TEST 1 / October 3, 2016

FIN 302 / Fall 2016 / Dr. Fernandez

Name:

TES
T1
1. Why do you think the Foreign exchange markets are
important for the global economy?

a. Why is the dollar so important in this market?

Foreign exchange markets facilitate the trade of one foreign currency for
another. Most exchanges are made in bank deposits and involve U.S. dollars.
Over a trillion dollars in foreign exchange trades take place every day;
foreign exchange dealers handle most transactions. Businesses, financial
institutions, governments, investors, and individuals use the foreign
exchange markets to adjust their currency holdings.
b. LABEL the Supply and Demand Functions below and describe
how the market for US dollars works.

1-1

TEST 1 / October 3, 2016

FIN 302 / Fall 2016 / Dr. Fernandez

a. Use the chart to explain what is currently happening to the

dollar versus most world currencies. Why do you think this is
happening?

There is equilibrium between the dollar and other world currencies wich
fixed the exchange rate. Suppose, the quantity demand of the dollar will
increase in one countries with respect to local currency. The price of the
local currency will be declined due to increase in the quantity demand of the
US Dollar and vice versa.

1-2

TEST 1 / October 3, 2016

FIN 302 / Fall 2016 / Dr. Fernandez

2. What is the loanable funds theory of interest rates? Use the chart
below to explain (make sure you label the Supply and Demand
functions)

According to loanable funds theory, equilibrium rate of interest is that

which brings equality between the demand for and supply of loanable
funds. In other words, equilibrium interest rate is determined at a point
where the demand for loanable funds curve intersects the supply curve of
loanable funds. It can be shown with the help of a Figure.

The rate of interest is determined at the point of intersection of the two

curvesthe supply of loanable funds curve (SL) and the demand for
loanable funds curve, DL. Fig. 4 shows that the equilibrium rate of interest
is EM; at this rate, the demand for loanable funds is equal to the supply of
loanable funds i.e. OM.

a. Define the composition of the Demand Function (i.e.

list in order of importance the Lender- Savers)

Investment (I):
The main source of demand for loanable funds is the demand for
investment. Investment refers to the expenditure for the purchase of
making of new capital goods including inventories. If the rate of interest is

TEST 1 / October 3, 2016

FIN 302 / Fall 2016 / Dr. Fernandez

low, the demand for loanable funds for investment purposes will be high
and vice- versa. This shows that there is an inverse relationship between
the demands for loanable funds for investment to the rate of interest.
Hoarding (H):
The demand for loanable funds for hoarding purpose is a decreasing
function of the rate of interest. At low rate of interest demand for loanable
funds for hoarding will be more and vice-versa.
Dissaving (DS):
Like hoarding it is also a decreasing function of interest rate.

b. Define the composition of the Supply Function (i.e.

list in order of importance the Borrower- Spenders).
Savings (S):
The amount of savings varies with the rate of interest. Individuals as well as
business firms will save more at a higher rate of interest and vice-versa.
Dishoarding (DH):
Dishoarding is another important source of the supply of loanable funds. At
a higher interest rate, idle cash balances of the past become the active
balances at present and become available for investment. If the rate of
interest is low dishoarding would be negligible.
Disinvestment (DI):
Disinvestment will be high when the present interest rate provides better
returns in comparison to present earnings. Thus, high rate of interest leads
to higher disinvestment and so on.
Bank Money (BM):
The money created by the banks adds to the supply of loanable funds.

TEST 1 / October 3, 2016

FIN 302 / Fall 2016 / Dr. Fernandez

c. What happened with s/d of loanable funds during the

crisis? (i.e. factors that changed the s/d functions).

Full Employment:
Keynes opined that loanable funds theory is based on the unrealistic
assumption of full employment.
Indeterminate:
This theory assumes that savings and income both are independent. But
savings depend on income. As the income changes savings also change
and so does the supply of loanable funds.
Impracticable:
In actual practice investment is not only affected by interest rate but also
by the marginal efficiency of capital whose affect has been ignored.
Unsatisfactory Integration of Real and Monetary Factors:
Monetary as well as real factors as the determinants of interest cannot be
integrated in the form of the schedule as is evident from the frame work of
this theory.
3. Describe the following dimensions in which the structure of
Financial Markets can be defined:

a. Debt Markets versus Equity Markets

In the debt market, individuals trade debt instruments such as bonds and
mortgages. In the equity market, usually called the stock market,
individuals trade securities that guarantee a portion of the earnings and
assets to the holder.

b. Primary versus Secondary Markets

the primary market deals with the newly issued securities while the
secondary market deals with already traded securities. When the
companies issue securities in the primary market, they collect funds

TEST 1 / October 3, 2016

FIN 302 / Fall 2016 / Dr. Fernandez

directly from the investors through the securities sales. But, in the
secondary market the money earned from selling a security does not go to
the company.
c. Money Market versus Capital Markets

Money markets are used for a short-term basis, usually for assets
up to one year. Conversely, capital markets are used for long-term assets,
which are any asset with maturity greater than one year.
Capital markets are perhaps the most widely followed markets. Both the
stock and bond markets are closely followed and their daily movements are
analyzed as proxies for the general economic condition of the world
markets.

