Suppose that discount brokers make bonds more liquid. (2 points)
a. In the liquidity preference theory, how does this development affect money demand and the interest rates? Explain your answer verbally and illustrate it graphically using the market for money diagram
b. What should the central bank do, if does not want the interest rate to change? Explain your answer verbally and illustrate it graphically using the market for money diagram
2. According to Moody’s, “Obligations rated as Aaa are judged to be of the highest quality, with minimal credit risk”. ( 2 points)
a. What “obligations” is Moody’s referring to?
b. What does Moody’s mean by “credit risk”?
3. According to the article in the New York Times, in 2012, “everyone has piled into” “the junk bond market. The article also observed, “The average yields on these bonds have dropped to 6.6%, hovering near a record low”. ( 2 points)
a. What are junk bonds?
b. Is there connection between everyone having piled into the junk bond market and the yields on these bonds having fallen to a record low? Explain
4. Predict what will happen to the interest rates on a corporation’s bonds if the federal government if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future. What will happen to the interest rates on Treasury securities? Explain. ( 2 points)
5. An article appeared in the New York Times in 2012 under the headline” Spanish Bond Yields Soar”. ( 2 points)
a. Can we tell from the headline whether the demand for Spanish government bonds was increasing or decreasing? Briefly explain
b. Can we tell from the headline whether the prices of Spanish government bonds were increasing or decreasing? Briefly explain
c. The article observes that Spain is “reaping the bitter harvest of a decade of ambitious and often unchecked spending on infrastructure and services”. What does this observation have to do with the article headline? Explain
Extra Points (4 points)
1. By 2012, actions by the Federal Reserve and other central banks had driven short-term interest rates close to zero. One portfolio manager was quoted as saying: “The market has heard… central bankers and has responded accordingly”.
a. In what ways did individual investors respond to very low short-term interest rates?
b. If you owned a portfolio of long-term bonds in 2007, before the beginning of the financial crisis, would the return on you portfolio have been helped or hurt by the fall in the short-term interest rates? Explain
c. If you were a new investor who was just beginning to build an investment portfolio, would your investment opportunities have been helped or hurt by the decline in interest rates? Explain
2. In the fall of 2008, AIG, the largest insurance company in the world at the time, was at the risk of defaulting. As a result, the U.S. government stepped in to support AIG with large capital injections, and an ownership stake. How would this affect, if at all, the yield and risk premium on AIG corporate debt? Explain.