WSJ Example

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AN EXAMPLE OF USING WSJ ARTICLES IN THE EXAMS Fall 2023

• This exam has 15 questions. Abstract • All the questions are inspired by the WSJ articles. The full articles are provided at the end of this document. • Except for question 11, which has 2 points, all other questions have 7 points each. • To get the full mark, for ALL the questions, you have to show your full work , which means you should clearly: 1. mention the theory you are using, (1 point) 2. explain the theory, (2 point) 3. draw the diagrams and equations when applicable, (2 point) 4. and conduct your final analysis. (2 point) • The best way to manage your time would be 1. to read the questions for each article first, 2. then skim the articles and look for the information that is directly asked in the questions, 3. highlight that information, 4. and then mix that information with the theories learned in the class 5. and write down your work fully, ensuring all the criteria mentioned above are met to get the full mark.

1 WSJ I- Yield Curve Inversion Reaches New Extremes By Sam Goldfarb — November 29, 2022 Summary: Yields on longer-term U.S. Treasuries have fallen further below those on short-term bonds than at any time in decades, a sign that investors think the Federal Reserve is close to winning its inflation battle regardless of the cost to economic activity. 1. What is an inverted yield curve? (7 Points) Grading tips: answers should include the definition of yield curve, (i.e,the liquidity premium theory of term structcure) (4point),and drawing the diagram (3 points) 2. What does an inverted yield curve ”say” about the market’s expectations for short-term interest rates in the future and why? (7 Points) Grading tips: students should extensively interprete the inversion pointing to the business cycle prediction, expectations about the Fed’s policies in the future, why short term interest rates are typically lower than long term rates and why in the inversion, short term interest rates are higher than long term (7 points). 3. Does the current shape of the yield curve indicate an impending recession or that the Fed is winning the war against inflation and the economic outlook is stabilizing? (7 Points) In this case, students should directly refer to the article. If they have not done so, we will lose at least 4 points. 4. What are the arguments supporting or rebutting these positions? (7 Points) Grading Tips: In this case, similar to the previous case, students should directly refer to the article. If they have not done so, we will lose at least 4 points. Also, students should write argumenets in favor (4 points) and against this prediction (3 points). WSJ II- Tech Selloff Catches Up With Private Startups By Julie Steinberg Ben Dummett — November 29, 2022 Summary: Tech startups are plunging in value in private trades, mirror- ing the big markdowns of their publicly listed brethren over the past year. Before companies go public, their shares are often traded by employees, founders, and institutions in secondary deals. The trades allow existing holders to cash out before a startup goes public, and buyers to make new investments or add to existing holdings.

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2 5. Using the Supply-Demamd framework, explain how can secondary trading of private company shares be used to measure investors appetite for these startups? (7 Points) Grading Tips: Students should explain porfolio choice theory (2 points), draw the diagram (2 points) and fully analyze the situation in this case (3 points). Specifically, they should “clearly” connect secondary market arguement with liquidity and explain the shift in the diagram when the liquidity situation changes. 6. Use the Treynor Model and show the impact of investors’ appetite for startups on the private dealing system. Show your work fully. (7 Points) Grading Tips:Students should explain the Treynor model, especially they should talk about inventories, dealer spread, finance need or finance limits, and the pricing dynam (i.,e dealers lower the price as their inventories deplete and vice versa)(2 points), draw the diagram (1 points) and conduct an analysis based on the model (4 points). There are different ways of responding to this, but the most robust and straightforward is that private investors are selling their shares in these startups. Therefore, there are more sellers than buyers, which means the dealers absorb these imbalances. In the Treynor model, the private dealing system is adding these imbalances to its inventories and needs to finance them. In response, they are reducing their prices to discourage poten- tial sellers from selling additional shares to them and encourage potential buyers to buy these assets off their balance sheets. 7. Let’s assume you are working for a dealer in this market. Based on the existing dealer’s position in this market, what would be the most signifi- cant risk that your company is facing? What is your hedging strategy for your company? (7 Points) Grading Tips: Students should briefly describe the problem again (no worries if they have not, as they have already written about it in the pre- vious questions. Absorbing inventories mean dealers are exposed to price risk, and funding/liquidity risk, and the risks of trading with value- based dealer: Price risk means that the value of these assets changes. As these inventories, in most cases, are used as collateral, lower collateral value reduces their ability to secure funding. Students then have to elaborate on these points. (2 points) Funding risk means that the dealers might need help to raise short-term, cheap funding to purchase these unwanted assets. This is called liquidity risk (2 points) If these risks materialize, the risk of reaching the finance limit, in this case, the max long position, will materialize. This is a risk that the dealer will trade with the value-based dealer and have to face negative spread (3 points) 8. What types of companies are seeing the largest discounts on secondary exchanges and why? (7 Points)