4. You buy a discount bond today at $750. It will mature one

year from today. Plug in the corresponding values in the
Present Value Formula and solve for the yield to maturity
(i.e. interest rate).

YTM (interest rate) = PV/(1+i)-1

= supposed the par value of the bond is
$1000 then YTM will be 33.33% for one-year bond.

TEST 1 / October 3, 2016

FIN 302 / Fall 2016 / Dr. Fernandez

5. You bought a 30 year above par bond for $1,200 yesterday.

What would happen to its price if you decided to sell it
tomorrow versus selling it in 29 years (1 year to mature)?
Due to application of time value factor, the value of the bond after 29 year
remain only $70 if 10% interest rate applied shows where as selling it today will
give you complete price i.e. $1,200.
a. Complete the chart below and use it to define the
relationship of the price of a bond and its yield to
maturity. (How YTM changes as the bond gets close to
maturity).

The bond price is the present value when discounting the future cash flows
from a bond; YTM is the interest rate used in discounting the future cash flows
(coupon payments and principal) back to their present values.
Current yield is defined as the annual coupon payment divided by the current
bond price. For premium bonds, the current yield is less than the YTM, for
discount bonds the current yield exceeds the YTM, and for bonds selling at par
value, the current yield is equal to the YTM. In all cases, the current yield plus
the expected one-period capital gains yield of the bond must be equal to the
required return.

Premium

Par

$1000
Today

Discount

Maturity

TEST 1 / October 3, 2016

FIN 302 / Fall 2016 / Dr. Fernandez

Par = $1,000

Discount = below than par value

Premium = above than par value

6. Estimate the Expected Return of an asset with four possible

states with probabilities and returns as follows:
STATE (S)
1
2
3
4

Prob. of State
Pr
0.25
0.25
0.25
0.25

Return in State
R
-15%
5%
20%
35%

a. Use your results to estimate the Standard Deviation ( )

in the returns of this asset.

= 0.0428

b. Use the normal probability distribution chart below

to show your answer, making sure you indicate the
68%, 95% and 99% range of returns that you may
get from this investment.

standard normal distribution is a normal distribution with mean 0 and

standard deviation 1. Areas under this curve can be found using a standard
normal table (Table A in the Moore and Moore & McCabe textbooks). All
introductory statistics texts include this table. Some do format it differently.
From the 68-95-99.7 rule we know that for a variable with the standard
normal distribution, 68% of the observations fall between -1 and 1 (within 1
standard deviation of the mean of 0), 95% fall between -2 and 2 (within 2
standard deviations of the mean) and 99.7% fall between -3 and 3 (within 3
standard deviations of the mean).
c. In your opinion, is this a risky investment? Why?
According to standard normal distribution 99% range is the riskiest
investment among the whole portfolio because, here chance of deviation is
more.
7. In the following chart, explain what happens if the price
of a bond is $900 (i.e. is that the market equilibrium? Or
excess supply/demand?

a. At $900, is there a pressure on the price to go up/down?

Describe the situation.
If the market pressure fluctuates and price goes up from the $850 to $900, it
will rise in the demand and supply of the bonds. It means due to change in
price the demand of the bonds will be decreases in the economy where
ultimately the quantity supply of the bonds will be increase in the market.

i. What happens to the interest rate in the market

adjustment?
Interest rate directly affect market adjustment. Hence, due to increase in the
price the interest factor value is also raised because the consumer is
expecting more interest in the form of the bonds and vice versa.
b. Use your own words to explain the relationship between
rates and the price of a bond.
Interest rate and bonds play a direct role between each other and fluctuate
the prices, therefore,

due to increase in the price the interest factor value is also raised because
the consumer is expecting more interest in the form of the bonds and vice
versa.

c. Use the chart above to show what happens if we

observe an INCREASE in the two determinants of
demand listed below. Explain with your own words what
happens to the market equilibrium after the increase of
each of the two.
i. Wealth

Due to increase in the price the demand and supply curve will be shifted
upwared and in this reset new price will be adjusted, hence, the wealth in
term of higy price of bonds will be increase.
ii. Risk
Due to bond volatility and fluctuation in the price will multiply the risk factor
due to decrease in the quantity demand of bonds.

