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FINAL EXAM: PRINCIPLES OF MACROECONOMICS Professor Lyn
Exam is due back by 9AM on Tuesday, April 2! Late submissions will not be accepted. Reminder: All work must be done independently! Email exam through Blackboard email. Note: Your exam grades will be posted within a week after submission. Good Luck!
Maximum possible score = 40 points
1) Suppose the yield to maturity on a 2 year Treasury note was 4 % while the yield on a 1 year note was 5%. Assume that neither Treasury note had coupon payments, so the only payment was the face value received when the note matured.
a) Why is it unusual for yields on longer term notes to be lower than yields on shorter term notes? 2pts
b) Why would any investor buy the 2 year note (instead of the 1 year) given its lower yield? (for full credit your answer must involve a specific number) Opts
2) Suppose the CFO of an American corporation with surplus cash flow has $90 million to invest and the corporation does not believe it will need to utilize these funds to retool or expand production capacity for 1 year. Suppose further that the interest rate on 1 year CD deposits in US banks is .5 %, while the rate on 1 year CD deposits (denominated in Australian dollars) is currently 2.5 %. Suppose further that the exchange rate currently is (.8) Australian Dollars per US $. What must the CFO expect about the Australian Dollar/US$ exchange rate 1 year from now if she chooses to invest in the US $ CD's instead of the Australian CD's? (Note: a specific numeric answer is required for full credit. Part credit can be earned for correctly identifying and discussing the issue here without a specific numeric answer.) 4pts.
3) Between February 2008 and Summer 2009 the Fed supplemented its open market operations with a greatly expanded program of direct lending (both overnight and short term 28 and 84 day loans) to commercial banks, investment banks, brokerage and primary dealer units of bank holding companies. It also agreed to accept a wider range of short tern securities (instead of accepting only T-Bills) as collateral on these loans and even initiated a program to buy commercial paper from money market funds.
A) Explain why the Fed created all these extraordinary direct lending facilities, instead of simply relying on traditional open market purchases of Treasury securities.(hint: You may wish to look at Bernanke's recent lecture series at GW university (on the Federal Reserve Website)---particularly the 3rd in the 4 lecture series. A link to it is on the main Federal Reserve site page) 4 pts
1 of 3 3/31/2013 12:46 PM
Answered Same DayDec 31, 2021

Solution

David answered on Dec 31 2021
31 Votes
1) Suppose the yield to maturity on a 2 year Treasury note was 4 % while the yield on a 1 year
note was 5%. Assume that neither Treasury note had coupon payments, so the only payment was
the face value received when the note matured.
a) Why is it unusual for yields on longer term notes to be lower than yields on shorter term
notes? 2pts
Answer:
These results are unusual as per liquidity preference theory. As per liquidity preference theory,
longer term securities (because of uncertainties and associated illiquidity) involves more risks
than shorter term securities and therefore yields on longer term securities must be higher than
yields on shorter term securities.
In the given scenario, we note that it is other way round and hence it is believed to be unusual.
) Why would any investor buy the 2 year note (instead of the 1 year) given its lower yield? (for
full credit your answer must involve a specific number) 4pts
Answer:
An investor would buy 2 year note (instead of the 1 year) despite its lower yield, if the total yield
on 2 year note is greater than expected combined yield on 1 year treasury note for two years.
Example: suppose the expected yield rate for the next year is 2.5%. So expected combined yield
on 1 year Treasury note for two years = 5%+2.5% = 7.5% and total yield on 2 year note =
4%+4% = 8%.
Since the total yield on 2 year note is greater than expected combined yield on 1 year treasury
note for two years, the investor would buy 2 year note.
2) Suppose the CFO of an American corporation with surplus cash flow has $90 million to invest
and the corporation does not believe it will need to utilize these funds to retool or expand
production capacity for 1 year. Suppose further that the interest rate on 1 year CD deposits in US
anks is .5 %, while the rate on 1 year CD deposits (denominated in Australian dollars) is
cu
ently 2.5 %. Suppose further that the exchange rate...
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