Gallaway
ECO 305

Fall 2003

Homework #2

All homework is to be typed. Hand-written graphs and equations are acceptable as long as they are neat

  1. According to the pure expectations theory, what would the interest rate on a two, three, four and five year bonds be if the expected interest rates on 1 year securities for the next five years are: 2%, 3% ,5% , 7%, 5% ? (That is, solve four different equations.) Plot the  resulting yield curve.
  2. If  the interest rate on a 1-year Canadian CD was  5.5% , the spot exchange rate is 1.75 Canadian dollars per US dollar, and the dollar is expected to appreciate to 1.85 by next year, what is the expected rate of return from investing in that Canadian CD? (show work)
  3. Briefly explain why the law of one price is unrealistic for most goods but why it might be appropriate when considering interest parity.
  4. If  a bank a bank's equity capital to assets ratio is 4% and its return on assets (ROA) is 1%, what is its return on equity (ROE)?

 

Assets Liabilities
Reserves    $60 million
Loans       $540 million
  Deposits   $500 million
 Capital Acct. $100 million
  1. Given the balance sheet above, explain what would happen if the bank has a reserve requirement of 10% and a deposit outflow of $50 million.  Is the bank in trouble? Why? (Be specific) What actions might this bank take?  What suggestions would you make to prevent such problems?
  2. Who regulates or supervises state banks? Explain.