3 The answer to this question is clearly mentioned in the article. Please read the article. Per Grading distribution, what type.. part has (3 points) and why part has (4 points). 9. What are the arguments referenced in the article in support of and against the current levels of discounts being an attractive buying opportunity? (7 Points) The answer to this question is clearly mentioned in the article. Please read the article. Per Grading distribution, mentioning supporting arguements has (3 points) and against arguements has (4 points). 10. How has the Fed’s interest rate increase impacted the relative performance of these shares and why? (7 Points) Grading Tips: This is a standard textbook question where students should use their knowledge of stock pricing. To answer the questions, students should name and write the Dividiend-Discount equation, also referred to as the Gordon-Growth Model ( 1 point). Next, they should use the model to show that when Fed increases the rates, the risk-free rate increases; hence, the required return on equity will also increase. In this case, the stock prices fall (2 points). However, at the same time, when Fed increases the rates, the bond prices will fall as the existing fixed-income assets were issued when rates were low, and investors should accept lower prices if they want to sell their bond holdings (2 points). In this environment, the stocks become more attractive in terms of relative expected return, and investors increase their demand for stocks. This means that according to this channel, share prices should increase. In theory, after the Fed increases the rate, this impact dominates the former, and stocks gain value. (2 points) WSJ III- Rocky Treasury-Market Trading Rattles Wall Street By Matt Grossman Sam Goldfarb — October 30, 2022 Summary: Rising friction in the trading of U.S. government debt has investors worried about the health of a $ 24 trillion market that is critical to the functioning of the broader financial system. 11. What is Treasury Buyback? (2 Points) Treasury buyback is a new proposal by US Treasury that involves swap- ping long-term bonds with short-term bills. The idea is that long- term US Treasuries are losing their attractiveness for investors as they yield very low rates during the high-interest rate period. Therefore, they are becoming illiquid and causing issues. US Treasury is fighting this liquidity problem by buying long-term US T-Bonds and paying for these purchases by issuing higher-yielding short-term US Treasury bills.

4 12. Explain why are traders and portfolio managers concerned about liquidity in theTreasurys market? (7 Points) Please read the articles for the details. Students should provide at least one reason, with a detailed explanation, directly from the article. (3 points). They should then use portfolio choice theory and explain that lower liq- uidity will mean demand for T-Bonds will fall compared to other assets, and the demand curve will shift to the left, which causes the prices to fall even further. Application of portfolio choice theory has (3 points) and the supply-demand diagram for T-Bond worth (1 point). 13. How does trading in Treasury securities compare to trading in stocks and corporate bonds? (7 Points) The answer to this question is clearly mentioned in the article. Please read the article. Students should clearly mention at least one of the views expressed in the articles. Per Grading distribution, comparing with stock has (3 points) and comparing with corporate bond has (4 points). 14. What are the perceived causes of the reduced liquidity in the Treasurys market? (7 Points) The answer to this question is clearly mentioned in the article. Please read the article. Students should clearly mention at least two of the views expressed in the articles. Each view has (3.5 points). 15. How do market participants measure liquidity in the Treasury markets? (7 Points) The answer to this question is clearly mentioned in the article. Please read the article. The liquidity is measured by the dealers’ spread (i.e., how cheap the transactions are), the speed of execution, and whether they can sell large positions without changing the prices. Students should clearly mention at least two views expressed in the articles. Each view has (3.5 points). Full Articles WSJ I- Yield Curve Inversion Reaches New Extremes Yields on longer-term U.S. Treasurys have fallen further below those on short-term bonds than at any time in decades, a sign that investors think the Federal Reserve is close to winning its inflation battle regardless of the cost to economic activity. A scenario in which short-term yields exceed long-term yields is known on Wall Street as an inverted yield curve and is often seen as a red flag that a recession is looming. Yields on Treasurys largely reflect investors’ expectations for what short-term interest rates set by the Fed will average over the life of a bond. Longer-term yields are generally higher than shorter-term yields be- cause investors want to guard against the risk of unexpected inflation and rate increases.

