Question;Name;Last 4;PLEASE PUT FIRST TWO;LETTERS OF YOUR LAST NAME ON THE TOP RIGHT HAND CORNER OF THIS PAGE.;Homework;Assignment #4? Econ 351 ?Fall 2013 ? PLEASE STAPLE, DUE, Wednesday, November 20 at;the beginning of class. NO LATE HWS;ACCEPTED -;YOU MUST USE THIS;AS A TEMPLATE ? Please be a neat as possible, especially with graphs and please;show all work. HIT ENTER TO MAKE ROOM;FOR YOUR ANSWERS. PLEASE STAPLE!;THE TERM AND RISK STRUCTURE OF INTEREST RATES;In this HW;assignment we are going to consider 4 specific relatively recent episodes in;the US;economy ? 2 of the 4 apply mainly to the term structure of interest rates and;the other two apply mainly to the risk structure of interest rates. In this assignment you are getting your hands;dirty with real economic data (interest rates) and then you graph the data and;interpret (You need to know a little;about excel - if you need help see me or a friend)!;1) EPISODE #1! GREENSPAN;THE HAWK!!! It was November 1994 and the;US;economy had just ?gotten through? the jobless recovery following the 1990 ? 91;recession. The graphic below helps us;understand what Greenspan was thinking ? The Fed has a dual mandate and;unemployment rates above 7% is certainly not consistent with the full;employment objective. As such, Greenspan;was dovish;in the sense that he continued to lower the federal funds rate until it hit 3%;(see FF graphic). At the time, inflation;was running about 3% which implied the real federal funds rate was zero;certainly falling into the category of easy or expansionary policy. What we are;interested in is the behavior of the yield curve towards the end of this;episode.;BOTH GRAPHICS ?;MONTHLY DATA (8/1990 ? 11/1994);Note that during 1994 the Fed was quite aggressive in;raising the funds rate and this is when AG showed his ?Hawk-like;qualities.? In particular, the funds target rose from 3% to 4.75% during the;first 10 months of 1994. Greenspan, as;was the norm, was looking very closely at the behavior of the 10 year Treasury. In what follows, you are to examine the;behavior of the yield curve during this job-less recovery episode. To do so, we need data on the three ? month;T-bill and the 10 year Treasury (Click Here for;the T-bill data and Here for;the 10 year Treasury data). Please choose ?download data? and create a;worksheet with data that begins in August 1990 and goes through to the present;(we will use data later in the sample in a different episode). Your worksheet should begin looking just like;the one below.;3;month T bill;10;Year Treasury;1990-08-01;7.69;8.75;1990-09-01;7.60;8.89;1990-10-01;7.40;8.72;1990-11-01;7.29;8.39;1990-12-01;6.95;8.08;Below is an excerpt from;Fed Chief's Style: Devour the Data, Beware;of Dogma;As Retirement Looms in 2006, Greenspan's;Strong Record Will Be Hard to Replicate;Did He Help Create a Bubble?;By GREG IP;Staff Reporter of THE WALL STREET;JOURNAL;November 18, 2004, Page A1;1994: Soft;Landing;In the first eight;months of 1994, in a bid to slow the economy, the Fed raised its short-term;interest rate five times, or a total of 1.75 percentage points, to 4.75%. The;Greenspan Fed had a long tradition of moving in small increments, hoping to;give officials time to assess the impact on corporate borrowing or consumer;spending before moving again. Changing rates too rapidly, the theory went;risked an unnecessarily sharp slowdown and higher unemployment.;But the economy showed;no signs of slowing. Investors still worried about inflation -- then running at;an annual rate of about 3%. That concern;led the bond market to drive up long-term interest rates. When bond buyers;worry their investment will be eroded by inflation, they typically demand a;higher rate of return as compensation (THIS IS THE FISHER EFFECT!!!).;The Fed's challenge;was to raise rates enough to slow growth and yet also contain inflation -- an;elusive combination called a "soft;landing." But the Fed might raise rates too much, or the;inflation-obsessed bond market could drive up long-term interest rates too;high, causing the economy to fall into recession with a "hard;landing." THIS IS WHY THE FED IS SO VIGILANT ON ANCHORING INFLATION;EXPECTATIONS BECAUSE IF THEY BECOME UNANCHORED, POLICY BECOMES VERY DIFFICULT;VERY FAST.;In November 1994, Mr.;Greenspan made a dramatic proposal to the Federal Open Market Committee, the;body that votes on interest rates: Jack;up the Fed's key short-term interest rate by three-quarters of a percentage;point in one shot, something he had never recommended before. Mr. Greenspan;believed such a move would demonstrate the Fed's resolve and finally stamp out;inflation worries (TOTALLY HAWKISH);I think that we;are behind the curve," he told the Fed's policy committee, transcripts;show. Doing less, he said, could undermine confidence in the Fed's ability to;control inflation. With none of the ambiguity that marked his public;statements, Mr. Greenspan said such an eventuality could provoke a "run on;the dollar, a run on the bond market, and a significant decline in stock;prices.;Some of the six other;governors and 12 regional bank presidents who made up the FOMC worried Mr.;Greenspan was overdoing it. Especially concerned were two new Clinton-appointed;governors, Janet Yellen and Mr. Blinder;academic economists inclined at the time to worry more about unemployment than;inflation. THIS IS THE DEFINITION OF;BEING DOVISH "There is a real risk of a hard landing, instead of a;soft landing, if we are too impatient and overreact," Ms. Yellen, who is now president of;the San Francisco;regional bank, told the committee.;a) (10 points);We know that the Yield curve typically slopes upward due to the term;premium and we also know that the Yield Curve slopes upward when short rates;are abnormally low. Greenspan was;watching the 10 year and the slope of the yield curve carefully during the Fed?s;tightening of 1994 and was upset. Why;was he upset exactly? Use the real data that you downloaded and use the Fisher;equation and Fisher effect to buttress your argument.;b) (10 points) As a;result of these