Problem Question (23p+12extra=35p) This is a bond market question. a. (8) Suppose financial markets are operating normally and no changes in market conditions are expected. Consider the yield on 20-year Treasury bonds; the yield on 20-year Baa-rated corporate bonds; and the yield on 2-year Treasury bonds. Rank these three yields from lowest to highest. Briefly explain your ranking. b. (15p) Unexpectedly, a pandemic strikes. Many businesses shut down temporarily and lose revenue. Explain the likely impact of this news on the prices and yields of 20-year Treasury bonds and 20-year Baa-rated corporate bonds (up, down, unchanged, uncertain). [Hint: Consider only the immediate impact on financial markets; disregard broader macro issues.] Draw a diagram with demand and supply curves of Treasury bonds, and a second diagram for corporate bonds. Indicate how the news will shift demand and/or supply curves in these markets. c. (Sextra) Suppose the FOMC announces that during the pandemic, the Fed will provide ample reserves to the banking system and reduce the interest rate on reserves to zero. Assume the pandemic is expected to end within two years; thereafter, the Fed is expected to return on pre-pandemic policies. Draw a yield curve diagram and show how the pandemic and Fed response will shift the yield curve. Note in particular the impact on the 2-year yield, on 20-year yield, and on the difference between them. d. (4extra) Suppose a few days after bond prices have adjusted to the news in (b) and (c), the Fed announces that during the pandemic, the Fed is willing to buy investment grade bonds at the same yields at which they traded before the pandemic. Explain the likely impact of this announcement on the yields on 20-year Treasury bonds and on 20-year Baa-rated corporate bonds. Your answer should be arranged similar to the Answer Template on the next page. If you need more space for explanations, use two pages for your answers. Lowest Middle Highest a) Ranking by yield: Explanation (a): Treasury bonds Yield Price Baa Corporate Bonds Yield Price b) Impact on: (up, down, unchanged, uncertain) Treasury Bonds Baa Corporate Bonds Explanation (b): 2-year yield 20-year yield Difference 20yr-2yr c) Impact on: (up, down, unchanged, uncertain) Yield curve diagram Explanation (c): Explanation (d): Problem Question (23p+12extra=35p) This is a bond market question. a. (8) Suppose financial markets are operating normally and no changes in market conditions are expected. Consider the yield on 20-year Treasury bonds; the yield on 20-year Baa-rated corporate bonds; and the yield on 2-year Treasury bonds. Rank these three yields from lowest to highest. Briefly explain your ranking. b. (15p) Unexpectedly, a pandemic strikes. Many businesses shut down temporarily and lose revenue. Explain the likely impact of this news on the prices and yields of 20-year Treasury bonds and 20-year Baa-rated corporate bonds (up, down, unchanged, uncertain). [Hint: Consider only the immediate impact on financial markets; disregard broader macro issues.] Draw a diagram with demand and supply curves of Treasury bonds, and a second diagram for corporate bonds. Indicate how the news will shift demand and/or supply curves in these markets. c. (Sextra) Suppose the FOMC announces that during the pandemic, the Fed will provide ample reserves to the banking system and reduce the interest rate on reserves to zero. Assume the pandemic is expected to end within two years; thereafter, the Fed is expected to return on pre-pandemic policies. Draw a yield curve diagram and show how the pandemic and Fed response will shift the yield curve. Note in particular the impact on the 2-year yield, on 20-year yield, and on the difference between them. d. (4extra) Suppose a few days after bond prices have adjusted to the news in (b) and (c), the Fed announces that during the pandemic, the Fed is willing to buy investment grade bonds at the same yields at which they traded before the pandemic. Explain the likely impact of this announcement on the yields on 20-year Treasury bonds and on 20-year Baa-rated corporate bonds. Your answer should be arranged similar to the Answer Template on the next page. If you need more space for explanations, use two pages for your answers. Lowest Middle Highest a) Ranking by yield: Explanation (a): Treasury bonds Yield Price Baa Corporate Bonds Yield Price b) Impact on: (up, down, unchanged, uncertain) Treasury Bonds Baa Corporate Bonds Explanation (b): 2-year yield 20-year yield Difference 20yr-2yr c) Impact on: (up, down, unchanged, uncertain) Yield curve diagram Explanation (c): Explanation (d)