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5 At a basic level, an inverted curve means that investors are confident that short-term rates will be lower in the longer-term than they will be in the near- term. Typically that is because they think the Fed will need to slash borrowing costs to revive a faltering economy. The yield curve is more than just a little bent out of shape at the moment. Last week, the yield on the 10-year U.S. Treasury note dropped to 0.78 percentage point below that of the two-year yield, the largest negative gap since late 1981, at the start of a recession that pushed the unemployment rate even higher than it would later reach in the 2008 financial crisis. Still, many investors and analysts see reasons to think that the current yield curve may presage waning inflation and a return to a more normal economy, rather than an approaching economic disaster. The current yield curve is “the market saying: I think inflation is going to come down,” said Gene Tannuzzo, global head of fixed income at the asset management firm Columbia Thread- needle. Investors, he added, believe “the Fed does have credibility. Ultimately the Fed will win this inflation fight and in the meantime, we have to bear higher short-term interest rates.” Notably, the yield curve has become more deeply inverted in recent weeks due largely to good economic news. For months starting in the summer, the 10-year yield had repeatedly failed to drop much further than 0.5 percentage point below the two-year yield. That only changed earlier this month, when the Labor Department released better-than-expected consumer-price index data, raising hopes that inflation might finally be easing. The October CPI report did cause short-term yields to fall a little, with the two-year yield slipping to around 4.47% as of Tuesday from 4.63% earlier in the month. Investors, though, haven’t adjusted their near-term rate expectations nearly as much as their longer-term bets, with the 10-year yield sliding to 3.75% from 4.15%. Taking cues from Fed officials, investors still expect the central bank to raise the fed-funds rate to about 5% by early next year—up from its current level between 3.75% and 4%. However, the encouraging CPI report has led many to believe the Fed will start cutting rates later in 2023—a bet that officials will be able to shift to promoting economic growth without worrying too much about prolonging the inflation problem. Treasury yields shape the economic outlook as much as they reflect it. Longer-term yields, in particular, play a key role in determining borrowing costs across the economy. They also heavily influence stock prices, with rising yields often causing stocks to fall as investors demand more attractive prices to reflect the better returns they can now get by simply holding ultrasafe government debt to maturity. Stubbornly high inflation and rapidly rising expectations for short-term interest rates have already led to huge increases in Treasury yields this year, with the prices of existing bonds dropping to reflect higher rates of- fered on new bonds. That in turn has led to the worst returns for major bond indexes in records going back to the 1970s. The S&P 500 has also lost 17% this year. But, as longer-term yields have fallen, it too has stabilized in recent weeks, gaining 6One threat for investors: the recent decline in yields and gains in stocks might not last precisely because they

6 have made it a little easier for businesses to raise and spend money— undermining the conditions that led to the possible moderation of inflation in the first place. On more than one occasion this year, Fed Chairman Jerome Powell has snuffed out rallies in stocks and bonds by delivering the message that the central bank is likely to not just raise rates higher but keep them at elevated levels for longer. In a press conference following the Fed’s Nov. 1-2 meeting, Mr. Powell emphasized that inflation remained a major threat and that, even though the Fed may raise rates in smaller increments going forward, it was still likely to lift them higher than officials had signaled in their last official forecast in September. That November meeting, though, took place before the latest inflation data, and investors are now eagerly looking forward to what Mr. Powell has to say when he speaks at an event hosted by the Brookings Institution think tank on Wednesday. Bonds “have rallied significantly since the last meeting,” so there is a risk that Mr. Powell could use Wednesday’s event as “an opportunity to push back,” said Jan Nevruzi, U.S. rates strategist at NatWest Markets. WSJ II- Tech Selloff Catches Up With Private Startups Tech startups are plunging in value in private trades, mirroring the big mark- downs of their publicly listed brethren over the past year. Before companies go public, their shares are often traded by employees, founders and institutions in secondary deals. The trades allow existing holders to cash out before a startup goes public, and buyers to make new investments or add to existing holdings. Private valuations are typically slower to adjust than public ones. That is because startup holdings trade less frequently, and owners are reluctant to accept lower prices that might mean selling at a loss or writing down the value of their remaining holdings. Many startups held on to lofty valuations for months after the technology- heavy Nasdaq Composite began to sell off in November 2021. However, the market’s resilience started to wane this summer, as venture-capital firms and hedge funds began to unload to make up for losses in their public holdings. People involved in the trades say they are seeing discounts from around 30% to 40% to as much as 80% off valuations from earlier fundraisings. With many companies putting plans to raise new funds or go public on hold due to weak markets, secondary deals have become a key gauge of investor appetite. Secon- daries trading was almost nonexistent from March to July, market participants say. Now, some prospective buyers are tiptoeing back into the market, look- ing for bargains as they bet the selloff has bottomed. Meantime, regular stock markets have staged a modest comeback, with the Nasdaq Composite ending Monday more than 7% above its mid-October closing low. “We are seeing more buying come back to the market,” said Idan Miller, head of Unicorns Exchange. The Israeli-based marketplace lets investors trade in closely held tech startups such as Klarna Bank AB, Stripe Inc. and Chinese social-media giant ByteDance Ltd. Citing the discounts in July, Mr. Miller said a record volume of shares, topping $ 150 million in total value, traded on his platform in the third quarter.

