UNIVERSITY OF TORONTO MISSISSAUGA

DEPARTMENT OF ECONOMICS
Money, Banking & Financial Markets
ECO349H5F (LEC0101)
PROF. ANGELO MELINO
MID-TERM TEST SOLUTIONS
DURATION: 90 MINUTES
OCTOBER 18, 2016
IMPORTANT INSTRUCTIONS:

(i) This test should be answered in ballpoint pen (graphs excepted). Any part done in pencil will not be
eligible for re-assessment.
(ii) You must put all your answers to Part A in the table provided on page 2 or a 5-mark penalty will be
imposed.
(iii) Answer all Part B questions in point form and only in the designated pages. Answer every part of all
the questions and clearly label each part of your answer.
(iv) Please ensure that your handwriting is legible.
(v) A 10-mark penalty will be imposed if any page is separated from this test.

Student Name (Print Clearly): Student ID#:

(DO NOT WRITE IN THIS BOXFOR GRADERS USE ONLY)

Part A Part B
Question Total
A1 A20 B1 B2 B3
Marks 40 20 25 15 100
(a) /5 /4 /5
(b) /5 /10 /10
(c) /5 /4
(d) /5 /4
(e) /3
Score /40 /20 /25 /15 /100

Version A Page 1 of 8
 PART A (40 Marks): Answer all twenty multiple-choice questions (each is worth 2 marks), choosing the best
answer for each question. Write each answer in the table below or a 5-mark penalty
will be imposed.
Part A Answers
A1 A2 A3 A4 A5 A6 A7 A8 A9 A10

D A D C B A A C A D

A11 A12 A13 A14 A15 A16 A17 A18 A19 A20

A C C A C A A A A D

A1. The price of a consol equals the coupon payment ________.

A) times the interest rate
B) plus the interest rate
C) minus the interest rate
D) divided by the interest rate

A2. When talking about a coupon bond, face value and ________ mean the same thing.
A) par value
B) coupon value
C) amortized value
D) discount value

A3. As a store of value, money ________.

A) does not earn interest
B) cannot be a durable asset
C) must be currency
D) is a way of saving for future purchases

A4. Stock prices are ________.

A) relatively stable trending upward at a steady pace
B) relatively stable trending downward at a moderate rate
C) extremely volatile
D) unstable trending downward at a moderate rate

A5. Which of the following is generally true of all bonds?

A) The longer a bond's maturity, the greater is the rate of return that occurs as a result of the increase
in the interest rate.
B) Even though a bond has a substantial initial interest rate, its return can turn out to be negative if
interest rates rise.
C) Prices and returns for short-term bonds are more volatile than those for longer term bonds.
D) A fall in interest rates results in capital losses for bonds whose terms to maturity are longer than
the holding period.

Version A Page 2 of 8
 A6. In the market for money, an interest rate below equilibrium results in an excess ________ money and
the interest rate will ________.
A) demand for; rise
B) demand for; fall
C) supply of; fall
D) supply of; rise

A7. If Microsoft sells a bond in London and it is denominated in dollars, the bond is a ________.
A) Eurobond
B) foreign bond
C) British bond
D) currency bond

A8. In explaining the evolution of money, ________.

A) government regulation is the most important factor
B) commodity money, because it is valued more highly, tends to drive out paper money
C) new forms of money evolve to lower transaction costs
D) paper money is always backed by gold and therefore more desirable than cheques

A9. If a $5000 coupon bond has a coupon rate of 13 percent, then the coupon payment every year is ____.
A) $650
B) $1300
C) $130
D) $13

A10. If fluctuations in interest rates become smaller, then, other things equal, the demand for stocks
________ and the demand for long-term bonds ________.
A) increases; increases
B) increases; decreases
C) decreases; decreases
D) decreases; increases

A11. An investment intermediary that lends funds to consumers is ________.

