Mitchell Jackson

HW Assignment #4
BECON 301 A

1. Explain how the stock market is likely to react to these scenarios:

a) The Fed unexpectedly cuts policy rate by 25 basis points:

Since the policy rate change is unexpected there will surely be an

impact on the stock market. This policy rate cut is expansionary in
nature and will increase output which will likely lead to higher
dividend expectations (at least in the short run) and will also result
in a lower discount rate (since current and future rates are now
lower). Stock prices will go up.

b) The Fed, as expected, cuts policy rate by 50 basis points:

Since the policy rate change is fully expected by the market the
stock market will be unaffected. This is because current/future
interest rates are unchanged, as investors have already accounted
for the upcoming policy rate move in their expectations.
Additionally, expected future dividends do not change since output
is unaffected in this scenario.

c) The Fed unexpectedly raises policy rate by 25 basis

points:

Similar to the above scenario (question 1a) there will be an impact

on the stock market on the grounds that investors have not
accounted for this change in policy rate. A higher discount rate will
result and lower dividend expectations in the short run (due to slight
contraction in output), leading to lower stock prices.

d) The government, as expected, cut taxes by $1 trillion:

The tax cut will increase output by shifting the IS curve to the right
(fiscal expansionary policy). It is unclear in this scenario whether or
not investors believe the Fed will increase the policy in response.
However, what is important is that the market already expects this
tax cut, and hence they already expected and accounted for the
increased output and higher dividends that come with it. Because
of this, stock prices remain unchanged.

e) The government unexpectedly cuts annual spending by

$400 billion:

This decrease in government spending will shift the IS curve to the

left (contractionary fiscal policy). Similar to the above scenario,
 Mitchell Jackson
HW Assignment #4
BECON 301 A
investors opinion on potential policy rate decreases in response to
lower spending is not given, so it is most likely that stock prices will
go down. Unforeseen lower output will lead investors to become
more pessimistic about future dividend payments and will cause
prices to decrease in response.

2. Expected Profit and Investment Decision Question:

The machine starts to profit next year (t+1) and costs $450,000
in year t
Starts depreciating next year (t+1) at a rate of 10%
The machine will make $100,000 in the first year
Hold the machine for 3 years*, then sell for $300,000
o **Here I am going to assume it means hold on to the
machine for 3 full years of profit making and then sell the
machine in the year after its last full use

a) Calculate PV for the machine investment with a discount

rate of 4%:

Profit t: -$450,000 =
-450,000
Profit t1: $100,000 profit * 1 / (1.04) =
96,153.85
Profit t2: $90,000 profit * 1 / (1.04)2 = 83,210.06
3
Profit t3: $80,000 profit * 1 / (1.04) = 71,119.71
Profit t4: $300,000 sale * 1 / (1.04)4 =
256,441.26

PV = $56,924.88; Yes they should invest

b) Calculate PV for the machine investment with a discount

rate of 8%:

Profit t: -$450,000 =
-450,000
Profit t1: $100,000 profit * 1 / (1.08) =
92,592.59
Profit t2: $90,000 profit * 1 / (1.08)2 = 77,160.49
3
Profit t3: $80,000 profit * 1 / (1.08) = 63,506.58
Profit t4: $300,000 sale * 1 / (1.08)4 =
220,508.96
 Mitchell Jackson
HW Assignment #4
BECON 301 A
PV: = $3,768.62; Yes they should invest under these
assumptions.

I hope you get where I am coming from on my assumptions and

see I did the math correct in calculating the present value for
each years cash flow. The only part that was confusing to me in
the instructions was which year the machine would get sold off
at, and also whether holding on to the machine for three years
meant 3 total (including the non-profit year) or 3 profiting years.

3. US one-year bond Par: $1,000 Price: $956.48

German one-year bond Par: 1,000 Price: 994.53
Current Exchange Rate (Et) = 1.04 per $

a) Compute the current one-year interest rate in Germany

and U.S.:

P1, t = Par Value / (1 + i1, t); Solve for i1, t (current 1-year rate)
Par Value / Current Price = Current 1-year bond rate

US: $1,000 / $ 956.48 = 1.0455; 1-year interest rate =

4.55% (it)
German: 1,000 / 994.53 = 1.0055; 1-year interest rate =
0.55% (it*)

b) If interest parity condition holds, what is Eet+1?

Eet+1 = Et / [(1 + it)/(1 + it*)]

Rearranging: Eet+1 = Et * (1+it*)/(1+it)
1.04 * (1.055/1.0455) = 1.0002 = the expected exchange rate
next year

4. As of February 29, 2016, the interest rate on one-year UK gilt was .

25%, and the interest rate on a two-year gilt was also .25%

a) What was the one-year gilt interest rate expected for

next year (Feb. 2017)?

Since the interest rate for one-year bonds is the same as the
interest rate for two-year bonds (both .25%), then we can
assume the expected one-year interest rate for Feb. 2017 is the
same as the current one-year rate. This is because the two-year
 Mitchell Jackson
HW Assignment #4
BECON 301 A
interest rate is the average of the current one-year rate and the
expected one-year interest rate for the next year.
Mathematically this is shown by [i2 t = .5 (i1 t + ie1 t+1)], using the
rates given for the UK gilt this is .25% = .5 (.25% + x). Solving
for the unknown variable we indeed do find that the one-year
interest rate expected by financial market participants for late
February 2017 is .25%.

b) As of February 28, 2017, the interest rate on a one-year

gilt is .03%. Were the market expectations correct from a
year ago?

No, the market expectations in February 2016 were incorrect. In

fact, market participants expected the one-year gilt interest rate
to stay the same reflecting that they believed the Fed would not
change the interest rate on one-year bonds. What actually
happened was interest rate on the one-year gilt dropped below
expectations (expected rate of .25%, actual rate of .03%)

What happened in the UK that could of accounted for this

drop in one-year rate?

The Fed could of possibly been pursuing an expansionary market

operation during 2016 in light of actual economic events (a
policy such as this could be responding to a slight economic
downturn) that participants simply could not, or did not, predict.
This is a potential answer to why the Bank of England lowered
the policy rate below market expectations.

c) As of February 28, 2017, the interest rate on a two-year

gilt is .05%. What one-year interest rate is expected for
next year in the UK? Does this mean participants expect
the Bank of England to change the policy rate and in
which direction?

Lets use the equation from above (question 4a) assuming that
the one-year gilt rate as of February 28, 2017 is the same as it
was in question 4b (.03%).
Therefore we can solve for the expected one-year gilt rate for
February 2018 by solving this equation: .05% = .5(.03% + ie1 t+1)
resulting in ie1 t+1 = .07%.
In conclusion, participants expect the Bank of England to change
the policy rate (on one-year gilts) in the upcoming year from its
current rate of .03% to .07%. These participants therefore
expect the Bank to increase the policy rate or liftoff.
 Mitchell Jackson
HW Assignment #4
BECON 301 A