GEORGE MASON UNIVERSITY

School of Business
FNAN 421 Money and Capital Markets
Sample Midterm Examination
NAME: ___________________________________

Dr. Gerald Hanweck

G#: ________________________

(Answer all questions. Place your answer to each question on a separate sheet of paper. Please write your
name or initials on the top left corner of each page. Document your answers and show your work. Read each
question carefully and answer all parts. Your guess may turn out to be correct. The number in parentheses is
the point weight for the question. Please, turn in this exam with your answers.
(15)

(20)

1. What are the economic functions that financial intermediaries and markets perform that benefit
society? In your answer, discuss the relationships of financial intermediaries and financial markets
to the savings-investment process within an economy and to each other. In addition, provide in
your discussion an analysis of the differences in preferences among economic agents as an
explanation for the wide variety of primary and secondary securities found in financial markets and
the reasons for federal and state regulation of depository institutions and other financial
intermediaries. In this regard, consider what role asset-backed securities, securitization and the
secondary markets for these instruments play in the efficiency of the financial intermediation
process. For example, the mortgage-backed securities secondary markets development and the
funds flows to finance home ownership. In this discussion consider the role of interest rates in
determining the demand for current and future consumption and the relationship of this to
individual and aggregate saving.
2. Using the graph and definitions below of the supply of loanable funds, SLF, and the demand for
loanable funds, DLF, discuss the following:

a.

What is meant by the equilibrium nominal rate of interest?

b.
Illustrate and discuss how an autonomous increase in the expected rate of inflation will
change the equilibrium nominal interest rate. Express your discussion in terms of the effect on
the supply and demand for loanable funds. Consider an initial real rate of interest of 3 percent
and an expected inflation rate of 3 percent. If the expected rate of inflation rises to 4 percent
with the real interest rate constant, what would the resulting nominal interest rate become in
equilibrium using the Fisher relationship? Assume that investors believe the rise in the expected
rate of inflation will remain at the higher level indefinitely.
1

c.
Starting from an equilibrium position as in 1.a, discuss the effects of a tightening monetary
policy if the markets believe that a Fed tightening will lower future (next period) inflation. How
might a recession occur under this scenario?
HINTS: Recall the Fisher relationship where (1+i) = (1+r)(1+pe), where i is the nominal interest
rate, r is the required real rate of return before taxes, and pe is the expected rate of inflation.
DLF = I + G - T + NX
I = investment in real assets;
NX = net exports
G - T = the government deficit (excess of government spending over tax revenues).
SLF = S + Ms - H
S = private savings
H = desired hoarding
Ms = change in the money supply (under Federal Reserve discretionary control).
(15)

3(a).
Discuss the relationship of a coupon bond's price, duration, and convexity of the price-yield
relationship with respect to changes in the bond's maturity, coupon rate, and the market yield to
maturity. Define your terms, state assumptions, and clearly identify the algebraic sign (positive or
negative) in the relationships discussed. You may use diagrams to explain your answer, but
describe clearly each diagram.
3(b)
Compare the interest rate risk of a noncallable 10-year Treasury coupon bearing bond with a
mortgage-backed pass-through security with prepayments related to the level of interest rates
lower market interest rates raise the rate of prepayments. Discuss how the changes in cash flows,
arising from prepayments, on a mortgage-backed security affect the duration of such securities.
HINT: consider the coupon effect on duration.
Macaulay Duration Measure:
M
tC
MF

t
P (1 y )
(1 y ) (1 y ) M
DM
, For a coupon bearing bond : DM tM1
C
F
y P

t
(1 y ) M
t 1 (1 y )

A more complete approximation to the proportional change in price of a bond with respect to a change
in yield to maturity takes into account the convexity of the price-yield relationship for the bond:
dP
P 1
1 2P 1 2

dy
dy
P
y P
2 y 2 P
where P = Price, C = coupon, F = Face value, y = Yield to maturity, M = maturity (years), t = time (year), dP
is the total change in price, and

P
y

is the partial change in price with respect to a change in yield to

maturity. The second term, excluding the dy2, is the convexity effect.
(20)

4.