A) a finance company
B) an investment bank
C) a finance fund
D) a consumer company

A12. Financial institutions that accept deposits and make loans are called ________ institutions.
A) investment
B) contractual savings
C) depository
D) underwriting

A13. The ________ is defined as the payments to the owner plus the change in a security's value expressed
as a fraction of the security's purchase price.
A) yield to maturity
B) current yield
C) rate of return
D) yield rate

Version A Page 3 of 8
 A14. People hold money even during inflationary episodes when other assets prove to be better stores of
value. This can be explained by the fact that money is all of the following except ________.
A) perfectly liquid
B) a unique good for which there are no substitutes
C) the only thing accepted in economic exchange
D) backed by gold

A15. When the price of a bond is above the equilibrium price, there is an excess ________ bonds and price
will ________.
A) demand for; rise
B) demand for; fall
C) supply of; fall
D) supply of; rise

A16. Increasing the amount of information available to investors helps to reduce the problems of ________
and ________ in the financial markets.
A) adverse selection; moral hazard
B) adverse selection; risk sharing
C) moral hazard; transactions costs
D) adverse selection; economies of scale

A17. If an individual moves money from a money market mutual fund to currency, ________.
A) M1+ increases and M2+ stays the same
B) M1+ stays the same and M2+ increases
C) M1+ stays the same and M2+ stays the same
D) M1+ increases and M2+ decreases

A18. ________ are financial intermediaries that acquire funds by selling shares to many individuals and
using the proceeds to purchase diversified portfolios of stocks and bonds.
A) Mutual funds
B) Investment banks
C) Finance companies
D) Credit unions

A19. Currency includes ________.

A) paper money and coins
B) paper money, coins, and cheques
C) paper money and cheques
D) paper money, coins, cheques, and savings deposits

A20. Everything else held constant, if the expected return on government bonds falls from 8 to 7 percent
and the expected return on corporate bonds falls from 10 to 8 percent, then the expected return of
corporate bonds ________ relative to government bonds and the demand for corporate bonds
________.
A) rises; rises
B) rises; falls
C) falls; rises
D) falls; falls

Version A Page 4 of 8
 B1. Define [for 2 pts] and Explain the Importance of [for 3 pts] each of the following (you may answer in
point form):

B1.a Capital Market

Defn: The capital market is the market in which longer-term debt instruments (generally with original
maturity of one year or greater) and equity instruments are traded.

Imp:
Debt instruments with (original) maturity of one year or less are traded in the money market.
Capital markets instruments tend to be less liquid than those in the money market.
Capital market instruments tend to be held by financial institutions with longer horizons, such as life-
insurance companies and pension funds.
Examples of capital market debt instruments include mortgages, corporate bonds, government bonds
Capital market instruments are issued in the primary market and traded in the secondary market.
The quantity of capital market instruments issued by private agents greatly exceed those in the money
market
Improves social welfare among investors and fund demanders
Allows for a more efficient allocation of funds
Allows for a more efficient allocation of risk

B1.b Repos

Defn: Repurchase agreements, or repos, are contracts where the seller of a security promises to buy it
back within a short time, often the next day.

Imp:
Repos are effectively a short-term collaterized loan. The security sold serving as the collateral.
The collateral is usually a very liquid security, such as a Treasury Bill.
The security is sold at a price lower than its market price (the haircut) and the higher repurchase price
compensates the lender.
An advantage of repos over a collaterized loan is that in the event that the seller goes bankrupt before
the repo matures, the purchaser owns the collateral, so there is no need to go through the bankruptcy
process to enforce the claim on the seller, as there would be with a collateralized loan.

Version A Page 5 of 8
 B1.c Fisher Equation

Defn: The Fisher equation says that the nominal interest rate equals the real interest rate plus the
expected rate of inflation i=r+e.

Imp:

The Fisher equation is named after Irving Fisher (famous Yale economist of the late 19th and early 20th
century, and wealthy inventor!).
Economic theory tells us that real interest rates are what matters for households consumption/savings
decisions and firms investment decision
The Fisher equation lets us link the real interest rate, which we dont see, to the nominal interest rate,
which we do.
Nominal interest rates have decline by about 15 percent since the early 1980s. Most of the decline has
been a decline in inflation expectations. But in the last few years, we have also seen declines in the
real interest rate.
.

B1.d Liquidity Preference Framework

Defn: The LPF determines the equilibrium interest rate in terms of the demand and supply of money,
rather than the demand and supply of bonds.

Imp:
The LPF was developed by J.M. Keynes
Although it looks different, it is closely related to the supply and demand framework in the bond market
(loanable funds theory).
LPF makes two simplifications: 1. Agents have a two-stage framework, where they first decide how
much to consume/save, which determines how much wealth they have to allocate to different assets. 2.
In the second stage, they allocate their assets between two assets only: Money and Bonds
By an adding up constraint, any excess demand for bonds must be equivalent to an excess supply of
money. So equilibrium in the bond market can occur only if there is equilibrium in the money (medium
of exchange) market.
The LPF framework is useful for seeing the effects of a change in the money supply, income, or the
price level on interest rates.

