I.Short Answer Questions

Show all work. If you are using a calculator, you must write down the calculations you are making.

(1)[5 points] Suppose that there is a global pandemic. The US federal response alternates between denying its severity, advocating for unsafe/unproven measures, and blaming others. One result is that the US remains a pandemic hot spot, while most other developed counties largely have the pandemic in check. A second result is that more than 6 months after the start of the pandemic the unemployment rate is 8.6%, as compared to 3.5% before the pandemic. Use the Liquidity Preference framework to answer the following:

• Show graphically what happens to the money demand curve. Explain the rationale.
• The Federal Reserve has made large amounts of emergency credit available, and in so doing, expanded the money supply. Show graphically what happens to the money supply curve.
• What will happen to the equilibrium interest rate? Explain.

(2)[10 points] Suppose that there is an increase in the relative risk of bonds. Use the Portfolio Theory framework to answer the following:

• Show graphically what happens to the bond demand curve. Explain the rationale.
• Show graphically what happens to the equilibrium bond price and quantity. Explain.
• What will happen to the equilibrium interest rate? Explain.

(b)Show graphically what happens to the bond supply curve. Explain the rationale.

(3)[5 points] What is the present value of a two year fixed payment loan with two end of year payments of $10,000 if the yield to maturity is 3% (assume inflation is zero)?

(4)[5 points] What is the yield to maturity (assume inflation is zero) of a one year discount bond with a face value of $800 that you purchase for $750?

(5)[5 points] What is the current market price of a two year coupon bond with a face value of $1,000, that pays a $50 coupon, and has a yield to maturity (assume inflation is zero) of 5%?

(6)[5 points] Use the perpetuity coupon bond formula to approximate the current market price of a 30 year coupon bond with a face value of $500, coupon payments of $25, and a yield to maturity of 5%.

(7)[10 points] Broker Bob wants to sell you another bond. He says that since you are a return customer that he will give you a good deal. Broker Bob offers to sell you a coupon bond with a two year maturity for $640. The bond has a face value of $600, a coupon of $50, and a yield to maturity of 5%.

(a)Calculate the current market price of the bond. Should you buy the bond for $640?

(b)Suppose you buy the bond. What is your one year return if the interest rate increases to 6% one year from now?

(8)[10 points] Which investment has a higher return (in percent terms) after one year? Assume that the interest rate increases from 4% to 8% starting the beginning of the second year:

(a)A discount bond with a face value of $500 that you purchased for $475.

(b)A two year coupon bond that you buy at the market price. The bond has a face value of $500 and a coupon of $50.