ECO 342 810    Banking & Financial Markets            Homework #4  Answer Key

1. Consider the overall level of interest rates today.  What are the implications for the price volatility of bonds in response to a change in interest rates?

The overall level of interest rates today is quite low.  At a low level of yields, bonds exhibit greater price volatility than when yields are high.

2. Consider a municipal and corporate bond with the same rating, liquidity and maturity.  Suppose you are in a 30% marginal tax bracket, and the municipal bond yield is 3.5%.

a) What yield on a corporate bond would make you indifferent between a taxable bond and the tax-free municipal?

The equivalent taxable yield = .035/(1-.30) = .05 = 5%

b) If the corporate bond in part has a yield of 5.5%, which bond would the investor choose?  At what tax rate would an investor be indifferent between the corporate and municipal bond?

Choose t so that
.055 (1-t) = .035
1-t = .035/.055
1-t = .64
t = .36 = 36%

3. Consider the market for loanable funds.   Explain what would happen to this market (supply/demand, interest rates) if

a) tax laws are changed to make interest payments are car loans and credit cards tax deductible.

This is favorable tax treatment for borrowers and will increase borrowing, so the demand for loanable funds will increase or shift right.
The equilibrium interest rate will rise.

b) the federal government issues more Treasury debt to finance the deficit.

The federal government is borrowing more money due to its deficit.  This is an increase in the demand for loanable funds and will increase interest rates.
(NOTE:  The federal government issuing debt is NOT the same as the FRBNY selling Treasuries as part of open market operations.  These are two different things.)

c) the FOMC votes to raise the federal funds rate target

If the FOMC raises the federal funds rate target, then the FRBNY must sell Treasuries to meet the new, higher target.  So reserves fall, causing the supply of loanable funds to fall or shift left, and the interest rate rises.

A GENERAL NOTE ABOUT #3:  RECALL FROM ECO 101 THAT SHIFTS IN DEMAND DO NOT CAUSE SHIFT IN SUPPLY OR VICE VERSA.  THERE IS A DIFFERENCE BETWEEN AND CHANGE IN DEMAND OR SUPPLY AND A CHANGE IN QUANTITY!

4. Consider the following statement: “Risk averse investors will not hold bonds with low credit rating or a high duration.”  Is this statement true or false?  Explain your answer.

This statement is FALSE.  We assume investors are risk averse, yet we see that some doe how bonds with high default risk and/or high interest rate risk.  The issue here is the tradeoff between risk and yield.  A risk averse investor will hold risky bonds if the yield is high enough to compensate for the risk.

5. Consider the three bonds below.  Which one has the greatest interest rate risk (price volatility)?  Explain your answer.

• a zero-coupon bond with 10 years to maturity

• a 4% coupon bond with 8 years to maturity

• a 4% coupon bond with 10 years to maturity

The greatest interest rate risk will be for the bond with the longest maturity and the lowest coupon rate.  This is the first bond, the zero coupon bond with 10 years to maturity.