MFIN6690 Unemployment, Inflation
Unemployment, Inflation
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MFIN6690
1. Unemployment, Inflation, and the Bank of Canada
The Bank of Canada is expected announce its next monetary policy report on July 14,
2021. In the last meeting, the Bank decided to keep the key target interest rate on hold at
0.25%. The rate has been on hold at its rock-bottom level since the onset of the pandemic
last year and the central bank has said it won’t increase the rate until the economy has
recovered. Recent data indicates that inflation has been picking up more than 3.4% while
the unemployment rate remaining at an elevated level. If you are one of the Board of
Governors of the Bank of Canada, what would be three KEY OBJECTIVES you would
suggest the Bank of Canada to pursue while conducting monetary policy? Given the recent
inflation and unemployment numbers, what would be your advice to the Bank on July 14,
2021, i.e., keep the rate on hold at 0.25%, or increase the rate to more than 0.25%, or lower
the rate below 0.25%? How does the Bank of Canada make sure that the interest rate
remains at the target level? Please explain your answer GRAPHICALLY and as succinctly
as you can. (5 Marks)
2. Gold vs Bitcoin vs USD vs VIX
The following figure shows the value of $100 investment in January 1, 2015 in Gold, Bitcoin,
U.S. dollar, and VIX over 6 years (2015–2020). Despite the heterogeneity in return of these
assets, Central Banks of the world seem to favor Gold over other assets and are building
their gold reserve at a pace that we have not seen since Richard Nixon’s, former U.S.
president, abandonment of the gold standard for the U.S. dollar. Moreover, more and
more investors and financial institutions are accepting Bitcoin as a legitimate financial
asset and a store of value. Furthermore, volatility in the financial market seems to gone
up compared to historical levels.
12
It is not obvious since all these variables are standardized with mean 0 and variance 1.
However, looking at the range (Max-Min), VIX appears to be most volatile, and Gold
appears to be least volatile.
Q(e): 5 Marks
Value of your investment from 2015- Mid-2021:
It is clear from the figure that investing in Bitcoin will give you the highest possible payoff
from the investment. However, students may argue that investing in Bitcoin comes with
greater risk and, therefore, may have to be done with caution.
In light of these obs rvations bout Gold, Bitcoin, and VIX, what do think the future holds
for U.S. dollars? Do you think U.S. dollar will still be the dominant currency of reserve
and preferred hedge for uncertainty and inflation in the near future?
answer as succinctly as you can. (5 Marks)
3. Cash vs Cashless Economy
The following figure (from the International Monetary Fund (IMF)) shows that countries
like Japan like to have cash as the preferred medium of transaction while countries like
Sweden and Norway are planning to go cashless.
Give three reasons why Japan prefers to have more cash than Sweden. Is cashless economy
necessarily good or bad? (5 Marks)
4. A Simple Forecasting Model
Consider the following model of revenue:
REVi t = S0 × Kαi t−1 × Lβi t−1 × A1−α−βi t−1
Where REVi t is the revenue (in millions of dollars) of firm i in period t, Ki t−1 is the capita
expenditure of the firm in period t−1, Li t−1 is the labour input of the firm in period t−1,and Ai t−1 is the advertising expenditure of the firm in period t − 1. We know that the
most popular empirical model in Finance is Ordinary Least Square (OLS) which is also
known as the Best Linear Unbiased Estimator (BLUE). Suggest how can yo estimate the
revenue model using OLS? How would you interpret the α and β coefficients from the OLS
model? You observe the following data regarding the key parameters and inputs of the
model based on historical data:
Parameter Min Max Average
S0 120 200 170
K 150 250 200
L 165 215 185
A 160 190 175
α 0.25 0.75 0.50
β 0.25 0.75 0.50
Based on the observed data in the table above, what would be your forecast of revenue for
your firm in the next period? Be as precise as you can. (5 Marks)
5. Testing the CAPM model
The following is the well-known Capital Asset Pricing Model (CAPM):
Ri = R f + β .(Rm − R f )
where Ri is the return on individual asset i, R f is the risk free rate of return, Rm is the
return on the market portfolio, and (Rm−R f ) is the market excess return over the risk-free
asset. Suppose you want to test the CAPM model using the IBM stock return. You ob-
serve the following in the capital market: (i) over the last 15 years IBM stock generated,
on average, 6.5% excess return over the risk-free asset (RIBM − R f ); (ii) over the same last
15 years, the average market excess return over the risk-free asset (Rm−R f ) has been 4.5%;
(iii) the variance of (Rm−R f ) is 15%; (iv) the covariance between (RIBM −R f ) and (Rm−R f )
is 21.6%. Based on this information, how can test and conclude whether CAPM is indeed
a good asset pricing model? (5 Marks)
6. Developing the COVID-19 Vaccine
The pharmaceutical industry deals with a very high degree of uncertainty. Over 90% of all
products under development fail to come to the market resulting in large loses. Products
that do come to the market can earn multi-billion dollar profits annually for 10-15 years
until the patent for the drug expires. In this exercise, you will analyze the COVID-19
vaccine development decision by Pfizer Inc. The new vaccine being developed is called
COVAX and before going to the market COVAX must go through the following stages of
development:
1. Initial Research & Development (R&D) Phase
2. Phase I – Pre-Clinical Testing
3. Phase II – Clinical Trial
4. Phase III – Clinical Trial
Only after all development stages succeed can the COVAX be sold to the general pop-
ulation. If the COVAX fails at any stage, then the development process is terminated
all together. A success at any stage leads to the next stage. You have to determine the
risk-adjusted Net Present Value (NPV) from this COVID-19 vaccine development project
and investigate the key drivers of the new vaccine’s profitability. You have to use the
Triangular random variable from @RISK/Excel to model the following uncertain inputs
at each stages of the development process: Cost, Probability of Success, and the Time
Required to Complete the Stage. You will also model the PROFIT earned from the sale
of COVAX as a Triangular random variable. The discount rate for this project is 15%.
