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Test I- Finance 408

Note:  State assumptions where you feel it is necessary

100 Total Points

1)  (15 points) Find the yield to maturity on a semiannual coupon bond with a face value of $1000, a 10% coupon rate, and 15 years remaining until maturity, given that the bond price is $862.35.

a. What do we know about the direction of market interest rates since the bond initially came to market? Explain.

b. Consider the same bond but suppose interest rates are now 10%, what price would the bond be trading for now in the market?

c. Suppose you are also pricing out a zero-coupon Treasury Bill.  If the current interest rate is 10%, what is the price of a fifteen-year, zero-coupon Treasury Bill with a face value of $1,000?

d. Which of the two bonds (the original semiannual or the zero coupon bond) would you expect to have a higher Duration?  Why?

e. If you strongly expect interest rates to fall, in which bond would you choose to invest? Why?

2) (15 points) Suppose that you are considering buying a $1,000 face value bond with an annual coupon rate of 10%, a maturity of three years and a price of $1,079.

a) Calculate the current yield of the bond

b) Calculate the Yield to maturity

c) Now assume that this original bond is callable in two years and carries a call premium of $1025.  What is the Yield-to-Call for this bond?

d) Under what economic conditions would a company execute this call option?  Why would an investor purchase this callable bond?

3) (15 points) Some things to make you go Hmmmmmm—Be sure to carefully explain your reasoning:

A. True, False, Uncertain? Treasury Bonds are the “safest” investment for market participants.  

B. Why does the Yield to Maturity (YTM) of a bond increase when market interest rates increase?

C. Why does the Duration of a Bond change as interest rates change?

D. Explain how corporate bonds can have less interest-rate risk than government bonds of similar terms-to-maturity?

4) (15 points) An individual faces two alternatives for an investment:

Investment A has the following probability return schedule-

Investment B has a guaranteed Nominal return of 8.0%

A) What is the expected risk and return associated with Investment A? How certain are you of the result?

B) Will a risk-averse investor always choose to purchase Asset B?  Please explain your answer.

5) 
(20 points) Please read the following articles and use sources you find to address the following questions:

A) “What Everyone Got Wrong About The Economy and the Ominous Implications for the Fed”,  Barron’s  Latest Update 3/3/23

B) “A Playbook from the 1980’s for Dealing with Inflation”, The Economist, 12/2/22

C) “Is Stagflation Coming Back? This Economist Sees Parallels with the 1970’s—And Differences.  Barron’s 10/23/21

D) From  Economic Forces: https://pricetheory.substack.com/p/what-theory-does-and-does-not-say  “What Theory Does and Does Not Say: Lessons from the Phillips Curve”, by Josh Hendrickson 2/23/23

E) “Stocks’ and Bond Yields’ ‘Virtuous’ Link May be About to Break, Barron’s, 1/31/23

Your new boss at Goldman Sachs is impressed with your knowledge of financial markets and would like you to provide a detailed report concerning the dangers of inflation/stagflation/recession possibly threatening the economy in the short and/or long run, especially in light of the recent banking crises.  

The Fed often speaks of being “Data Dependent” in making its economic forecasts and policy decisions.  Your Boss would like your help in interpreting important data, provide advice/forecasts ( interest rates, inflation, Unemployment and GDP) and explain the implications for the U.S. stock and bond markets.  You may also wish to consider Treasury Bond Liquidity, The Housing Market. Commodities, Retail Sales, Manufacturing and Services  

The articles above will get you started, but your boss will only be impressed if you bring information from other sources to your report. As a guide for your report, she wants you to be sure to discuss the following in your report:

1)  In your opinion, what is the bigger threat to the U.S. Economy Inflation or Recession? Is there now a danger of the economy experiencing a stagflation similar to the 1970’s? What data leads you to your decision?

Your boss could just read these articles. Your value-added to the project is a clear and concise, yet comprehensive, discussion of what YOU think about the inflation/recession/stagflation question: What is your detailed forecast? What data, metrics, observations, and economic/market activity can you point to in support of your opinion?

 Do you think the Federal Reserve is on the right track with it’s policy decisions?  What concerns do you have if any? How do your forecasts differ from what you expect the Federal Reserve will do vs. should do with interest rates?

QUESTIONS CONTINUE ON NEXT PAGE:

2) Some Economists are now concerned that markets are experiencing a “Minsky Moment”  What is a Minsky Moment and why should we worry? What is your opinion about the state of financial markets currently—Minsky or not?

3)  In your opinion, are TIPS a good investment today as a way to play inflation risk in the current market?  What is the TIPS market indicating as its estimate for inflation expectations given current trading data? How does this data compare the detailed forecast you discussed above? Would you like to revise or defend your opinion now that you have examined information from the TIPS market? Explain.

4) How have the Bond and Equity markets been correlated historically?  Have these correlations changed at all over the past 6 months?  How do you think they will be correlated throughout 2023—Explain why/how you came to this conclusion.  What drives the changes in this correlation through history, i.e., why is the correlation positive sometimes and negative in other times.  How does your correlation forecast influence your relative recommendation to favor investing in stocks or bonds at this time?

6) 
 (20 Points) Please go to the website “Yield Curve.com http://yieldcurve.com/marketyieldcurve.htm    You can also use the cite https://www.ustreasuryyieldcurve.com/  You may wish to consult other sources as well.

a. Using the Liquidity Premium Theory as a guide, interpret what the US Treasury Yield Curve is telling you as a Financial Market Participant.

b. Please provide an explanation as to why the US Treasury and UK Gilt curve may be different both in terms of “shape” and the yields presented for both Treasuries and Gilts. (Hint: what is different about the US and UK economies, and how are these curves and rates being influenced by expectations in these two markets?)

c. It is now time to investigate and play:  Using this site or others that you find, What has been happening to the yield curve over the past 6 months?  How would you interpret these changes?  How would your interpretation influence your outlook on the economy, or decisions as an investor?

d. Now-On the right hand side, just below the graph, you will see a “pull down box” that allows you to watch historical yield curves.  Please pull down the year 2007, and hit the button below “show rates”.  It may take a couple of seconds to load.  It will then show quickly the changes in the yield curve throughout 2007.  Please describe what you see, and interpret what the yield curves were telling us about expectations of future economic events. (Hint: yield curve shapes are often used to predict “the future”—were they right?  How and why?)

e. You are sitting in an interview with a recruiter for the job you desperately want.  The Question:  “What is the current Yield to maturity on the 10-year Treasury?  Predict what you think the 10-year bond will be yielding at this time in 2023—be sure to use data, variables, risks, etc. to defend and logically present your assessment.”