semi-annual

coupons of 12% (pays 6% of face amount every 6 months), a 2-year maturity and a face amount of $100. The following table gives interest rates for various maturities. All interest rates are of the form (1+r )t where t is measured in years.

Maturity in years Interest Rate0.5 1.5%1 2.0%1.5 2.5%2 3.0%

a. (4 points) Fill out the following table to three decimal places:

Maturity in years Discount Factor

0.5

1

1.5

2

b. (4 points) What is the present value of the bond?

c. (4 points) What is the duration of the bond?

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d. (4 points) If I buy this bond today for $110 and sell it in 1 year for $102 what is my return in dollar terms? Assume that all cash flows are reinvested at a 2% interest rate.

In the final part of this question we are considering the same bond but with a changed interest rate environment. The changed interest rates are:

Maturity in years Interest Rate0.5 1.6%1 2.1%1.5 2.6%2 3.0%

e. (2 points) Given the change in interest rates would you expect that the value of the bond to increase or decrease? Explain why?

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Name: __________________________________________________

2. The following questions are to do with securities lending:a. (2 points) Describe two investment strategies that require the

borrowing of securities?

b. (2 points) Why might a company that has a portfolio of securities be interested in lending them out?

AIG Securities Lending Corporation was set up to centrally manage the lending operations of AIG’s insurance company subsidiaries. The insurance companies would lend securities to AIG Securities Lending Corporation and it would lend the securities to other counterparties – banks and hedge funds. At its peak, AIG Securities Lending Corporation had lent $76bn of securities and invested 60% of the resulting cash in residential mortgage backed securities.

c. (2 points) What advantages might AIG have had in setting up AIG Securities Lending Corporation rather than allowing each insurance subsidiary to manage its own lending?

d. (2 points) As borrowers of AIG securities became concerned about AIG, what did they do to protect themselves from AIG? Why did this create a problem for AIG?

e. (2 points) In bailing out AIG, why did the Federal Reserve set up Maiden Lane II to buy the RMBS AIG had bought with the cash from its securities lending program? How did this help the Insurance subsidiaries of AIG?

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Name: __________________________________________________

3. The following question has to do with two traders making markets in foreign exchange. Trader 1 makes the following markets: 0.82-0.84 EUR/CHF and 1.31-1.33 USD/EUR. Trader 2 makes the following markets: 0.83-0.86 EUR/CHF and 1.28-1.32 USD/EUR.

a. (4 points) Fill in the following tableMarket Participant Currency1/Currency2 Market Buys

Currency1 and sells Currency2

Market Buys Currency2 and sells Currency1

Trader 1 EUR/CHF

Trader 1 USD/EUR

Trader 2 EUR/CHF

Trader 2 USD/EUR

b. (4 points) Fill in the following table. Round to 3 decimal places.Market Participant Currency1/Currency2 Market Buys CHF

and sells USDMarket Buys USD and sells CHF

Trader 1 USD/CHF

Trader 2 USD/CHF

c. (4 points) If you currently have $1,000 USD what is the maximum number of Swiss Francs (CHF) that you can turn these into? How?

a. (4 points) Two traders are making the following markets. Is there an arbitrage opportunity available? If there is explain how to take advantage of it.

Market Participant Currency1/Currency2 Market Buys ZAR and sells USD

Market Buys USD and sells ZAR

Trader 1 ZAR/USD 8.5 8.4Trader 2 ZAR/USD 8.3 8.2

b.

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4. The following has to do with exchange rates and interest rates between Europe and Switzerland.

a. (4 points) The current exchange rate between Euros (EUR) and Swiss francs (CHF) is 0.8400 EUR/CHF. 1-year interest rates in Europe are 0.51% and 1-year interest rates in Switzerland are 0.36%. What is the forward exchange rate in 1-years time?

b. (2 point) Does your answer in (a) imply that CHF will strengthen or weaken versus EUR in the next year? Explain your answer.

c. (4 points) Given the current crisis in Europe, investors have been buying Swiss assets. Would you expect this to cause a strengthening or a weakening of CHF? Demonstrate this with supply demand graphs for the exchange rate versus the supply of CHF assets. On your supply and demand graph clearly label - your axes, the supply and demand curves and write the units of the currency.

d.

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5. The following has to do with the following order book for a stock:Bid Quantity Bid Price Offer Price Offer Quantity5,000 100 102 6,0004,000 99 103 10,0006,000 98 110 15,000The following traders enter orders into the order book

Trader OrderA A stop limit order to sell 2000 shares at 100B A limit order for 8,000 shares to buy at 102C A market if touched sell order for 5,000 shares at 103D A market sell order for 8,000 shares

a. (8 points) How many shares does each trader buy/sell and at what average price?

