US Govt. Long term bonds.

  1. In the above graph, identify at least three points of time when the interest rates of 3-month T-bills crosses the rates of US Govt. Long term bonds. Are those crossing good or bad for the economy? Explain why. (5 points)
  2. According to the expectations theory, how should the long-term interest rates be determined? Explain. (5 points)
  3. Should the interest rates of short-term bonds be higher than long-term bonds? Why? Explain based on “Expectations” and “Liquidity Premium” theories. (5 points)
  4. The US government provided around $2.2 trillion stimulus in the economy in the first half of 2020 to avoid the economic downturns following the breakdown of global pandemic. The government is expected to approve another near $2 trillion stimulus for the economy. Consequently, the government would suffer higher budget deficit and need more borrowing to carry on expenditure. If you expect that the government would borrow more from credit market by issuing more T-bills in the next couple of years, explain how such policy would affect – 1) overall supply of bonds; 2) price of bonds; and 3) yields of bonds. (10 points)
  5. Suppose you have two alternative options to invest in the bond market. Option 1: purchase Bond A today, which has a maturity of 5 years and face value of $1,000, and sell next year, Option 2: purchase Bond B today, which has a maturity of 3 years and face value of $1,000, and sell next year. Both bonds A and B are zero-coupon and have same price today.
    a) Calculate expected price at which you can sell Bond A or Bond B and standard deviation of the prices of each bond and complete the following tables. (8 points)
    Bond A
    Original Maturity FV Economic Condition Probability Expected Yield Price next year ProbPrice Prob(Price – Expected Price)2
    5 $1,000 Bullish 0.3 0.05
    5 $1,000 Normal 0.4 0.058
    5 $1,000 Bearish 0.3 0.065
    Expected price
    Standard deviation

Bond B
Original Maturity FV Economic Condition Probability Expected Yield Price next year ProbPrice Prob(Price – Expected Price)2
3 $1,000 Bullish 0.4 0.04
3 $1,000 Normal 0.5 0.05
3 $1,000 Bearish 0.1 0.08
Expected price
Standard deviation

b) Think about two types of investors – risk-averse and risk-loving. Do you think the risk-averse investor would chose Bond A over Bond B? Why or why not? (4 Points)

  1. Following table shows risk and maturity structure of two bonds: Bond A and Bond B.
    Factors Bond A Bond B
    Default risk Lower Higher
    Liquidity factor Highly liquid Less liquid
    Maturity 5 years 10 years

Given that both bonds have same face values, which bond should provide higher yield at a lower price and why? (5 points)

  1. Municipal bonds are usually considered as safe assets – these are the bonds for higher education, health care, etc. However, around 20 municipal borrowers defaulted in May and June of 2020 following economic lockdown. But, surprisingly, even with rising default risk, there is a surge in demand of municipal bonds we have been observing in the recent months. What kind of investors (risk-averse or risk-lovers) do you think are creating such higher demand for risky municipal bonds? Why? (8 points)
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