There are a number of theories of the term structure of interest rates including the unbiased
expectations hypothesis, preferred habitat hypothesis, and market segmentation hypothesis.
Discuss the implications of the unbiased expectations hypothesis within the context of the
following problem. Problem 1: For a two-year, default-free, zero coupon security, compute its
yield to maturity and draw the respective yield curves assuming two different expectations of
inflation employing the Fisher Effect and the data below: (a) 4 percent one year from now, and
(b) 2 percent one year from now. In addition, define and compute the implied forward yield on
a one-year security one year from now, assuming the current two-year yield is 6.0 percent.
Discuss the assumptions underlying this calculation and how it can be used to evaluate the
implied forward yield on a 1-year loan, next year. (c) What is the implied expected rate of
inflation if the real rate remains at 3 percent?
Use the following definitions and values:
2

(a)
(b)
1y1
e
2y1
1y2

R
p1
p2e
p2e

=
=
=
=
=
=
=

0.03 (constant real rate of interest)

0.02 (period 1 rate of inflation)
0.04 (expected period 2 rate of inflation)
0.02 (expected period 2 rate of inflation)
current yield on one-year securities
Expected period 2 yield on one-year securities
current yield to maturity on two-year securities

Unbiased Expectations Hypothesis

In general, (1 + 1ym) = [(1 + 1y1)(1 + 2y1e). . .(1 + my1e)]1/m and jy1e = the forward rate, jf1.
Fisher Relationship: (1 + jy1) = (1 + jR1)(1+ jp1e ), where jp1e is the expected rate of inflation for period j for 1
year, and jR1 is the real rate of interest for period j for 1 year.
Specifically, (1 + 1y2) = [(1 + 1y1)(1 + 2y1e)]1/2 and

y e = the forward rate, 2f1.

(1 1 y 2 ) 2
e
.
The expected future 1-year yield factor is: 1 2 y1
(1 1 y1 )
Dont forget to draw the yield curves under assumptions (a) and (b), above, for each of the expected rates of
inflation. Give the reasons for the shapes of these yield curves (HINT: are forward rates on future
short-term securities equal to, greater than, or less than current short-term interest rates).
(20)

5.

2 1

Consider the following bank balance sheet (fixed rates and pure discount securities unless
indicated otherwise). Interest rates on liabilities (yL)are 4 percent and on assets (yA) are 6
percent.
Duration
($millions)
(years)
Super Now Checking Accounts (rates set daily)
$200
1.0
6-Month Certificates of Deposit
80
.5
3-Year Certificates of Deposit
100
3.0
Total Liabilities
380
?
Net Worth
20
-Total Liabilities and Net Worth
400
?
Prime-Rate Loans (rates set daily)
100
2.0
2-Year Auto Loans
130
1.0
30-Year Mortgages
170
7.0
Total Assets
400
?
a.

What is the duration of assets and the duration of liabilities?

b.

The bank will (benefit)/(be hurt) if all interest rates rise. Define your terms and state
clearly your assumptions.
DA
L DL
E y

A
(1 y A ) A (1 y L )

Setting E equal zero implies:

3

DA
L DL

1 y A A 1 y L
E
DA
DL
L
A
y

=
=
=
=
=
=

change in the market value of equity,

duration of assets,
duration of liabilities,
market value of liabilities,
market value of assets, and
change in interest rates.

c. What is the duration of assets that would be necessary to immunize the market value of
equity from interest rate changes for this banks portfolio holding the DL constant?
(10) 6. Data on weekly stock prices for Microsoft Corporation, Exxon Mobil Corporation and the S&P
500 Index were used to compute the following historical volatility and expected return. Using these results,
answer the following questions:
The historical returns volatility (standard deviation of returns) at an annualized rate for each stock are:
MSFT= 0.182, XOM= 0.120 and S&P500 = 0.108. The expected return for each stock and the index at an
annual rate for MSFT, XOM and S&P500 is respectively:
0.136

0.308

0.105

a. Using the computed (beta) of 0.997 for MSFT and 0.508 for XOM and expected return for
each stock and the S&P 500 index over the past year, draw the Securities Market Line (SML)
using a risk-free rate of 5.37 percent based on the 3-month Libor rate at the time. Do each of the
stocks fall on the SML? Analyze their relative position and which stock is the best buy and why.
HINT: Use the average return of the S&P 500 stock index provided above as the expected
return for the market.
b. Using the data in above and in a. and assuming the average return on the S&P 500 index is a
representation of market expected return and risk, compute the slope of the Capital Market Line
(CML) when the risk-free rate is approximated by the Libor rate given in a. From your results,
what is the market price of risk?