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Extracredit Answers

Cristina Danciulescu Tulane University Due Date: November 19, 2012 Total points: 50
1. (10 points) Suppose that 10 years from now it becomes possible for money managers to engage in time travel. In particular, suppose that a money manager could travel to January 1981, when the 1-year Treasury bill rate was 12.5%. a. If time travel were costless, what riskless arbitrage strategy could a money manager undertake by traveling back and forth between January 1981 and January 1982? b. If many money managers undertook this strategy, what would you expect to happen to interest rates in 1981? c. Since interest rates were 12.5% in January 1981, what can you conclude about whether costless time travel will ever be possible? a) A money manager could take a large amount of money in 1982, travel back to 1981, invest it at 12.5%, and instantaneously travel forward to 1982 to reap the benets, i.e. the accured interest. The argument of time value of money breaks down. b) If many money managers undertook this strategy, competitive market forces would drive the interest rates down. The reasoning for other investement alternatives follows the same pattern. c) Unfortunately, these arguments mean that costless and riskless time travel will not be possible. 2. (20 points) Suppose you know nothing about widgets. You are going to approach a widget merchant to borrow one in order to short-sell it. (That is, you will take physical 1

possession of the widget, sell it, and return a widget at time T .) Before you ring the doorbell, you want to make a judgement about what you think is a reasonable lease rate for widget.( The lease payment is a dividend. If we borrow the asset, we have to pay the lease rate to the lender, just as with a dividend-paying stock.) Think about the following possible scenarios. a. Suppose that widgets do not deteriorate over time, are costless to store, and are always produced, although production quantity can be varied. Demand is constant over time. Knowing nothing else, what lease rate might you face? b. Suppose everything is the same as in part a) except that demand for widgets varies seasonally. What lease rate might you face? c. Suppose everything is the same as in part a) except that demand for widgets varies seasonally and the rate of production cannot be adjusted. How do seasonality and the horizon of your short-sale interact with the lease rate? d. Suppose everything is the same as in part a) except that demand is constant over time and production is seasonal. How do the production seasonality and the horizon of your short-sale interact with the lease rate? e. Suppose that widgets cannot be stored. How does this aect your answers to the previous questions? a) Widgets do not deteriorate over time and are costless to store, therefore the lender does not save anything by lending me the widget. On the other hand, there is a constant demand and exible production-there is no seasonality. Therefore, we should expect that the convenience yield is very close to the risk-free rate, merely compensating the lender for the opportunity cost. b) Demand varies seasonally, but the production process is exible. Therefore, we would expect that producers anticipate the seasonality in demand, and adjust production accordingly. Again, the lease rate should not be much higher than the risk-free rate. c) Now we have the problem that the demand for widgets will spike up without an appropriate adjustment of production. Let us suppose that widget demand is high in June, July and August. Then, we will face a substantial lease rate if we were to borrow the widget in May, to return it in September: We would deprive the merchant of the widget when he would need it most (and could probably earn a signicant amount of money on it), and we would return it when the season is over. We most likely pay a substantial lease rate. On the other hand, suppose we want to borrow the widget in 2

January, and return it in June. Now we return the widget precisely when the merchant needs it, and have it over a time where demand is low, and he is not likely to sell it. The lease rate is likely to be very small. However, those stylized facts are weakened by the fact that the merchant can costlessly store widgets, so the smart merchant has a larger inventory when demand is high, osetting the above eects at a substantial amount. In conclusion, the lease rate will uctuate around the year depending on the seasonality in the demand. d) Suppose that production is very low during June, July and August. Let us think about borrowing the widget in May, and returning it in September. We do again deprive the merchant of the widget when he needs it most, because with a constant demand, less production means widgets become a comparably scarce resource and increase in price. Therefore, we pay a higher lease rate. The opposite eects can be observed for a widget-borrowing from January to June. Again, these stylized facts are oset by the above mentioned inventory considerations. In conclusion, the lease rate will uctuate around the year depending on the seasonality in the production. e) If widgets cannot be stored, the seasonality problems become very severe, leading to larger swings in the lease rate due to the impossibility of managing inventory. 3. (20 points) Short questions i. Why might a variable rate mortgage be considered a derivative and a xed rate mortgage not? The pure denition of a derivative is one in which its value is determined by the price of another item. ARMs often use LIBOR to determine their value, thus have their values derived from another security. ii. As with Chrysler Corp. many years ago, the government occasionally guarantees loans. What option is the government granting and to whom in a loan guarantee? The government is giving the banks (or lenders) a put option. If the borrower defaults (thus the price of the loan drops) the banks may exercise their put options and sell the loans to the government. iii. What function does the convenience yield serve in setting forward prices and how does this inuence arbitrage opportunities? In contrast to a speculator, a manufacturer earns the convenience yield. This yield should be factored in to forward prices for manufacturers, but not for speculators. 3

The result is a range of possible forward prices, which could be considered an arbitrage-free zone. iIV. Explain the expectations hypothesis and its ability to accurately forecast interest rates. The expectations hypothesis is a generally held belief that the implied forward rate equals the spot rate of interest that will occur in the future. Since risk premiums exist, this forecast is biased and usually does not accurately predict interest rates. iV. How would a market-maker hedge a swap involving variable price and quantity? The market-maker will enter into varying quantities of forward contracts in different months to match the variable quantity called for in the swap.