developments, Greenspan decided to crank the funds rate target;up by 75 basis points at the November;1994 FOMC meeting. Greenspan continued;to watch the 10 year very closely and was he satisfied with the result? Why or why not? Explain. Consider the;movement of the 10 year from November 1994 through June of 1995.;c) (10 points) Now draw;two yield curves on the same diagram.;The first, label YC11/94 and the second label YC6/95;being sure to label everything with actual numbers!. Comment on the difference in the shape and;what this means, theoretically in terms of the future path of short term;interest rates employing the pure expectations theory of the term structure. Be;sure to explain how and why the 75 basis point move at the November meeting seems;to have ?done the trick.?;d) (5 points) Finally;I often use the following phrase and sometimes suggest to students to go home;over Thanksgiving and tell their parents that the Fed lowers interest rates by raising them! Is there any merit to the phrase given this;episode of 1994? Why or why not?;EPISODE #2 ? THE;RUSSIAN FINANCIAL CRISIS OF 1998. For;this episode, we are going to focus on the risk structure of interest rates and;the signal it sends as to the state of affairs in the credit markets. We are again going to download and graph some;data. In this exercise, we are using daily;data. We can do this with two series;the rate on 3 month AA financial commercial paper and our friend, the 3 ?month;T-bill (daily). Note how we match maturities, critical when evaluating the risk;structure of interest rates. Click Here for;the commercial paper data and Here for;the T-Bill data. Parse your data so that;it begins in Jan 1998 and continues through to the present (we use the later;data for Episode #4) Make a third column and call it the spread (icp;? iT-Bill). The spread is the;signal!! The beginning of your worksheet should look like the one below;3month commercial;paper;3M T-Bill;spread;1998-01-01;#N/A;#N/A;#N/A;1998-01-02;5.57;5.32;0.25;1998-01-05;5.53;5.23;0.3;1998-01-06;5.51;5.22;0.29;1998-01-07;5.48;5.23;0.25;1998-01-08;5.48;5.13;0.35;1998-01-09;5.42;5.05;0.37;1998-01-12;5.39;5.12;0.27;1998-01-13;5.37;5.17;0.2;1998-01-14;5.41;5.18;0.23;1998-01-15;5.41;5.13;0.28;a) (5 points) Note the;relatively low spread during the beginning of 1998. What does a low spread indicate with regard;to these credit markets? In your answer;mention what it means if the spread was;zero!;b) (10 points for;explanation) The Russian default occurred on August 17, 1998 Please graph (10 points for correct;graph) the paper ? bill spread from;August 17, 1998 until November 30, 1998 (line graph using excel) and comment on;the movement of the spread during this time period. Be sure to explain why the spread changed;during this period and what signal it sent to policy makers. Was the movement;in the spread due primarily to changes in the paper rate or changes in the rate;on T-Bills or a little of both? Why would we expect the T-bill to move as it;did during this crisis?;c) (10 points) On what;day, during the fall of 1998 did the spread hit its highest point at what did;the Fed do about it. Click Here;for some help. In your answer, provide;all the policy changes(as defined;by changing the target for the federal funds rate) and the associated dates;conducted by the FOMC during the fall of 1998.;EPISODE #3 ? THE;CONUNDRUM!!! During the ?Job-loss? recovery following the 2001 recession;Greenspan arguably kept interest rates ?too low for too long.? In this episode, we turn our attention to the;tightening cycle that began June 30, 2004.;Beginning with this FOMC meeting, the Fed raised the target for the;federal funds rate by 25 basis points 17 FOMC meetings in a row.;a) (10 points) ?;according to the pure expectations theory of the term structure (PET), comment;on the implied movement of long term interest rates such as the 10 year;Treasury. Please explain using the equation that determines the yield on 10;year Treasury according to PET.;b) (5 points) We now;consider the facts and the so-called conundrum.;Using the worksheet that you created for Episode #1 (monthly), consider the;level of the T-Bill and compare it to the rate on the 10 year in May 2004, a;month before the tightening cycle began.;Is the slope of the yield curve during this time consistent with PET and;the term structure facts? Why or why not?;c) (10 points) Now consider the sample period from May 2004;through December 2006. Comment on the;movement of the T-Bill and compare to the movement on the 10 year. Are these movements consistent with PET? Why;or why not?;d) (10 points) Using;the liquidity premium theory of the term structure (write it out), give an;alternative explanation of the facts ? that is, explain why short rates kept;going up but the 10 year didn?t budge! Click Here;for a big hint.;EPISODE #4: THE;BEGINNING OF THE GREAT RECESSION AND THE COLLAPSE OF LEHMAN BROTHERS. In this problem, we are going to let the data;on the risk structure of interest rates, the;daily data, identify the beginning of the Great Recession as well as;identify the collapse of Lehman Brothers.;a) (10 points for;graph and 10 points for explanation) Provide a graph of the paper ? bill spread;during the entire month of August 2007.;Identify the date that this spread peaked and was the Fed and the FOMC;doing anything about it ? if so, what?;Go Here;for some help! Be sure to include all the Fed?s activity during August of 2007.;b) (10 points for;graph and 5 points for explanation) We now consider the Lehman collapse ? this;occurred as you may know during September 2008. Provide a graph of the paper ?;bill spread during the entire month of September 2008 (again, use excel). Identify the date that this spread peaked and;is this the date that Lehman went down? What else was happening during this;week? Click Here for some;help.; We could use some more rates in between the three month T-bill and;the 10 year T-note to get a more accurate yield curve but these two rates will;do the job.
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