Trader Shares bought/sold Average PriceA

B

C

D

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b. (4 points) Given these trades what is the resulting order book?Bid Quantity Bid Price Offer Price Offer Quantity

6. The following question has to do with the market segmentation theory. The Federal Reserve is concerned that long-term corporate bond yields are too low and short-term corporate bond yields are too high. They would like to conduct open market operations involving buying and/or selling treasury bonds that should affect these yields appropriately. At this time they do not want to affect the Fed Funds rate.

a. (4 points) Describe open market operation(s) that could achieve this goal.

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Name: __________________________________________________

b. (6 points) Draw supply and demand curves for treasuries and corporate bonds. Demonstrate the effects of the operations described in (a) on the supply and demand of both treasuries and corporate bonds. For the supply and demand curves clearly label the curves as well as the axes appropriately. You will be marked down for leaving out the labels.

c. (4 points) According to the market segmentation theory why do changes in supply and demand of short-term treasuries affect short-term corporate bonds?

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Name: __________________________________________________

d. (4 points) Draw supply and demand curves for non-borrowed reserve at the Federal Reserve compared to interest rates. Clearly mark:

The Fed Funds rate The primary credit rate (discount rate) The rate the Fed pays on reserves. Units on both axes Your supply and demand curves

e. (2 points) Why will your strategy not affect the Fed Funds rate?

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Name: __________________________________________________

7. A hedge fund is going to set up a pairs trading strategy for 270 days between Pepsi (PEP) and Coca-Cola (KO). They are going to go long PEP and short KO. In order to compute the cost of borrowing a share use the following formula:

InitialStockValue×BorrowRate× days365

The current market in these share are:Stock Today’s Share Price Commission per

shareBorrow Rate

PEP $73.00 $0.20 0.75%KO $35.00 $0.10 0.25%

a. (2 points) If the strategy is to have $1,000,000 long of PEP and $1,000,000 short of KO how many shares is the hedge fund going to buy of PEP and how many shares of KO is it going to sell? Do not include any costs in these calculations.

b. (6 points) What percentage outperformance must PEP have over KO in order for the strategy to break even? Include all costs in your analysis.

c. (4 points) Upon further analysis both PEP and KO are expected to pay dividends during the 270 days that the strategy is to be held. Both are expected to pay a $0.50 dividend per share. Does the strategy have a higher or lower probability of making money? Why?

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Name: __________________________________________________

8. The following question deals with financial intermediaries.a. (2 points) Define financial intermediary.

b. (4 points) Financial markets often suffer from asymmetric information. There are two primary types of asymmetric information – adverse selection and moral hazard. Define these two terms.

c. (2 points) A life insurance company is a common type of financial intermediary. Give one example of adverse selection that a life insurance might face.

d. (2 points) A credit union is a common type of financial intermediary. Give one example of moral hazard that a credit union might face.

e. (2 points) A money market mutual fund is a common type of financial intermediary. Give two advantages that a money market mutual fund might have over an individual investing directly in money markets.

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Name: __________________________________________________

9. Assume the liquidity premium theory of interest rates. The interest rates in the following table are of the form (1+r )t where t is measured in years. Maturity in years Interest Rate Liquidity Premium1 2.00% 0%2 2.5% 0.5%3 3.0% 0.75%

a. (2 points) Given this information would you expect that the present value of $1,000 dollars paid in three years time would be higher, lower or stay the same under the expectations theory of interest rates? Explain your answer.

b. (4 points) Find the 1-year forward interest rate starting in 2 years time.

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Name: __________________________________________________

10. A seldom-used tool of monetary policy is the changing of reserve requirements.

a. (4 points) Would increasing the reserve requirements increase or decrease the Fed Funds rate? Why?

b. (4 points) Assuming a bank had very little excess reserves and the Federal Reserve increased the reserve requirements from 10% to 20% name two actions that the bank could take to meet the increased reserve requirements.

c. (4 points) Name two actions that the Federal Reserve might take in order to minimize the impact of increasing reserve requirements.

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Name: __________________________________________________

11. 10 year Hewlett Packard (HPQ) debt is trading at $900 for a face amount of $1000. A trader spends $900,000 buying this debt. He is concerned about the company and buys a $1m 5 year credit default swap (CDS) against HPQ defaulting. The annual CDS spread is 1% and the upfront payment is $20,000.

a. (2 points) Describe the cash flows on this credit default swap prior to default.

b. (2 points) Name 2 events that will trigger a default event for a credit default swap.

c. (4 points) IF HPQ were to trigger a default event on this credit default swap describe how the settlement of the credit default swap works.

