Investment Midterm

Chicago Booth

BUS 35000 Winter 2016

Problem 1. Drivers of the yield curve (8 points)

Midterm Exam Solutions

In parts (a) and (b), each item is worth 2 point. Give a brief (one sentence) justification for each of your answers.

(a) (8 points) Which of the following factors would you consider bullish (positive) for U.S. Treasury bond prices? Which are bearish (negative)?

• (I) You expect a recession.

• (II) U.S. government deficits are expected to increase.

• (III) The Federal Reserve announces that it will begin selling its accumulated stock of U.S. Treasuries.

• (IV) The USD strengthens against foreign currencies, which is expected to produce lower inflation.

Solution: Items I and IV would be bullish factors for U.S. Treasury bond prices. A recession might lead the Federal Reserve to lower interest rates, and government bond yields would move lower in anticipation. Similarly, lower inflation would reduce the nominal yield that investors demand to hold assets, and may also influence the Federal Reserve to pursue less hawkish yield policy. Bond prices are inversely related to bond yields.

Items II and III would be negative factors for bond prices. Higher U.S. deficits should boost the supply of government bonds, lowering the equilibrium-clearing price. Large sales of U.S. Treasuries by the Federal Reserve (unwinding of QE) would shrink the demand base for government bonds, also leading to lower equilibrium prices.

(b) (8 points) Which of the following statements about yield curve term premium are true? Which are false and which are uncertain?

• (I) An upwards-sloping yield curve indicates positive term premium.

• (II) Risk-averse investors with short-term trading horizons should demand positive

risk premium to hold long-dated bonds.

• (III) The expectations hypothesis and the market segmentation hypothesis make the same prediction about term premium.

• (IV) Credible forward guidance from the central bank should decrease the term premium demanded by fixed-income investors (in an absolute sense).

Solution: Items II and IV are true. Short-term investors typically demand high yield compensation to invest in long-term debt, which is riskier for them given their short-term trading horizon. This is because long-term debt has higher price risk than short-term debt. If investors have more certainty about the future path of interest rates, they