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Economics 350 Student Name:

Spring 2014 ID #:

Homework #2

Due: Hardcopy of your assignment is due on Tuesday, March 4 at the beginning of the

class.

Total Points Available: 40

Question 1. (Mishkin, question 5.3.) Explain why you would be more or less willing to buy

gold under the following circumstances. (Be succinct.)

a. (2 points) Gold again becomes acceptable as a medium of exchange. b. (2 points) Prices in the gold market become more volatile. c. (2 points) You expect inflation to rise, and gold prices tend to move with the price level. d. (2 points) You expect interest rates to rise.

Question 2. (2 points) (Mishkin, question 5.16.) The president of the United States

announces in a press conference that he will fight the higher inflation rate with a new anti-

inflation program. Predict what will happen to interest rates if the public believes him.

Question 3. How does the following events change equilibrium in the bond market? Explain

the changes in price, quantity and interest rate using graph.

a. (2 points) In an article dated February 5, 2014, Fox News reports that "... [The island's

treasury secretary] Melba Acosta said: S&P cut its ranking of Puerto Rico's debt from

BBB- to BB+ and suggested further cuts could be forthcoming."

b. (2 points) In the January 30,2014 edition of The New York Times Nelson D. Schwartz

writes: "The Commerce Department reported on Thursday that the economy grew by 3.2

percent in the final quarter of 2013, echoing the even stronger 4.1 percent pace of

expansion in the summer months and providing the White House with a rare bit of good

news despite dismal public approval ratings." Question 4. Suppose that the liquidity premium theory is the correct theory of term structure

and that the expected one-year interest rates are:

Suppose further that in 2011, the term premium on a two-year bond is 0.2 percent and the

term premium on a three-year bond is 0.3 percent.

a. (2 points) Without doing any calculations, explain whether the yield curve slopes up or down over the first three years.

b. (2 points) Labeling the points, plot the yield curve for the next three years.

2011-2012 2012-13 2013-14

3.0% 4.0% 6%

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Question 5. (4 points) (Following Mishkin, question 6.16.) If the yield curve looks like the

one shown to the right, how are investors expecting short-term interest rates to move?

What might the yield curve be indicating about expected inflation?

Question 6. In the March 11, 2010 edition of Purchasing, Tom Stundza wrote:

Whirlpool Corp. has added steel to the list of metals being hedged as part of its

production materials sourcing program. The world's largest appliance maker has joined

other large-tonnage users ... in buying futures on commodity exchanges to hedge against

volatility in prices.

a) (2 points) Suppose that on October 18, 2010, you were developing Whirlpool’s materials sourcing plan for April 2011. What would be the main (downside) risk associated with

this upcoming purchase of steel? To put it differently, in the absence of a hedge, would

you want the spot price of steel on April 18, 2011 to be high or low?

b) (2 points) Explain how on October 18, 2010 you could hedge against this risk with a futures contract. In particular, would you contract to buy or sell steel?

c) (2 points) Explain how on October 18, 2010 you could hedge against the risk described in part (a) with an option instead. In particular, would you acquire a put or a call option for

steel?

d) (2 points) Suppose that on April 18, 2011 the spot price of steel was $300 a ton, while the price on your futures contract was $350 a ton. From a “hindsight perspective,” would

Whirlpool have benefited, lost, or broken even from having entered the futures contract?

By how much?

e) (2 points) Suppose that on April 18, 2011 the spot price of steel was $300 a ton, while the strike price on your option was $350 a ton. Ignoring the option premium, would

Whirlpool have benefited, lost, or broken even from having purchased the option? By

how much?

f) (4 points) The same article also noted that:

[Whirlpool] remain[s] the exception, however ... [For example, t]he purchasing director

of a manufacturer of store fixtures in Nebraska says “we don't [hedge] very often, due to

Y-T-M(%)

Maturity(years)

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the risk in this very unpredictable market. We weigh the risk versus rewards and make

decisions that help us give savings to our customers.”

Briefly explain whether you agree with the purchasing director that: (i) hedging is a bad

strategy when prices are unpredictable, and (ii) the purpose of hedging is to reduce costs.

Question 7. (Mishkin, question 7.24.)The current price of a stock is $65.88.If dividends are

expected to be $1 per share for the next 5 years and the required return is 10%.( You may

find the concepts covered in the topic 'understanding interest rates' useful to solve this

question).

a. (2 points) What should the price of stock be in five years when you plan to sell it?

b. (2 points) If the stock price is expected to increase by $1 five years from now, does the

current stock price also increase by $1?Why or why not?