1. (a) Discuss various measures of capital market efficiency and how efficient capital markets contribute to the efficiency in the market for goods and services (including productive capital).  As part of your discussion, consider the implications of the fact that the bulk of trading in capital markets is in outstanding securities and analyze the meaning of the terms "depth," "breadth," and "resiliency" as descriptions of capital markets.  Include in your discussion the types of legislative and regulatory reforms that might be or have recently been instituted in order to improve the efficiency of capital markets and the role of "insider trading" and the SEC as they affect market efficiency.

(b) Compare money and capital markets and identify the major issuers of securities in the different markets and the difference among the various types of securities within and between each of the markets. Within your discussion of the money markets include a consideration of the role of the Federal Reserve System (Fed) and the banking system as they interact through required reserve maintenance, needs for liquidity and monetary policy actions by the Fed.  Consider in your analysis the types and significance of the links between the money and capital markets via the term structure of interest rates, issuers of debt and equity and the presence of interest rate and credit risk derivatives.

2. (a) Within the loanable funds theory, graphically show the effect of an increase in the money supply, assumed to be determined solely by the Fed, on the supply and demand for loanable funds and the equilibrium rate of interest assuming a constant real rate of interest and expected inflation to be constant.

(b) Illustrate and discuss how an autonomous increase in the expected rate of inflation will change the equilibrium nominal interest rate.  Consider an initial real rate of interest of 3 percent and an expected inflation rate of 2 percent.  If the expected rate of inflation rises to 4 percent with the real interest rate constant, what would the resulting nominal interest rate become, using the Fisher relationship?   The rise in the expected rate of inflation is considered to remain at the higher level. Define your terms and discuss a recommended monetary policy to achieve economic stabilization with price stability and an improvement in the balance of payments.

(c) Starting from an equilibrium position as in 2.a, discuss the effects of the conduct of a more restrictive monetary policy if the markets believe that a Fed tightening will lower future (next period) inflation. How might a recession occur under this scenario?

2.1. There are a number of theories of the term structure of interest rates including the unbiased expectations hypothesis, preferred habitat hypothesis, and market segmentation hypothesis.  Discuss the implications of the unbiased expectations hypothesis within the context of the following problem.

Problem 1:  For a two year, default free, zero coupon security, compute its yield to maturity and draw the respective yield curves assuming two different expectations of inflation employing the Fisher Effect and the data below: 

(a) 4 percent one year from now, and

(b) 2 percent one year from now.  In addition, define and compute the implied forward yield on a one year security one year from now, assuming the current two year yield is 6.0 percent. 

Discuss the assumptions underlying this calculation and how it can be used to evaluate the implied forward yield on a 1-year loan, next year. 

(c) What is the implied expected rate of inflation if the real rate remains at 3 percent?

2.1. There are a number of theories of the term structure of interest rates including the unbiased expectations hypothesis, preferred habitat hypothesis, and market segmentation hypothesis.  Discuss the implications of the unbiased expectations hypothesis within the context of the following problem.

Problem 1:  For a two year, default free, zero coupon security, compute its yield to maturity and draw the respective yield curves assuming two different expectations of inflation employing the Fisher Effect and the data below: 

(a) 4 percent one year from now, and

(b) 2 percent one year from now.  In addition, define and compute the implied forward yield on a one year security one year from now, assuming the current two year yield is 6.0 percent.

Discuss the assumptions underlying this calculation and how it can be used to evaluate the implied forward yield on a 1-year loan, next year. 

(c) What is the implied expected rate of inflation if the real rate remains at 3 percent?

3.1 Mortgage markets have developed significantly since the early 1970s through the creation of secondary market instruments in the form of mortgage pass-throughs, collateralized mortgage obligations (CMOs), and REMICs. 

These collectively have been generally referred to as mortgage backed securities (MBS).  In many ways, these instruments carry the characteristics of their underlying assets -- individual mortgages.

a. Why is the cash flow of a mortgage, or a MBS, uncertain in the sense that the investor in the mortgage has granted the borrower a call optionto prepay the mortgage? Compare a mortgage cash flow with a Treasury coupon bearing bond paying interest semi-annually and a payment of principal at maturity.

b. What does this call option depend upon and why?

c. The cash flow for a mortgage pass-through typically is based on some prepayment speed benchmark.  Why is the assumed prepayment speed necessary to price the MBS?

d. Suppose a bank has decided to invest in a MBS and is considering the following two securities:  a Freddie Mac pass-through with a WAM of 340 months and an average life of 7 years or a PAC tranche of a Freddie Mac CMO issue with an average life of 2 years. 

In terms of prepayment risk, contraction risk and extension risk, which MBS would probably be best for the bank's asset/liability management perspective when it is known that liabilities generally have a duration less than 1 year and that assets have durations in the 2-year to 7-year range?

e. Compare the interest rate risk of a noncallable 10-year Treasury coupon bearing bond with a mortgage-backed pass-through security with prepayments related to the level of interest rates - lower market interest rates raise the rate of prepayments. Discuss how the changes in cash flows from a mortgage-backed security affect the duration of such securities. HINT: consider the coupon effect on duration.

3.2. Are the following statements consistent or inconsistent?  Explain your answer and discuss how equilibrium is achieved between the futures and cash markets.

1. Futures markets serve an important function of the global financial markets by giving investors the opportunity to better manage financial risks associated with their underlying business transactions.

2. The futures market is where price discovery takes place.

3. The introduction of futures contracts creates greater price volatility for the underlying commodity or financial asset.

3.3.  Suppose the current yields to maturity on 3-month and 6-month T-Bills are 4.0 percent and 5.0 percent, respectively (yields will need to be converted to 90-day returns).

(a) In perfectly efficient markets and risk-neutral pricing, what yield should you expect to find on a 3-month T-bill forward contract deliverable in 3 months?

(b) Show that for the forward yield calculated in (a) the 6-month returns on (i) a 6-month spot bill and (ii) 3-month spot and 3-month futures bills are the same.

 (c) Explain what factors would lead to a rejection of (b).