10 points
Explain why Interest rates can be volatile but also stable?
Answer: “If a long-term rate is expected to equal a geometric average of consecutive short-term rates covering the same time horizon (as is suggested by pure expectations theory), long- term rates would likely be more stable than short-term rates. As expectations about consecu- tive short-term rates change over time, the average of these rates is less volatile than the indi- vidual short-term rates. Thus long-term rates are much more stable than short-term rates.” (Madura, 2016 Ch 3 Pg. 58)
Explain whether the yield curve provides a reasonable forecast of future interest rates and what are the constraints of the yield curve.
As a manager of a large U.S. firm, one of your assignments is to monitor U.S. economic conditions so that you can forecast the demand for products sold by your firm. You are also concerned about interest rates as you plan to expand your plant and increase investments. You realize that the Federal Reserve implements monetary policy—and that the federal government implements spending and tax policies, or fiscal policy—to affect economic growth and inflation. However, it is difficult to achieve high economic growth without igniting inflation. Although the Federal Reserve is often said to be independent of the administration in office, there is much interaction between monetary and fiscal policies.
Assume that the economy is currently stagnant and that some economists are concerned about the possibility of a recession. Yet some industries are experiencing high growth, and inflation is higher this year than in the previous five years. Assume that the Federal Reserve chair’s term will expire in four months and that the president of the United States will have to appoint a new chairman (or reappoint the existing chair). It is widely known that the existing chair would like to be reappointed. Also assume that next year is an election year for the administration.
a. Given the circumstances, do you expect that the administration will be more concerned about increasing economic growth or reducing inflation? Why?
Answer: In my opinion, they will concentrate on both the economic growth, and inflation tare, as they are correlated by each other. In order to reduce inflation, the interest rate might be adjudyrf and increased to balance the economy; thus, affecting economic growth.
b. Given the circumstances, do you expect that the Fed will be more concerned about increasing economic growth or reducing inflation? Why?
Answer: The FEDs are more concerned with reducing inflation, but they will be more likely affected by both. In other words, they must focus on both economic growth and reduction of inflation.
c. Your firm is relying on you for some insight on how the government will influence economic conditions and therefore the demand for your firm’s products. Given the circumstances, what is your forecast of how the government will affect economic conditions?
30 Points
4. As a treasurer of a corporation, one of your jobs is to maintain investment in liquid securities such as Treasury securities and commercial paper. Your goal is to earn as high a return as possible, but without taking much of a risk.
a. The yield curve is currently downward sloping, such that 10-year Treasury bonds have an annualized yield 3 percentage points below the annualized yield of three-month T-bills. Should you consider using some of your funds to invest in 10-year Treasury securities?
b. Assume that commercial paper is presently offering an annualized yield of 7.5 percent, while Treasury securities are offering an annualized yield of 7 percent. Economic conditions have been stable, and you expect conditions to be very favorable over the next six months. Given this situation, would you prefer to hold T-bills or a diversified portfolio of commercial paper issued by various corporations?
c. Assume that commercial paper typically offers a premium of 0.5 percent above the T-bill rate. Given that your firm typically maintains about $10 million in liquid funds, how much extra will you generate per year by investing in commercial paper versus T-bills? Is this extra return worth the risk that the commercial paper could default?
20 points.
Explain how the bond market facilitates a government’s fiscal policy, and corporations raising funds. How do you think the bond market could discipline a government and discourage the government from borrowing (and spending) excessively? Also how could the bond market not be attractive for corporate