UNIVERSITY OF TORONTO MISSISSAUGA

DEPARTMENT OF ECONOMICS
Money, Banking & Financial Markets
ECO349H5S (LEC0101)
ANGELO MELINO
MID-TERM TEST SOLUTIONS
DURATION: 90 MINUTES
FEBRUARY 9, 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 20 20 100
(a) /5 /4 /10
(b) /5 /4 /6
(c) /5 /2
(d) /5 /3
(e) /2
(f) /4
(g) /3
(h) /2
Score /40 /20 /24 /16 /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 only 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

B B B C D B A B D C

A11 A12 A13 A14 A15 A16 A17 A18 A19 A20

B A C D B D A D B C

A1. The bond supply and demand framework is easier to use when analyzing the effects of changes in
________, while the liquidity preference framework provides a simpler analysis of the effects from
changes in income, the price level, and the supply of ________.
A) expected inflation; bonds
B) expected inflation; money
C) government budget deficits; bonds
D) government budget deficits; money

A2. Which of the following is an example of an intermediate-term debt?

A) A thirty-year mortgage
B) A sixty-month car loan
C) A six month loan from a finance company
D) A Treasury bond

A3. Which of the following is not included in the monetary aggregate M2?
A) Currency
B) Money market mutual funds
C) Personal deposits
D) Notice deposits

A4. If you expect the inflation rate to be 4 percent next year and a one year bond has a yield to maturity of
7 percent, then the real interest rate on this bond is ________.
A) -3 percent
B) -2 percent
C) 3 percent
D) 7 percent

A5. The price of a coupon bond and the yield to maturity are ________ related; that is, as the yield to
maturity ________, the price of the bond ________.
A) positively; rises; rises
B) negatively; falls; falls
C) positively; rises; falls
D) negatively; rises; falls

Version A Page 2 of 8
 A6. According to the segmented markets theory of the term structure ________.
A) bonds of one maturity are close substitutes for bonds of other maturities, therefore, interest rates
on bonds of different maturities move together over time
B) the interest rate for each maturity bond is determined by supply and demand for that maturity bond
C) investors' strong preferences for short-term relative to long-term bonds explains why yield curves
typically slope downward
D) because of the positive term premium, the yield curve will not be observed to be downward-
sloping

A7. During a "flight to quality" ________.

A) the spread between Canada bonds and Baa bonds increases
B) the spread between Canada bonds and Baa bonds decreases
C) the spread between Canada bonds and Baa bonds is not affected
D) the change in the spread between Canada bonds and Baa bonds cannot be predicted

A8. Nominal GDP is output measured in ________ prices while real GDP is output measured in
________ prices.
A) current; current
B) current; fixed
C) fixed; fixed
D) fixed; current

A9. When I purchase ________, I own a portion of a firm and have the right to vote on issues important to
the firm and to elect its directors.
A) bonds
B) bills
C) notes
D) stock

A10. Secondary markets make financial instruments more ________.

A) solid
B) vapid
C) liquid
D) risky

A11. In which of the following situations would you prefer to be the lender?
A) The interest rate is 9 percent and the expected inflation rate is 7 percent.
B) The interest rate is 4 percent and the expected inflation rate is 1 percent.
C) The interest rate is 13 percent and the expected inflation rate is 15 percent.
D) The interest rate is 25 percent and the expected inflation rate is 50 percent.

A12. Which of the following can be described as involving direct finance?

A) A corporation issues new shares of stock.
B) People buy shares in a mutual fund.
C) A pension fund manager buys a short-term corporate security in the secondary market.
D) An insurance company buys shares of common stock in the over-the-counter markets.

A13. A fall in the level of prices ________.

A) does not affect the value of money
B) has an uncertain effect on the value of money
C) increases the value of money
D) reduces the value of money
Version A Page 3 of 8
 A14. Stockholders' rights include ________.
A) the right to manage
B) the right to change personnel policy
C) the right to veto management's decisions
D) the residual claim on all of a company's assets

A15. A factor that could cause the demand for bonds to decrease ________.
A) an increase in the expected return on bonds relative to other assets
B) a decrease in the expected return on bonds relative to other assets
C) an increase in wealth
D) a reduction in the riskiness of bonds relative to other assets

A16. If merchants in the country Zed choose to close their doors, preferring to be stuck with rotting
merchandise rather than worthless currency, then one can conclude that Zed is experiencing a
________.
A) superdeflation
B) hyperdeflation
C) disinflation
D) hyperinflation

A17. The risk premium on corporate bonds reflects the fact that corporate bonds have a higher default risk
and are ________ Canada bonds.
A) less liquid than
B) less speculative than
C) tax-exempt unlike
D) lower-yielding than

A18. In the one-period valuation model, an increase in the required return on investments in equity
________.
A) increases the expected sales price of a stock
B) increases the current price of a stock
C) reduces the expected sales price of a stock
D) reduces the current price of a stock

A19. Bonds with relatively high risk of default are called ________.
A) Brady bonds
B) junk bonds
C) zero coupon bonds
D) investment grade bonds

A20. Other things being equal, an increase in the default risk of corporate bonds shifts the demand curve
for corporate bonds to the ________ and the demand curve for Canada bonds to the ________.
A) right; right
B) right; left
C) left; right
D) left; left

Version A Page 4 of 8
 B1. Define [for 2 pts] and Explain the Importance of [for 3 pts] each of the following:

B1.a Secondary Market

Defn: The secondary market is a market where investors buy/sell securities issues by firms with other
investors.

