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Questions: Answer the following seven questions

1. If the public expects a corporation to gain $5 per share this quarter and it actually gains $4 per
share, what does the efficient market hypothesis say will happen to the price of the stock when
the $4 gain is announced? Explain your answer. (Note: I do not expect a numerical answer for this
question will the price of the stock go up, go down, or be identified? Why?)

2. After careful analysis, you have determined that a firms dividends should grow at 8 percent on
average per year in the foreseeable future. The firms last dividend (paid earlier today) was $5.
Compute the current price of this stock, assuming the required return is 18 percent. Show how
you obtained your answer for full credit. You will not receive full credit if you do not show all your
work. (Note: I expect a numerical answer for this question.)

3. What is the originate-to-distribute business model? Why is the originate-to-distribute business

model subject to the principal-agent problem? Make sure you explain what is meant by the
principal-agent problem in this particular context.

4. The below shows current and expected future one-year interest rates.
Year One-Year Bond Rate
1 5%
2 6%
3 7%
4 8%

a. Assuming that the expectations theory is the correct theory of the term structure,
calculate the current interest rate for a three-year bond (predicted by that theory). Show
your work, and include a one-sentence explanation

b. Assume now that the liquidity premium theory is the correct theory of the term structure.
If the actual interest rate on a three-year bond is currently 9 percent, calculate the
liquidity premium for the three-year bond. Show your work, and include a one-sentence
explanation.

5. Suppose the yield curve is flat. What (according to adherents of the liquidity premium theory)
does a flat yield curve tell us about what is likely to happen to short-term interest rates in the
future? Include a brief explanation as well.

6. Predict what will happen to interest rates on a corporations bond if the federal government
guarantees today that it will pay creditors if the corporation goes bankrupt in the future. What
will happen to interest rates on Treasury securities? Include appropriate demand-supply graphs.
Make sure that you label the graphs axes, curves, and significant points appropriately.
7.
a. Explain what a yield curve shows. What must be held constant among the bonds whose
interest rates are shown on a yield curve?

b. When the Fed conducts conventional open market purchases it purchases short-term
Treasury bonds. Because short-term interest rates were near zero, the Fed undertook
some unconventional policies in response to the recent financial crisis. One of them was
termed Quantitative Easing (QE) by the media the Fed prefers the term Large Scale Asset
Purchases (LSAP). This policy involved very large purchases of long-term Treasury bonds.
Using the bond-market model (which you encountered first in Chapter 5), explain what
this QE policy does to long-term interest rates. You must appropriate demand and supply
graphs and explain your answer. Label the graphs properly.

c. What does this QE policy do the yield curve? Explain your answer.
Solutions

1. When a corporation reports its quarterly results and profits or earnings per share are less than
the public / market expectation, as per the efficient market hypothesis, the price of stock will go
down even though the company has reported profits during the quarter. This is because the
results are lower than market expectation. In the given case if the reported earnings per share is
$4 against public expectation of $5, the stock price will go down.

2. Dividend Growth Rate (g) 8% per annum (Constant Growth Rate)

Last Dividend (Do) $5 per share
Required Rate of Return (Ke) 18%

As per Gordons Dividend Growth Model, the current price of stock is given as

Po = Do * (1 + g) / (Ke g)
Or, Po = $5 * 1.08 / (0.18 0.08) = $54 per share

3. Originate-to-distribute refers to a model wherein a lender lends loan with an intention of selling
such loans to other institutions / investors. This is in contrast to originate-to-hold model, wherein
the lender lends loan with an intention to hold such loans till maturity.
Principal-agent problem refers to a situation wherein the former creates an environment for the
latter in which the agents incentives are not aligned to principal.
In the given context, originate-to-distribute model is subject to principal-agent problem because
the agents to investors and mortgage originator has little incentive to ensure that the mortgage
has a good credit risk.
4. (a) As per expectation theory, the forward interest rates in current long-term bonds are closely
linked to market expectations about future short-term interest rates. If the expectation theory
holds true, the current three year bond interest rate will be calculated as:

(Yr 1 Rate + Yr 2 Rate + Yr 3 Rate) / 3 = (5% + 6% + 7%) / 3 = 6%

4. (b) Liquidity refers to marketability. The easier it is to market or sell a bond the more liquid it will
be and thus will reduce liquidity risk and hence lesser premium will be attached. The liquidity
premium theory of the term structure of interest rate explains generally an upward sloping yield
curve for bonds of different maturities.