The input values are given below (note that the cost and profits are all-in cost/profit in
millions of dollars):
R&D Stage Phase I Phase II Phase III
Cost:
Best 50.000 10.00 350.00 3500.00
Worst 120.00 30.00 600.00 6000.00
Most Likely 70.000 15.00 480.00 4200.00
Time:
Best 3.00 0.50 3.00 3.00
Worst 7.00 3.00 6.00 6.00
Most Likely 4.00 1.00 4.00 4.00
Probability of Success:
Best 0.42 0.60 0.60 0.96
Worst 0.20 0.30 0.40 0.70
Most Likely 0.35 0.50 0.50 0.90
Likely Profits Once Developed
Best 60000
Worst 14000
Most Likely 18000
For example, in “Phase I: Pre-Clinical Testing” will cost $10 million in the best case, $30
million in the worst case, and $15 million in the most likely case. In the best case, the
Pre-Clinical stage will last for 0.50 years; in the worst case, the Pre-Clinical stage will
last for 3.0 years; and in the most-likely case, the Pre-Clinical stage will last for 1.0 years.
Finally, in the best case, the Pre-Clinical stage will have a success probability of 60%; in
the worst case, the Pre-Clinical stage will have a success probability of 30%; and in the
most-likely case, the Pre-Clinical stage will have a success probability of 50%. We are
assuming here that these random variables are independent of one another.
Based on these uncertain inputs, develop an NPV model for this COVID-19 vaccine de-
velopment project. Report the mean, median, 5th, 25th, 50th, 75th, and 95th percentiles
of your NPV. Report the NPV empirical distribution and the Value-at-Risk charts after
5000 simulation. Which stage of the development process is the most critical input of
your NPV model? Report the Tornedo graph of your sensitivity analysis. Please submit a
PDF hard-copy of your excel model and you may wish to submit your excel model as an
appendix. (15 Marks)
7. Mergers and Acquisition Valuation
Suppose you company is considering purchasing a firm called “Cleanco”. The management
of Cleanco is asking for $20 million for the acquisition. You expect the cash-flow from
Cleanco to be highly uncertain. In particular, cash-flow depends on many uncertain pa-
rameters such as Sales growth, Gross margin, SGA expenses, Variations in working capital,
Litigation liability, and Terminal value of Cleanco. The current data provided to you by
the Cleanco management is as follows:
• Annual sales revenue: $40 million.
• Annual cost of good sold: $28 million.
• SG&A annual costs: $10 million.
• Working capital: $4 million.
• Tax rate: 34%.
You have decided that the appropriate discount rate the acquisition is 12%. You are going
to project cash flows out seven years and then use future growth rate from that point to
assess a terminal value. Below is your assessment of uncertainty involving the factors that
will eventually impact your cash-flow from this acquisition:
1. Sales Growth:
• During Years 1-2 there is a 70% chance that growth will be between 3% and
6%, and a 30% chance that growth will be between 0% and 3%.
• During Year 3 there is a 40% chance that growth will be between 3% and 6%,
and a 60% chance that growth will be between -3% and 3%.
• During Years 4-7 there is a 10% chance that growth will be between 6% and
12%. There is a 40% chance that growth will be between 3% and 6%. There is
a 50% chance that growth will be between -3% and 3%.
2. Gross Margin:
• If sales decline, there is a 60% chance sales margin will be between 29% and
32%; there is a 30% chance that sales margin will be between 32% and 34%;
there is a 10% chance that sales margin will be between 34% and 36%.
• If sales growth is positive, there is a 15% chance sales margin will be between
29% and 32%; there is a 50% chance that sales margin will be between 32% and
34%; there is a 35% chance that sales margin will be between 34% and 36%.
3. SG&A Expenses:
• There is a 30% chance that the change in SG&A expenses will range from -2%
to 1%.
• There is a 50% chance that the change in SG&A expenses will range from 1%
to 4%.
• There is a 20% chance that the change in SG&A expenses will range from 4%
to 7%.
4. Working Capital:
• If sales growth is positive the changes in working capital will equal 15% of sales
growth.
• If sales growth is negative there is a 40% chance that the change in working
capital will equal 15% of sales growth and a 60% chance that the change in
working capital will be between 10%-15% of the sales growth.
5. Litigation Liability:
• During Year 2 there is a 5% chance of a liability cost that will range between 2
and 3 million dollars.