PART A: THE BEHAVIOR OF INTEREST RATES AND RISK
STRUCTURE
1. Go to the Federal Reserve Economic Database. Create a line graph of the
nominal interest rate on a 10-year Treasury bill (constant maturity). Include
that graph as your answer to question A.1.
2. What happened to interest rates at the beginning of the current recession?
Did they rise or fall?
3. Illustrate the bond market. Clearly label the axes (using words and
symbols), bond demand (Bd
), bond supply (Bs
), the equilibrium bond price
(P*) and equilibrium quantity of bonds (Q*). Label the equilibrium point
A.
4. Is bond demand affected by the savers or borrowers? Suppose we enter a
period of economic recession. How does this affect bond demand? Explain
why bond demand is affected in this way in detail, citing three reasons for
this change in bond demand.
5. Is bond supply affected by the savers or borrowers? Suppose we enter a
period of economic recession. How does this affect bond supply? Explain
in detail why bond supply is affected in this way.
6. Illustrate the effects you described in question #A.4 and #A.5 on your
diagram from #A.3. Note, carefully your answers to A.1-A.2. Your diagram
must be consistent with the data from #A.1 to receive credit.
7. Identify one example of a risk-free bond with a 30-year maturity. Identify a
corresponding risky bond for the purposes of analyzing risk structure. Do
not use the bond mentioned in A.1 to answer this question. Be specific
about the terms to maturity and the appropriate names for these two bonds.
Which bond has a higher yield? Why?
8. Go to FRED and create a time series graph that shows the interest rate
spread for the two bonds you mentioned in A.7.
9. Based on your answer to A.8, what happened to the spread at the beginning
of the current recession?
10. Illustrate change in the interest rate spread using the markets the two bonds
you cited in #A.7 using bond market diagrams for each. Each diagram
should be aligned horizontally and each market diagram should be labeled for each bond you mentioned in A.7. Be sure to indicate the initial
equilibrium points as Point A in each diagram and clearly label the price of
each bond in each market.
11. Now, suppose the economy enters a recession. Show how this affects the
bonds markets you described and illustrated in A.7-10. Be sure to indicate
the initial equilibrium points as Point A in each diagram, then illustrate how
the period of economic growth affects each market, labeling the new
equilibrium as Point B in each diagram.
12. Explain why you made the changes in your graph above. In particular why
did each curve in each market shift the way that they did?
13. Using your diagrams above and the relationship between bond prices and
yields, what happens to the interest rate spread between these two bonds?
Why does this change occur? Explain why the curves above shifted the way
that your showed in A.11 and why this affects the interest rate spread in the
way you illustrated.
14. Is your theoretical analysis of the bond market in A.10-12 consistent with
your empirical findings in A.8- A.9? Explain briefly.
PART B: TERM STRUCTURE AND THE BOND MARKET
1. Using FRED (or another source), look up the yields on the following riskfree bonds in June 5, 2019: 3- month, 1-year, 2-year, 5-year, and 10-year.
Use the end of period, constant maturity rate figures (you can usually see
these on the graph if you display the maximum range of dates).
2. Using your data from B.1, construct a yield curve for June 5, 2019. Be sure
to clearly label the axes, and the data points.
3. Is the yield curve normal, flat or inverted?
4. According to expectations theory of term structure, what does your yield
curve above tell us about expected future short-term interest rates?
Explain, citing at least one assumption from the expectations theory of
term structure to support your answer. I recommend you use an equation to
support your answer (you can compare one- and two-year bonds for
simplicity), but you must explain in words how you are arriving at this
conclusion using the data you cited in B.1-B.3.
5. Compare your response to B.4 if instead of using expectations theory, we
used liquidity premium theory to describe the general shape of the yield
curve you reported in B.2-B.3. Be sure to compare/contrast the differences
in how each theory interprets the yield curve from B.2-B.3.
6. Redraw your yield curve from B.2 here. You don’t need to relabel
everything (though you can if you want to), just draw the general shape you
showed in B.2. Label this yield curve YC1.
7. In mid-June 2019, the Federal Reserve began decreasing the money supply,
creating a liquidity effect in money m
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