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Name _______________________ Test 2-A, Fall 2002 Financial Markets FINC434 – Prof: David Eagle Answer 4 and only 4 of the following 6 WSJ questions: (2.5 points each) 1. Which one of the following statements is false concerning the article about the Federal Reserve's revamping of its discount rate system? A. Under the change, the federal funds rate will be higher than the discount rate. B. Currently the Federal Reserve rations use of the discount window and gives a negative stigma for using it. C. Technical conditions sometimes cause the federal funds rate to spite well above intended levels. D. Under the change, the Federal Reserve will continue to publish discount-window loans by district. E. The Bank of Canada has two discount rates, where the higher rate is for more troubled banks. 2. The credit-default swap market is A. the market for insurance against an individual company defaulting on a debt. B. the market for directors-and-officers insurance coverage. C. the market for surety bonds. D. the market for buying and selling corporate debt by insurance companies. E. the market for variable life insurance annuities. 3. Which of the following statements concerning single-stock futures is false? A. Single-stock futures have been prohibited from 1982 until recently. B. Single-stock futures have been traded in Europe for several years. C. The volume of single-stock futures is quite high in Europe. D. Single-stock futures might allow arbitrageurs to trade on price differences between single-stock options and single-stock futures without trading the individual stocks themselves. E. Some traders view single-stock futures as redundant given that individual stock options exist. 4. The plan agreed by the New York State attorney general and federal securities regulators would require securities firms to A. routinely publish positively slanted research to help investment banks get more business. B. make their research budgets totally independent from the total revenue of the firm. C. split off their research departments as separate firms. D. make their research departments as separate organizations within the company with the chief of the department reporting to either a senior executive having nothing to do with investment banking or to the CEO. E. base the bonuses of analysts on investment-banking revenues. Page 2 of 6 5. During what time period did leveraged closed-end bond funds lose more money than open-ended bond funds? A. Between 1982-1986 B. Between 1986-1990 C. Between 1993 and 1994 D. Between 1998 and 1999 E. Between 2000 and 2001 6. Explain the difference between IPO “spinning” and IPO “laddering”. To communicate which 4 of the above 6 questions you chose to answer, please clearly cross out the questions you chose not to answer. 7. (5 points) Assume the pure expectations theory is correct. The table on the right gives the yields on zero coupon bonds as related to their maturity. (a) What is the expected interest rate on a 6-month loan starting in 6 months and ending 1 year from now? (b) What should be the expected interest rate on a 6-month loan starting in 1 year and ending 18 months from now? maturity 1 2 3 4 5 6 7 yields (r0,t) 7.6% 8.8% 8.2% 8.4% 7.9% 8.2% 8.5% (c) What should be the expected interest rate on a 6-month loan starting in 18 months and ending 2 years from now? (d) What should be the expected interest rate on a 6-month loan starting in 2 years and ending 2.5 years from now? (e) What should be the expected interest rate on a 6-month loan starting in 2.5 years and ending 3 years from now? Page 3 of 6 8. (10 points) A money center bank in Germany quotes an exchange rate of 1.62 euros per pound, whereas a money center bank in France quotes an exchange rate of .68 pounds per euro. Suppose you have 1,000,000 euros. (a) Describe in sentences an arbitrage that will give you a riskless profit. (b) Clearly state the profit you would make. (c) State what type of arbitrage this is. 9. (10 points) Assume the liquidity preference theory is correct. The graph below shows the liquidity premium and the yield as functions of the maturity of a bond. (a) Precisely draw the expectations curve. (b) What is the expected instantaneous interest rate 8 years from now? 10% 8% 6% 4% 2% 0% rate yield curve liquidity premium years 0 2 4 6 8 10 12 14 10. (5 points) Assume the pure expectations hypothesis is correct and that the expectations curve is: E[rt] = 3% + 0.4% t Write an equation for the yield curve. Page 4 of 6 11. (6 points) Explain the difference between LIBOR, LIBID, and LIMEAN. 12. (6 points) Explain what commercial paper is and why a corporation would issue commercial paper rather than borrowing the money from a bank. 13. (15 points) Imagine that today a T-bill maturing in 26 weeks sells for 98.23, and another T-bill maturing in 52 weeks sells for 95.93. Also, a T-note that matures in 18 months pays a 7.2% coupon rate, paid semiannually, and sells for 102.91. A T-bond that matures in 24 months and that pays a 6.3% coupon rate, paid semiannually, sells today for 103.87. Another T-bond that matures in 30 months and that pays an 8.2% coupon rate, compounded semiannually, sells for 107.99. (a) What is the theoretical yield, compounded semiannually on a zero-coupon treasury bond maturing 6 months from now? (Note: this theoretical yield on a zero is what the book called the "spot rate".) (b) What is the theoretical yield, compounded semiannually, on a zero-coupon treasury bond maturing 1 year from now? (c) What is the theoretical yield, compounded semiannually, on a zero-coupon treasury bond maturing 18 months from now? (d) What is the theoretical yield compounded semiannually, on a zero-coupon treasury bond maturing 2 years from now? (e) What is the theoretical yield compounded semiannually, on a zero-coupon treasury bond maturing 2.5 years from now? Page 5 of 6 14. (15 points) Imagine two countries called Squid and Dolphin. Qs are Squid's currency and Ds are Dolphin's currency. Both Squid and Dolphin have high rates of inflation and, as a result, have high interest rates. The interest rate in Squid is 38% whereas the interest rate in Dolphin is 34%. Assume you are a money center bank, you have neither of these currencies to begin with, but you can borrow and lend at these interest rates. The spot exchange rate currently is 3.25 Qs per D. The exchange rate on a 360-day forward contract is 3.87Qs per D. Borrow 1,000,000 units of one of the currencies and engage in an arbitrage that will make you a riskless profit. (a) State the profit you would make from this arbitrage. (b) Clearly describe this arbitrage using sentences. (c) State what type of arbitrage this is. 15. (6 points) Explain the difference between a “fallen angel” and a “junk bond”. Multiple choice: (2 points each) 16. The dollar amount of the payments exchanged in a swap agreement is based on some predetermined dollar principal, which is called the: A. principal. B. notional amount. C. par value D. maturity value E. None of the above (Explain) Page 6 of 6 17. LEAPS are: A. Short-term options. B. Long-term options. C. Nearby options. D. Perpetual options. E. None of the above (Explain). 18. Option strategies that do not involve an offsetting or risk-reducing position in either another option or the underlying common stock are called: A. Naked strategies B. Covered strategies. C. Hedge strategies. D. Active strategies. E. Passive strategies. 19. The risk associated with a bond whose proceeds are reinvested at an unknown rate is referred to as: A. Reinvestment rate risk B. Interest rate risk. C. Price risk. D. Default risk. E. None of the above (Explain) 20. In the presence of inflation-driven high interest rates, mortgage repayment in real terms is no longer level, but instead starts high and ends low, shutting off many would-be-borrowers. This problem is referred to as the A. Pipeline risk. B. Mismatch problem. C. Tilt problem D. Maturity problem E. Inflation problem. 21. The effect of the prepayment right is that the cash flows from a mortgage are not known with certainty. This uncertainty is called: A. cash flow risk. B. prepayment risk. C. marketability risk. D. price risk. E. credit risk.