Financial Management

1. Let us evaluate the accuracy of the Liquidity Premium Theory to forecast bond yields for short term Treasuries. Guidelines for your analysis:

• The 1yr Treasury is the shortest duration instrument available.

• Gather data from FRED: DGS1, DGS2; monthly data; average of daily levels; maximum history available.

• The liquidity premium on a 2yr Treasury is 0.05 percent. (Specifically, the downloaded Treasury yields will have a number such as 1.0 to represent 1 percent. The liquidity premium should be entered as 0.05). Assume this premium is time invariant.

(a) Create a chart for the available time series that overlays the actual 1yr yield each month with the 1yr yield implied by the Liquidity Premium Theory.

(b) Provide a possible rationale for the forecasts you graphed in part a. (Note: you need not describe every movement in the data series. Comments regarding broad trends are sufficient.)

(c) Compute forecast errors associated with this model. Use (Expected - Actual)/Actual as a metric. Create a chart of these errors over time. Comment on when the model worked well, and when it worked poorly. Can you provide a rationale for the performance during the most recent periods?

2. Is the stock price of IBM”efficient”? It is your task to design a study that will address this question. Restrict your analysis in the following ways:

• Gather data for monthly adjusted closing prices and volumes from yahoo finance.

• Use monthly log returns in your analysis.

• Discuss the evidence for or against each of the three levels of efficiency.

3. What impact will the unwinding of QE2 have upon the fixed income market? Your task is to design a study to address this question. Restrict your analysis in the following ways:

• Use the 3yr discount bond as a proxy for the bond market as a whole.

• Use monthly data where needed.

• You may assume that the 3yr constant maturity Treasury yield(data available from FRED), is a proxy for the yield on this asset.

• Assume that QE2 began in November 2010 and ended in June 2011.

• Assume that 25% of the increase in money supply that occurred during QE2 will be extracted from the economy over the remainder of 2011.

• Identify the price of the 3yr discount bond at the end of 2011. Moreover, detail the annualized capital gains/loss on this asset by the end of 2011.

• Assume that the market’s reaction to removal of liquidity will be proportional its reaction of the injection of liquidity.