7 He said that eclipsed the previous record set in the fourth quarter of 2021. Wealth-management software provider Addepar Inc. is one of the companies that has repriced. One buyer accumulated stock in seven separate trades in September and October at prices that valued the Silicon Valley-based company at valuations of $ 1.7 billion and $ 1.8 billion. That is down from trades in December at a $ 2.5 billion valuation, Mr. Miller said. Unicorns Exchange isn’t the only venue where shares are being offered at re- duced valuations. Mirai Capital, another secondary network, has several sellers looking to unload stakes at discounted prices to previous rounds, trading in- formation viewed by The Wall Street Journal showed. The markdowns can be striking. Shares in ByteDance, the company behind TikTok, traded privately at a $ 450 billion valuation last year, Mr. Miller at Unicorns Exchange said. Recent offers imply a valuation of $ 220 billion to $ 260 billion, he added. The comedown was to be expected after years of fundraising at overheated levels, said Itamar Har. Even, co-founder of Ion Pacific, a New York and Hong Kong-based firm that invests in secondaries. Mr. Har-Even said firms with especially inflated valuations above a billion dollars “are the ones that are really getting hit in the secondary market.” Firms that prioritized growth at all costs, or didn’t achieve a unique edge or enormous scale, are being punished, said Adrian Valenzuela, chief executive of MCM Partners. Hong Kong-based MCM facilitates private trades in tech stocks. U.S., Chinese and Indian consumer-internet companies are being aggressively remarked, Mr. Valenzuela added. “Too much got priced around the benefit of the pandemic,” he said. Some similar pullbacks are evident in disclosures by large asset managers. Between September 2021 and June this year, a T. Rowe Price Group Inc. fund slashed the valuation of its Stripe shares by more than half. A Fidelity Investments fund valued its shares in Instacart Inc. this July at 55% less than it did in October 2021. Stripe and Instacart themselves earlier this year cut an internal valuation often used to price stock options for employees, The Wall Street Journal reported. Some investors are betting that recent markdowns were too steep. For in- stance, the buy-now, pay-later company Klarna tapped investors in July for new funds at a $ 6.7 billion valuation, far less than it was worth last year. By September and October, secondary trades were valuing it at as much as $ 9 billion, a 34% uplift. Others think there is further to fall. Christian Vogel- Claussen, who runs London-based Alanda Capital Management Ltd., says he has seen discounts of 40% to 70%. He hasn’t bought any stock in secondary deals yet, though, saying he prefers to wait for prices to drop another 10% to 15%. He expects to pull the trigger in the first half of next year. Eliot Brown contributed to this article. WSJ III- Rocky Treasury-Market Trading Rattles Wall Street Rising friction in the trading of U.S. government debt has investors worried about the health of a $ 24 trillion market that is critical to the functioning of the broader financial system.