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Name: __________________________________________________

12. Assume that the reserve requirements by the Federal Reserve are 10% of all checkable deposits. In the following problems there are two people with currency: Neville has $5,000 in his pocket and Nadia has $5,000 dollars in her pocket. Further assume that two banks, Bank 1 and Bank 2 have just opened for business and have no assets or liabilities. Assume that the Fed has issued only the cash held by Neville and Nadia and has the following balance sheet. Finally assume that there are no treasury monetary liabilities.

Federal ReserveAssets Liabilities

T-Bills $10,000 Cash in Circulation $10,000a. (6 points) Neville opens a bank account at bank 1 and deposits $4,000.

Nadia opens a bank account at bank 2 and deposits $5,000. Both banks place all funds into reserves and excess reserves.

Neville and Nadia borrow $5,000 each from Bank 2. The money is deposited into their respective bank accounts. If Bank 2 does not have enough reserves to complete this transaction then it will borrow directly from the Federal Reserve.

Correctly fill out the following T-accounts for the bank balance sheets after these transactions – distinguish between reserves and excess reserves.

Bank 1Assets Liabilities

Bank 2Assets Liabilities

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b. (4 points) Complete the following T-account describing the Federal Reserve’s balance sheet.

Assets Liabilities

c. (2 points) What is the Monetary Base after these transactions?

d. (2 points) What is M1 after these transactions?

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Name: __________________________________________________

13. Assume the expectations theory of interest rates. The first 13W T-bill has a discount rate of 2% and starts today. The second 13W T-bill starts in 13 weeks time and has an expected discount rate of 3%.

a. (4 points) What is the present value of the first 13W T-bill? What is the discount factor from today to 91 days?

b. (4 points) What is the expected value in 13 weeks of the second 13W T-bill? What is the expected discount factor from 91 to 182 days?

c. (2 points) What is the discount factor from today to 182 days?

d. (4 points) What is the discount rate for a 26W T-bill?

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Name: __________________________________________________

14. The following question is about inflation.a. (4 points) There are generally considered to be two drivers of

inflation. The first is cost-push and demand pull. Explain what is meant by demand-pull inflation. Give at least two drivers of demand-pull inflation in your answer.

b. (4 points) The EUR is trading at 1.3 USD/EUR. If inflation expectations increased in Europe relative to the United States how would you expect the exchange rate to be affected? Why?

c. (4 points) Draw a supply and demand curve for corporate bonds. Your axes should be the yield of the bond and the quantity of bonds available. Using your supply and demand graph demonstrate what you would expect the effect of an increase in inflation to be on the demand for the bonds. What would this do to the price of the bond?

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Name: __________________________________________________

15. A bank has the following balance sheet. The reserve requirements are 10%. The bank earns 0.25% interest on any reserves (to compute interest use

the formula ((1+r )t−1 )where t is measured in years). The Fed Funds rate is 0.50% (to compute interest use the formula

((1+r )t−1 )where t is measured in years). The mortgages have just been issued and are 30 year fixed rate

mortgages with an annual interest rate of 3% and monthly fixed payments.

The bank pays 0.5% simple interest per month to its deposit holders. Assume that interest paid to deposit holders is added to the total deposits.

Assets LiabilitiesReserves $9m Deposits $90mExcess Reserves $1m Bank Capital $5mMortgages $90m Borrowing of Reserves from

other Banks$5m

a. (3 points) What is the monthly payment on the mortgage? How much of this payment is interest and how much is principal?

b. (3 points) Compute all other income and expenses for this bank.

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c. (6 points) Draw T-accounts that show the bank’s balance sheet after one month. Include in the balance sheet any interest income and expenses.

d. (2 points) What is the bank’s 1-month return on equity?

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Name: __________________________________________________

16. The following question has to do with the European foreign exchange crisis of September 1992. The crisis was centered on interactions between the Deutschemark (DEM) and the British Pound (GBP). Leading up to the crisis were the following events: The exchange rate at the time was pegged at 2.778 DEM/GBP. In the aftermath of German Reunification the German Central Bank, the

Bundesbank, faced rising inflationary pressures. Reacting to this they raised interest rates significantly.

The British economy was facing its worst recession since World War II. The British economy is much smaller than the German Economy.

a. (4 points) Explain why the above facts would cause a problem for the UK Government.

b. (2 points) Given these facts would you have expected that the DEM was over-valued or under-valued compared to the GBP? Why?

Before the peg was finally broken the Bank of England entered into unsterilized foreign exchange interventions. c. (2 points) What is an unsterilized intervention?

d. (2 points) Describe an unsterilized intervention that the Bank of England might have carried out.

e. (2 points) After the peg was finally broken would the Bank of England have made or lost money due to its unsterilized interventions?

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