Imp:
In the secondary market, investors receive funds for selling their securities, but the firms dont. Firms
only receive funds in the primary market.
Secondary markets make a security more liquid, which makes it more attractive, and therefore easier
to sell in the primary market
The price of the security in the primary market is determined by what investors believe it will sell for
in the secondary market.
Examples of secondary markets include securities exchanges (such as the NYSE, the TMX, etc.), OTC
bond exchanges, etc.

B1.b CSBs

Defn: Canada Saving Bonds are nonmarketable bonds issued by the Govt of Canada, issued
exclusively to individuals, estates, and specified trusts.

Imp:
CSBs are aimed at individuals (not institutions), hence they are referred to as retail debt, and come
in small denominations.
The have the valuable option of being redeemable at face value plus accrued interest at any time prior
to maturity. As a result, the coupon on the bonds is typically raised if market rates go up to prevent
outflows.
CSBs can be purchased using a payroll deduction plan.
CSBs used to be a significant source of GoC financing, but in recent years the value of CSBs
outstanding has been drifting towards zero.
They represent a relatively costly form of financing for the GoC, but politicians are reluctant to kill the
program
More recently, a related security called a Canada Premium Bond has been issued by the GoC which
is similar to the CSB but can be redeemed only once a year in a one month window around the annual
anniversary date.

Version A Page 5 of 8
 B1.c Credit Rating Agencies

Defn: CRAs rate the quality (default probability) of bonds issued by firms and governments.

Imp:

DBRS, Moodys, S&P, and Fitch are leading examples of CRAs

The rating is a discrete set from say {AAA, AA, down to B, CCC, etc).
Many institutions (such as pension funds) are restricted to hold only investment grade bonds, so the
opinion of CRAs is very important to them.
During the financial crisis, the CRAs performed badly giving very high ratings to some ABCP that
turned out to be junk.
Many argue that CRAs have a conflict of interestthey are paid by the bond issuer, who wants a high
credit rating, so they have an incentive to overrate the bonds initially.
DBRS was found to be particularly badthey rated Canadian ABCP with a generalized market
disruption clause, even though the other agencies refused to do so.

B1.d Efficient Market Hypothesis

Defn: The EMH says that asset prices quickly adjust to reflect all available information.

Imp:
The EMH predicts that there is no point trying to beat the marketunless you have superior
information than others, or are better at processing the importance of news for asset prices, then the
best you can do is to hold a well-diversified portfolio with low transactions costs. You can get higher
returns by holding more risk, or by holding risk when the price of risk is high (such as during
recessions), but you cant time the market.
More refined versions of the EMH, say that information will be used up to the point where the costs of
acquiring and processing this information equals its marginal value. For large investors, these costs are
relatively low, so we often approximate them as zero.
Empirically, the evidence suggests that it is difficult for active money managers to beat the market, so
as predicted by EMH it is hard to time the market. But there is some debate about whether the markets
level is set correctly or whether it includes bubbles and fads.

Version A Page 6 of 8
 B2. Suppose at time t that the one-year interest rate 1% and the two-year interest rate is 2%. Consider a
bond issued at time t that matures in two years with a face-value of $1000 and a coupon rate of 3%.
[In your answers, round all bond prices to the nearest penny and all interest rates to the nearest basis point.]

A. [4] Find the one-year ahead one-year forward rate. 3.01%.

B. [4] What is the price of the bond at time t? $1019.71
C. [2] What is its current yield at issue? _2.94%_.
D. [3] Is the yield on the bond greater, equal, or less than 2%? Lower
E. [2] Suppose the one-year interest rate at time t+1 climbs to 3%. What will be the bonds price at
time t+1? _$1000__.
F. [4] What will the return to holding the bond from year t to year t+1? _1.01%___.
G. [3] What will the return to holding the bond from year t+1 to year t+2? __3.00%__
H. [2] If the price level at time t equals 100 and falls to 98, what is the ex post real return to holding
the bond from year t to year t+1? _
Write your answers beside each question on the line segment given. Show your step-by-step
calculations or give your reasoning for each question, or a zero will be given.
Calculation/Explanation: 24 marks

A. 1.02 1.01 1
B. $1019.71
. .
C. Current yield: 2.94% 2.942012925%
.
D. $1019.71 ,so yield is lower than 2%
. .
E. 1 $1000.00
.

.
F. , 1.01% 1.0091104%
.
G. In its last period before maturity, the coupon bond is just like a discount bond. There will be no
capital gain or loss, so the return will equal the interest rate on the bond (OR, you can do the entire
calculation as in part F to get the same result).
H. The ex post real return, call it , , , 1.01 2.0 3.01%

Version A Page 7 of 8
 B3. (a) Use the Liquidity Preference Theory to analyze the effect of a ceteris paribus increase
in income on the money supply and the nominal interest rate. Present your results using a graph in
(i,M) space. Derivation/Explanation: 16

Consider a money market originally in equilibrium at (i1,M).

The increase in income increased the demand for money at each rate of interest, so the money demand
schedule shifts right from Md1 to Md1. Nothing happens to the supply of money schedule. At the new
equilibrium, nominal money balances are unchanged, but nominal interest rates rise to i2.

(b) Give three different explanations consistent with the Liquidity Preference Theory that can
account for procyclical interest rates. Which do you think best explains the Canadian experience.
Why? Explanation: 6 marks

Procyclical interest rates could be caused by a right-ward shift of the money demand curve, caused
either by higher income, or by a combination of higher income and higher prices (or by higher
income and higher expected inflation). Alternatively, we could have higher income along with a
higher money supply. So the necessary condition is higher income during economic booms, but this
could come with higher prices and a higher money supply. As central banks try to smooth the
business cycle, it is unlikely that they expand the money supply during booms and contract it during
busts. So the most likely explanation for a procyclical interest rate is a combination of income
expansion and higher prices (or expected inflation) during booms.

Version A Page 8 of 8