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8 The ranks of traders ready to buy and sell Treasurys are shrinking. Individ- ual trades are moving prices more. Treasury securities with similar characteris- tics are trading at larger-than-normal price differences. Major players, including the big banks and asset managers that have long been significant buyers, are in retreat. Investors expect to be able to buy and sell Treasurys quickly at the listed price, no matter what else is happening. Difficulty doing so reflects a lack of what traders call liquidity, and it can scramble the most basic signals that help the economy run: How much home buyers should expect to pay for a loan, what kinds of investments businesses should make, and what kinds of stocks likely will perform the best in a given period. Climbing Treasury yields have recently sent mortgage rates above 7% for the first time in two decades, slashed stock valuations and slowed corporate borrow- ing. While there hasn’t been a serious breakdown in Treasury trading so far, the possibility is far from unthinkable given the tumult this year. Many traders and portfolio managers warn that such a development would tear through other markets, potentially requiring intervention from the Federal Reserve to prevent a full-blown financial crisis. Andrew Kreicher, a director at Wells Fargo, said liquidity in Treasurys has been about the worst he has seen over a sustained period recently. “There are so many systems in other asset classes that use Treasurys as a building block,” he said. “If you have rot in the foundation, the whole house is at risk.” Investors rely on easy Treasury sales to obtain quick cash for debt payments, margin calls and a variety of other pressing short-term needs. When that pro- cess hits hiccups, financial trouble can spiral, said Jim Caron, a fixed-income portfolio manager at Morgan Stanley Investment Management. “If the Treasury market isn’t working, nothing is working,” he said. While many agree trading Treasurys remains smoother than during the worst moments of 2020’s pandemic-fueled market breakdown, the current unease has built gradually over months without a single precipitating event, said Deirdre Dunn, co-head of global rates at Citi. Some traders believe the Fed’s rapid interest-rate increases are the main cause. Treasurys—especially shorter-term notes—closely reflect expectations for the Fed’s overnight rates, so quick changes can cause choppy moves. This week, the Fed is expected to raise rates by 0.75 percentage point for the fourth straight meeting. Other traders lay some blame on rules enacted after the global financial crisis that make it more expensive for banks to keep Treasurys on their balance sheet. Big banks function as Treasury-market dealers, helping match buyers and sellers. When they step back, trading stalls, said Ariel da Silva, director of fixed income at Wealth Enhancement Group, a wealth-management firm. Given the current regulatory regime, “It doesn’t behoove them to take on the inventory,” he said. Measuring the ease of trading isn’t straightforward. Some approaches gauge the differences between the prices buyers and sellers are demanding. Others look at how much deal flow the market can absorb at the current price, or, similarly, how much a single large trade swings prices for everyone else. “We’re seeing plenty of concerns about liquidity, but it’s coming at the same

9 time that we’re seeing real concerns about volatility, and it’s very difficult to untangle those things,” said Steven Abrahams, a senior managing director at Amherst Pierpont Securities. During the Fed’s smaller, more predictable rate increases between 2004 and 2006, trading stayed more fluid, he said. One problem is a growing difference between yields on the newest Treasurys in the market and older vintages that are still traded among investors. The- oretically, a five-year note sold this year should trade at the same yield as a five-year-old 10-year note, because both come due in 2027. But fresh Treasurys are trading at a growing premium to older notes, a sign the older securities have become harder to find buyers for. To address that issue, Treasury Department officials have considered buying back outstanding bonds, funding the purchases with auctions of more fresh debt. Earlier in October, the Treasury surveyed dealers for feedback on the plan, a version of which the government enacted to sustain the market during the budget surpluses of the early 2000s. Treasury Secretary Janet Yellen said the department is still studying it. For now, doing business in Treasury markets takes more finesse than a year ago, traders say. Some report working harder than usual to shield their inten- tions from the broader market, lest their bids or offers send jumpy prices moving against them. Trading conditions aren’t nearly as difficult as they were in March 2020, when dealers demanded extraordinarily large discounts to buy Treasurys from investors, said Michael Lorizio, a senior fixed-income trader at Manulife Invest- ment Management. But he has sometimes found it necessary to make larger trades “in a more quiet way” than in the past, communicating his intentions to dealers carefully rather than “just blast it out there without any sort of qualifications.” Upheaval in U.K. bond trading this autumn showed one scenario investors hope the U.S. can avoid. In September, a new debt-heavy British budget plan ignited such a sharp bond-price decline that U.K. pension plans had to sell bonds to cover esoteric bets on a strategy called liability-driven investment. Yields soared, forcing the Bank of England to step in as a buyer even though it had been reducing its bondholdings before the furor began. In the U.S., the Fed’s own effort to trim its holdings of Treasurys—part of the central bank’s anti-inflation efforts—is yet another factor some traders blame for falling liquidity. The program, known as quantitative tightening, amounts to “a mechanical withdrawal of liquidity” that reduces banks’ ability to absorb government debt, said Alex Lennard, investment director at Ruffer, a British investment fund. Still, the Treasury market continues to process massive trading volumes without disruption. Last month, an average $ 570.5 billion of Treasurys changed hands daily, similar to levels in recent Septembers, according to data from Sifma, a financial-industry trade group. Daily U.S. stock trading last month, by com- parison, was $ 510.5 billion. Trading Treasurys remains far more frictionless than trading corporate bonds or other debt securities. “Internally, when I complain about liquidity, our corporates guys are quick

10 to tell me to stop whining,” said Mr. Lorizio. —Andrew Duehren contributed to this article

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