Eco 342 Banking and Financial Markets           Homework #5             Due 4/23/2004   Answer Key

1. What are the key distinctions between a private placement and a public offering in the primary market?

A private placement involves placing the security directly with a small number of buyers with no general solicitation to public.  No registration w/ SEC required.  There are some resale restrictions on private placements.
A public offering involves many buyers from the general public.  These securities must be registered with the SEC.

2. Consider a 10-year inflation indexed Treasury note issued with a coupon rate of 2%, semiannual coupon payments, and a face value of $10,000.  If inflation is 1.8% in the first year after issue and is 1.5% during the second year after issue, what be the adjustment to the face value and coupon payments after year 1 and year 2?  (Give me numerical answers)

Year 1:  1.8%
face value = 10,000 (1.018) = 10,180
coupon pmt = .02(10,180)(.5) = 101.80

Year 2:  1.5%
face value = 10,180(1.015) = 10,332.70
coupon pmt = .02(10,332.70)(.5) = 103.33

3. Consider a Treasury bill with 180 days to maturity, a face value of $10,000 and a discount yield of 2%.  Calculate the price and yield to maturity for this bond.

discount yield = [(F-P)/F](360/d)
.02 = (10,000-P/10,000)(360/180)
.02(10,000)(.5) = 10,000 - P = 100
P = 9900

YTM = [(10,000 - 9900)/9900](365/180)
YTM = 2.05%

4. Describe in your own words the difference between an underwriting arrangement and a best efforts arrangement in the primary market.

An underwriting arrangement  is when an investment bank buys the securities from the issuer, and then resells it to the public, bearing the price risk of the new issue.  A best efforts placement is the alternative to underwriting where the investment banks sells issue at highest possible price, but no guarantees about that price.  Here the issuer retains the price risk of the new issue best efforts is typically done with firms deemed risky or with limited market recognition.

5. Describe the basic tradeoff between a competitive and noncompetitive bid in a Treasury auction.

Competitive bids are by yield, with the lowest yields being successful (in getting the securities); Competitive bidders name their reservation price, but bid may not be successful.  Noncompetitive bids are by quantity. They agree to pay average yield of successful competitive bids.  This bids are   guaranteed to be successful, but do not name their reservation price and have stricter quantity limits.