In part (a), the current three year bond interest rate derived is 6% and if the actual three-year
bond interest rate is 9%, the liquidity premium is 3%.

5. If the yield curve is flat, in the parlance of liquidity premium theory, and risk premium on long-
term bonds relative short-term bonds are positive, then rates are expected to fall more often than
one would expect them to rise. Given that the yield curve is flat or the rate are as likely to fall as
they are expected to rise, the risk premium will become zero, the rates on short bonds and long-
term bonds will become identical and the short term interest rate will fall moderately.
6. If the Federal Government guarantees the creditors from corporate default risk, they are making
corporate bonds more desirable and demanding than the treasury bonds as the default risk on
the former reduces to zero. The increased demand of corporate bonds will push the price of these
bonds and as a result the yield / interest on these bonds will fall. Reverse will happen for Treasury
securities where the demand for such bonds will reduces as a result, the price will fall and yield /
interest on such bonds will go up.

Demand- Supply of Corporate Bonds

Price of Bond increases Interest Rate decline

P2 i2

P1 i1
D2
D1

Qty of Corporate Bonds

Bond Prices and Interest Rates are inversely related and are shown
on left and right axes respectively. Price increases as we go up on
left vertical axes and interest rate increases as we go down on right
vertical axes.

When demand for such bonds rises, the price increases from P1 to
P2, as a result interest rate decline from i1 to i2 and hence the
demand curve shifts to the right.
Demand Supply of Treasury Bonds
Price of Bond increases Interest Rate decline

P1 i1

P2 i2
D1
D2

Qty of Treasury Bonds

When demand for such bonds decline, the price decreases from
P1 to P2, as a result interest rate rises from i1 to i2 and hence the
demand curve shifts to the left.
7. (a) Assuming similar tax structure, liquidity risk and default risk among bonds whose term
structures are plotted on the yield curve, the curve shows the relationship between yield to
maturity and time to maturity which are plotted on vertical (y axis) and horizontal axis (x axis)
respectively.

7. (b) Federal Reserve conducts conventional open market purchases of short-term Treasury bonds
in order to lower interest rates on short-term bonds to pep up economic activity and spur growth
by increasing liquidity in the market. When the near term interest rates are near zero levels, there
is little room available for preaching conventional open market purchases. Thus the Federal
Reserve went ahead with unconventional approach to make very large and sustained purchases
of long-term Treasury Bonds to lower the long-term interest rates and infuse liquidity to bail out
large banks and spur economic growth.

Using the bond market model, the unconventional approach also reduce the long-term interest
rates
10-Yr Nominal T-Bill Rates

Ro

Ri

10-Yr Demand Curve

So

Si

Qi Qo
Qty of 10-Yr T Bill Outstanding

As the demand for 10-Yr T-Bill increases due to QE, the supply reduces from So to Si, as we move
from A to B and as a result the interest falls from Ro to Ri. Fall in interest rates forces investors to
seek higher returns in assets with comparable maturities and interest rate risk structure. This
would push the demand for 10-Yr AAA corporate bonds and as result the demand curve for these
bonds will shift right from Do to Di leading to fall in interest rates as well from Ro to Ri.
10-Yr AAA Corporate Bond Interest Rate

Do
Di

Ro A

Ri B

Si

Qo Qi
Qty of 10-Yr Corporate Bond Outstanding

7. (c) QE will also take the yield curve to downward sloping. As part of QE, the supply of money
increases in the economy and rate of long term bonds interest fall leading to downward sloping
of the curve.