Version A Page 6 of 8
 B2. Suppose there are two coupon bonds ( and ) at time t with identical price ( ) $1,000, coupon
payment ( ) $120 (received each period beginning at time t+1 by whoever owns the bond in the
previous period), and face value ( ) $1,000. Bond will mature at time t+2 while Bond will mature
at t+5. The interest rate on bonds of all maturities at time t is 12%, but the interest rate on bonds of all
maturities will fall to 8% at time t+1 and will remain at the level.
a. [4 marks] What are the coupon yields on the two bonds at time t?
b. [10 marks] What are the prices of the two bonds at time t+1?
c. [4 marks] What are the rates of capital gain/loss on the two bonds between time t and time t+1?
d. [4 marks] What are the rates of return for holding the two bonds from time t to t+1?
e. [3 marks] Which bond is the better investment? Why?

Answers to parts {a,c,d} should be expressed in %, rounded to the nearest basis point; the answer to
part b should be expressed in $, rounded to the nearest cent.
Show your step-by-step calculation or a grade of zero will be given.

Bond Bond
Current Yield (ic ) 12% 12%
Bond Price ) $1,037.04 $1,132.49
Rate of Capital Gain/Loss ( ) 3.7% 13.25%
Rate of Return ( ) 15.7% 25.25%

Current yield / $120/$1,000 12%.

For Bond , its price in the second period equals to the present value of the coupon payment and the face value
discounted at 8% to the beginning of the second period,

$1,120 $1,000
$1,037.04 and .03704 15.7%
1 0.08 $1,000

For Bond , its price in the second period equals to the present value of the coupon payments and the face
value discounted at 8% to the beginning of the second period,

$120 $120 $120 $1,120

$1,132.49
1 0.08 1 0.08 1 0.08 1 0.08

$1,000
.013249 25.25%
$1,000

Bond is better investment when . In fact, if you invest in Bond , you will have an extra
$1,132.5 $1,037 $95.5 in the beginning of the second period when compared to holding
Bond .

When the holding period is shorter than the term to maturity, investors are exposed to interest rate risk. Falling
interest rate will discount future receipts from holding the bond less heavily and hence the higher the price
potential buyers will be willing to pay for the bond, which may lead to capital gain. The longer the term to
maturity of a bond, the more sensitive the bond price is to interest rate fluctuations, the larger the increase in
future bond price, the larger the capital gain, the higher the rate of return.

Version A Page 7 of 8
 B3. Suppose a country with a struggling economy suddenly discovers vast quantities of mineral reserves
under government controlled land. Assume that foreigners will want to buy the mineral exports but
are not allowed to borrow from or lend to this country. Using the model of demand and supply for
bonds, what would you expect to happen to the yields of that countrys bonds? Assume that, like the
oil sands, mining the resource requires a very large initial capital investment, but very little
afterwards. Distinguish between the near-term consequences [5 marks], where the economy gears up
to mine the new resource but national income remains essentially unchanged, and the long-term
consequences [10 marks], where the economy has adjusted to producing and exporting vast quantities
of the mineral.

Consider a bond market originally in equilibrium at (P0,B0).

NEAR TERM [5 marks]

Supply curve: The new investment opportunity will increase the supply of bonds at each interest rate
initially, as firms will want to raise capital to exploit this new profitable opportunity. There is no reason
to expect any change in expected inflation or government deficits (at least until the resources are being
mined and exported). So the supply curve will shift to the right.
Demand curve: Initially, nothing happens to wealth or income.

With an unchanged demand curve, the price of bonds falls and the quantity rises.
(Aside: As we see below, the response of the rate of interest will be reversed in the longer term, so
households in this economy might be willing to buy more bonds today in anticipation of falling interest
rates in the future, but by definition, this shift in the demand curve would not be enough to offset the
near term decline in the price of bonds).

LONG TERM [10 marks]

Supply curve: Eventually, the demand by firms for savings to finance the mining of the resource will
dwindle. Moreover, government deficits will decline also, so both factors will cause the supply curve
to shift back to the right. We are told that firms demand for investment goods returns to more or less
the same level as before the discovery of the mineral, so in the long run the supply curve will shift to
the left past S0.
Demand curve: With increasing wealth and higher incomes, the demand for bonds will increase at every
interest rate, shifting the demand curve to the right. The new equilibrium level of bonds may be higher
or lower than before the discovery of the mineral reserve, but the new equilibrium price in the long-run
will unambiguously be higher, so the new equilibrium interest rate will be lower.
Version A Page 8 of 8