TEST 1 / October 3, 2016

FIN 302 / Fall 2016 / Dr. Fernandez

8. Suppose hold a 2 year par-value bond with a coupon = 6%

and paid semiannually. YTM = 6%. Calculate the Macaulay
Duration. Interpret your results.

n=# of
cash flows
t=time to
maturity
C= coupon
i=YTM
M=Par
value
=1.81914 years.
It shows that the increase with the year of the maturity the Macaulay
duration is decreases with fractions due to measuring the convexity of the
formula.

9. Label the SUPPLY and DEMAND curves below. In the charts,

show what happens if the default risk on corporate bonds
DECREASES. Make sure you show what happens in the
Corporate Bond Market and the effects on the Treasury Bond
Market (i.e what happens to prices and required rate in each
market and the change in risk premium).

TEST 1 / October 3, 2016

FIN 302 / Fall 2016 / Dr. Fernandez

a. Based on you knowledge of the economy, what is

currently going on the US Treasury Bond
Market? (i.e. whats going on with the US treasury bonds
prices and required rates?

There is equilibrium in the bond and money market which defines the market
price. Hence, if the debts increases in the market which will increase in the
supply of the money and hence the price of US treasury bond price will be
goes up with the increase in the interest rates.

10.

What are the THREE primary functions of the Fed?

a. Describe the function of each of the primary elements in

the structure of the Federal Reserve System:

i. The Board of Governors

The Board of Governors, also known as the Federal Reserve Board, is the
national component of the Federal Reserve System. The board consists of the
seven governors, appointed by the president and confirmed by the Senate

ii. The Regional Federal Reserve Banks

A network of 12 Federal Reserve Banks and 24 branches make up the Federal

Reserve System under the general oversight of the Board of Governors.
Reserve Banks are the operating arms of the central bank.

The Federal Open Market Committee

A network of 12 Federal Reserve Banks and 24 branches make up the Federal
Reserve System under the general oversight of the Board of Governors.
Reserve Banks are the operating arms of the central bank.

11.
Define and describe how each of the monetary policy tools
of the Fed works.
b. Discount Rates

The discount rate is the interest rate charged by Federal Reserve Banks to
depository institutions on short-term loans.
c. Reserve Requirements
Reserve requirements are the portions of deposits that banks must maintain
either in their vaults or on deposit at a Federal Reserve Bank.

d. Open Market Operations

The Fed uses open market operations as its primary tool to influence the
supply of bank reserves. This tool consists of Federal Reserve purchases and
sales of financial instruments, usually securities issued by the U.S. Treasury,
Federal agencies and government-sponsored enterprises.

12.
Describe what happens to the overall economy when
Reserve Requirements decrease.
a. Suppose reserves are $5 billion and the Fed increases reserves
by 1% ($50 mill) when bank reserves are 10%. What is the
predicted increase in Bank Deposits (i.e. Change in Money
Supply)?

Resultant change in the money supply = (1/0.10) x $5 billion

= 10 x $5 billion = $50 billion

b. What if Bank Reserves are 15%?

Resultant change in the money supply = (1/0.15) x $5 billion

= 6.667 x $5 billion = $33.333 billion

c. And what it Reserves are 20%?

Resultant change in the money supply = (1/0.20) x $5 billion

= 5 x $5 billion = $25 billion
d. Why are your answers in a, b and c are different? What does it
mean for the economy? Why?
Baking reserve ratio directly affected the change in money supply as much as
the bank reserve increase the money supply will be decreases.

13.
In the Liquidity Preference Curve chart below assume that the
Fed has decided on $12 Bill money supply. Draw the Money Supply
Curve. Then, draw the demand curve assuming that the equilibrium
rare is 1%.

1. Now, use the chart to explain what happens when the Fed
conducts Open Market Sales. (Show the movement in the chart
and explain the transmission mechanism).

In the open market sale due to rise in the equilibrium in the market with 1% in
the interest rate, the
Quantity demand of the money is declined whereas, the supply of the money
is increased.

2. What if it conducts Open Market Purchases? (Show the

movement in the chart and explain the transmission
mechanism).
Due to open market purchases phenomenon the supply of the quantity will be
decrease which will also decrease the interest rate.

3. Explain the Feds trade off of Inflation versus

Unemployment.
Increase in inflation cause to increase the employment and vice versa. As due
to increase in inflation lead to increase in money supply which ultimately
tends the opportunity to open the new business.