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- Define risk, how risk is measured, and how an investor is compensated for risk.
- Describe the relationship between the quantity theory of money and aggregate demand curve relative to potential output versus actual output.
- Describe the monetary reaction curve and its role in aggregate demand and monetary policy changes.
- Describe the factors that lead to recessions. Why are these true?
- Describe the standard tools of monetary policy and how these tools carry out monetary policy. Why were these ineffective after the 2007 financial crisis?
- Suppose you were the manager of a bank with the following balance sheet.
Bank Balance Sheet
You are required to hold 10 percent of checkable deposits as reserves. If you were faced with unexpected withdrawals of $30 million from time deposits, would you rather:
a. Draw down $10 million of excess reserves and borrow $20 million from other banks?
b. Draw down $10 million of excess reserves and sell securities of $20 million?
Explain your choice.
- Suppose a bank faces a gap of -20 between its interest-sensitive assets and its interest-sensitive liabilities. What would happen to bank profits if interest rates were to fall by 1 percentage point? You should report your answer in terms of the change in profit per $100 in assets.
- Suppose you purchase a 3-year, 5-percent coupon bond at par and hold it for two years. During that time, the interest rate falls to 4 percent. Calculate your annual holding period return.
- Compute the present value of a $100 investment made 6 months, 5 years, and 10 years from now at 4 percent interest.
- You have $1,000 to invest over an investment horizon of three years. The bond market offers various options. You can buy (i) a sequence of three one-year bonds; (ii) a three-year bond; or (iii) a two-year bond followed by a one-year bond. The current yield curve tells you that the one-year, two-year, and three-year yields to maturity are 3.5 percent, 4.0 percent, and 4.5 percent respectively. You expect that one-year interest rates will be 4 percent next year and 5 percent the year after that. Assuming annual compounding, compute the return on each of the three investments, and discuss which one you would choose.
- Recently, some lucky person won the lottery. The lottery winnings were reported to be $85.5 million. In reality, the winner got a choice of $2.85 million per year for 30 years or $46 million today.
a. Explain briefly why winning $2.85 million per year for 30 years is not equivalent to winning $85.5 million.
b. The evening news interviewed a group of people the day after the winner was announced. When asked, most of them responded that, if they were the lucky winner, they would take the $46 million up-front payment. Suppose (just for a moment) that you were that lucky winner. How would you decide between the annual installments or the up-front payment?
- Suppose that the yield curve shows that the one-year bond yield is 3 percent, the two-year yield is 4 percent, and the three-year yield is 5 percent. Assume that the risk premium on the one-year bond is zero, the risk premium on the two-year bond is 1 percent, and the risk premium on the three-year bond is 2 percent.
a. What are the expected one-year interest rates next year and the following year?
b. If the risk premiums were all zero, as in the Expectations Hypothesis, what would the slope of the yield curve be?
- You are considering buying a new house, and have found that a $100,000, 30-year fixed-rate mortgage is available with an interest rate of 7 percent. This mortgage requires 360 monthly payments of approximately $651 each. If the interest rate rises to 8 percent, what will happen to your monthly payment? Compare the percentage change in the monthly payment with the percentage change in the interest rate.
- According to the liquidity premium theory, if the yield on both one-and two-year bonds are the same, would you expect the one-year yield in one-years’ time to be higher, lower or the same? Explain your answer.
- You are an officer of a commercial bank and wish to sell a car loan that the bank owns as an asset to another bank. Using equation A5 in the Appendix to Chapter 4, compute the price you expect to receive for the loan if the annual interest rate is 6 percent, the car payment is $430 per month, and the loan term is five years.