ECON 305 Problem Set 2 Due Date: 14 October 2020 Directions: Answers are to be turned in using Microsoft Word. Handwritten submissions will NOT be accepted, nor will photographs. This problem set is based on 15 total points and is worth a maximum 5 points. This substitutes for a quiz All calculations involving interest rates should be answered as a percentage to two decimal places, for example 5.42% rather than 0.05. 1. According to the segmented markets theory of the term structure (1 point) 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 2. An individual is in the 30% tax bracket. If the yield on a BBB rated corporate bond is 4.5%, what is the equilibrium yield on an otherwise identical municipal bond? (1 point) 3. Compare and contrast the term structure and the risk structure of interest rates. (2 points) 4. Describe the principal-agent problem in equity contracts. (2 points) 5. A bank has a ROE of 10% and a ROA of 2%, what is the value of the equity multiplier? (1 point) 6. A bank has $50M in rate-sensitive assets and $35M in rate-sensitive liabilities. What is the impact on the bank's profits if rates decrease by 50 basis points? (2 point) 7. A three year bond pays semiannually S3 ($6 per year) is trading at 98.50 and has a par value of 100. Find the Macaulay and modified duration. (4 points) 8. One strategy that is used to hedge interest rate risk is to match the modified duration of assets and liabilities. If we hedge the above bond in question 7 with a zero coupon bond, what would be the maturity of said zero (2 points) ECON 305 Problem Set 2 Due Date: 14 October 2020 Directions: Answers are to be turned in using Microsoft Word. Handwritten submissions will NOT be accepted, nor will photographs. This problem set is based on 15 total points and is worth a maximum 5 points. This substitutes for a quiz All calculations involving interest rates should be answered as a percentage to two decimal places, for example 5.42% rather than 0.05. 1. According to the segmented markets theory of the term structure (1 point) 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 2. An individual is in the 30% tax bracket. If the yield on a BBB rated corporate bond is 4.5%, what is the equilibrium yield on an otherwise identical municipal bond? (1 point) 3. Compare and contrast the term structure and the risk structure of interest rates. (2 points) 4. Describe the principal-agent problem in equity contracts. (2 points) 5. A bank has a ROE of 10% and a ROA of 2%, what is the value of the equity multiplier? (1 point) 6. A bank has $50M in rate-sensitive assets and $35M in rate-sensitive liabilities. What is the impact on the bank's profits if rates decrease by 50 basis points? (2 point) 7. A three year bond pays semiannually S3 ($6 per year) is trading at 98.50 and has a par value of 100. Find the Macaulay and modified duration. (4 points) 8. One strategy that is used to hedge interest rate risk is to match the modified duration of assets and liabilities. If we hedge the above bond in question 7 with a zero coupon bond, what would be the maturity of said zero (2 points)