Economics

Part 1.

1. Show graphically what happens to the risk premium when municipal bonds gain tax-exemption. Why might aAaa/AA Municipal Bond pay less yield than comparable Treasury that is rated Aaa/AAA? Comparable meaning they have the same liquidity and years to maturity. But, they do have different risk—they are rated differently.

Since tax is only applicable over capital gains, therefore once taxes are exempted, yield of the bonds decreases. However studies suggests that dealer arbitrage activities in the market for bonds substantially reduce the impact of taxes on long-maturity taxable bondprices and therefore reduce yields of taxable bonds relative to yields of tax-exempt bonds. However, in this case, the impact of dealer arbitrage activities in the market would not be considered for analysis. Therefore, once the municipal bond gets exempted from tax, its yield decreases, thus the risk premium decreases.

Though, Aaa/AA Municipal Bond has same liquidity and years to maturity as of Aaa/AAA rated, it is possible that aAaa/AA Municipal Bond pay less yield than comparable Treasury that is rated Aaa/AAA because yield of a bond is inverse to its price, therefore, as bond prices increase, bond yields fall. Since price of bond is inversely proportion to yield to maturity, therefore as rate increases price of the bond decreases. Discount rate can be considered as function of risk factors. Since risk associated with Municipal Bonds is higher than that of risk associated with Treasury Bonds having same rating, therefore the price of Municipal Bonds is lower than that of Treasury Bonds, therefore Aaa/AA Municipal Bond pay less yield than comparable Treasury that is rated Aaa/AAA.

2. Suppose that investors treat all bond maturities as perfect substitutes. What is this called and what would the yield curve look like if there is no future change in expected change in interest rates? Also, show graphically what would happen to the relative yields in short-term maturities and long-term maturities when the Fed engages in quantitative easing.

3. Suppose that the constant news releases in 2009 showing the fall of very large financial institutions started to scare many Americans about the safety of their money in banks. Using the market for reserves show graphically what this would do to the equilibrium Fed Funds rate in all cases. If the Fed is interest rate targeting how would they respond?

4. Suppose you purchase 400 shares of Company XYZ at $566 per share, but you are worried that it may fall in price so you wish to hedge part of your position by writing 2 call options. The option has a strike price of $245 and a premium of $320. If at that the time of expiration, the stock is selling at the following prices ($200, $500, $750) what will be your overall gain or loss?

No of Shares = 400

Price per share = $566

Total investment = 400 x $566   = $226400

2 call options wrote with Strike price $245, option premium = $320

1. If stock is trading at $200, call option will remain unexercised. Since I wrote the call option therefore, I will gain from option premium. Therefore, gain from option premium is $320. However the loss from fall in price of stock is $366. Therefore, if two call options wrote against each share therefore total payoff = 2x$320 -$366 = $274
2. If stock is trading at $500, call option will be exercised. Since I wrote the call option therefore, I will gain from option premium. Therefore, gain from option premium is $320. Loss from exercising the call option is $255 ($500-$245). However the loss from fall in price of stock is $66. Therefore, if two call options wrote against each share therefore total payoff = 2x$320 -$255-$66 = $319
3. If stock is trading at $750, call option will be exercised. Since I wrote the call option therefore, I will gain from option premium. Therefore, gain from option premium is $320. The gain fromrise in price of stock is $184($750-566). Loss from exercising the call option is $505 ($750-$245). Therefore, if two call options wrote against each share therefore total payoff = 2x$320 +$184 -$505 = $319
4. Meredith Whitney came out during the Great Recession and stated that there would be billions of dollars in municipalities defaulting on their debt from a lack of tax revenues and too much of a debt burden. Graphically show using the bond market what would happen to the premium between Munis and Treasuries following this announcement.

6. True/False and why: you would never buy a stock if you expect prices to fall from this year to next year.

True. If I have the information that price of the stock going fall from current level, then I will not buy the stock and hold for one year. However, in short run the stock price may increase and one can make money based on that (Technical analysis). Investors can also use derivatives such as put option and gain from the fall in prices.

The main rationale behind such behavior is the fact that all the individuals are rational in nature i.e. they always prefer more than less. It also suggests that at same level of risk, people always seek higher return. In this case, since investors are aware that they will incur higher loss, therefore they will refrain from buying the stocks

Part 2

1. Using the IS/LM model, AD/AS, the Asset Market, the Taylor Rule, and Okun’s Law:

Goods Market: C=225 + 1/2(Y-T) I=240-400r G=125

Money Market:
Money Supply=490 L(r,y)=(1/2)Y-100r
Long-Term Inflation: 2%
Natural Rate of Unemployment: 5%

T=100

1. What are the IS and LM equations?
2. Calculate and show the equilibrium output and interest rates?
3. Considering a Keynesian Model, show graphically what happens to P, Y, and r in the SR when

the there is an increased risk of the stock market changing the Money Demand by 25 regardless of Y or r.

1. What is the short run Y and r?
2. What is unemployment and Taylor Fed Funds Target in the SR?
3. Suppose that the Fed would like to stabilize the economy. Show how large of a policy they 
would conduct.
4. Compare the magnitudes of the Governments policies if they use only a change in expenditure, 
only a change in taxes, or only a balanced budget policy.

Extra Credit: Prior to the Great Recession, which famous economist infamously claimed that the Federal Reserve understood monetary policy so much there would never be another phenomenon such as the Great Depression. Provide documentation—website etc.—of this.