# Written Short Essays Should Be About a Paragraph Or Two Money, Banking, and Financial Markets
Midterm I
Summer 2014

Short Essay Section

Written short essays should be about a paragraph or two.

1. (41 points) A bill is introduced into Congress proposing that the U.S. go back to the gold standard, in which only gold coins could circulate as money. What are the major drawbacks of such a proposal?
1. (41 points) Describe the difference between inside money and outside money, and explain whether each of the following items represent inside money or outside money:

a. / Checking account
b. / Coin
c. / Travelers check
d. / Money-market mutual fund
e. / \$100 bill
1. (43 points) Suppose the quantity demanded for a security is

BD = 100  0.1b,

and the quantity supplied of the security is

BS = 50 + 0.1b,

where b is the price of the security in dollars.

a. / Calculate the equilibrium price and quantity of the security.
b. / Suppose demand increases by 50, so that BD = 150  0.1b. Now, calculate the new equilibrium price and quantity of the security.
1. (43 points) Consider three alternative bonds that you might invest in, each of which matures in one year. The following table shows the probability that you will receive each possible return. For example, if you buy bond A, the probability is 90 percent that your return will be 20 percent and the probability is 10 percent that your return will be 100 percent (in other words, you lose the entire amount invested).

Bond / Probability / Return
Bond A / 90% / 20%
10% / 100%
Bond B / 75% / 40%
25% / 40%
Bond C / 60% / 10%
40% / 10%
a. / Calculate the expected return for all three bonds in percentage terms.
b. / The standard deviations of the returns on these bonds are: Bond A, 36.0 percent; Bond B, 34.6 percent; Bond C, 9.8 percent. If you are extremely risk averse, which of the three bonds would you buy? Why?
c. / Would a risk-averse investor ever buy Bond A instead of one of the other bonds? Why or why not?
Explain and show all your work. In your calculations, you may round after three significant digits.
1. (42 points) Consider the following four debt securities, which are identical in every characteristic except as noted:

W: / A corporate bond rated AAA
X: / A corporate bond rate BBB
Y: / A corporate bond rated AAA with a shorter time to maturity than bonds W and X
Z: / A corporate bond rated AAA with the same time to maturity as bond Y that trades in a more liquid market than bonds W, X, or Y

List the bonds in the most likely order of the interest rates (yields to maturity) of the bonds from highest to lowest. Explain your work.

1. (42 points) Suppose that the price of a stock is \$50 at the beginning of a year and \$53 at the end of the year, and it pays a dividend of \$2 during the year.

a. / What is the stock's current yield?
b. / What is the stock's capital-gains yield?
c. / What is the stock's return?
1. (43 points) Consider a one-year discount bond that pays \$2,000 one year from now. If the rate of discount is 3 percent, calculate the present value of the bond.
1. (43 points) Consider a coupon bond that pays \$350 every year and repays its principal amount of \$5,000 at the end of four years. If the rate of discount is 6 percent, what is the present value of the bond?

On September 1, 2012, Al buys a bond for \$15,000 that makes coupon payments of \$750 after each of the following three years and returns its principal of \$15,000 at the end of the three years. In other words, it is a standard coupon bond with a 5 percent annual interest rate making payments once each year.

On September 1, 2013, Al receives his first coupon payment of \$750. At that time, the market interest rate on bonds like Al's has risen to 6 percent. Al sells his bond to Biff at that time, for a price equal to the present value of the bond's payments.

a. / How much does Biff pay Al for the bond?
b. / Calculate Al's current yield, capital-gains yield, and total return for the year.

On September 1, 2014, Biff receives a coupon payment of \$750. The market interest rate on bonds like his remains 6 percent. Biff sells his bond to Cass at that time, for a price equal to the present value of the bond's payments.

c. / How much does Cass pay Biff for the bond?
d. / Calculate Biff's current yield, capital-gains yield, and total return for the year.

On September 1, 2015, Cass receives a coupon payment of \$750 and the principal of \$15,000. Over the course of the year (between September 1, 2014, and September 1, 2015), the market interest rate on bonds like his rose to 7 percent. But Cass decided to keep the bond.

e. / What is Cass's total return for the year?

Explain and show all your work for each part.

1. (43 points) Explain how an economist could use the slope of the yield curve to analyze the probability that a recession will occur. Explain why the spread may matter.
2. (43 points) Suppose an investor purchased 100 shares of JDSU stock at a price of \$50 per share on December 31, 2011. On December 31, 2012, JDSU paid dividends of \$1.50 per share, and the investor received the dividends, then sold the stock at a price of \$65 per share.

a. / If there were no taxes or inflation, what was the total return?
b. / If there were no taxes, but inflation was 3.5 percent, what was the real return?
c. / If the tax rate was 15 percent on dividends and capital gains, what was the after-tax real return?

825-124

1. (43 points) Write the equation for the capital-asset pricing model.

Describe, in words, what the CAPM is trying to explain, and describe each element of the equation in part a.
Use the capital-asset pricing model to predict the returns next year of the following stocks, if you expect the return to holding stocks to be 12 percent on average, and the interest rate on three-month T-bills will be 2 percent. Show your calculations.
A stock with a beta of 0.3
A stock with a beta of 0.7
A stock with a beta of 1.6

Long Essay (83 points)

Long essays should be about 2 to 3 pages.

How do payday loans differ from overdraft courtesies and the subsequent overdraft fees? Is the current situation fair? If your answer is yes, defend the current situation by demonstrating that commonly cited grievances are truly fair. If no, suggest potential legislation and clearly describe how your suggestions will improve fairness.