Reference no: EM13880100

New issues of U.S. Treasury bills are sold at auction. The government decides on the total quantity of bills to be sold and seeks to pay the lowest possible interest rates on these bills. Private parties submit sealed bids specifying the quantity of bills sought and the interest rate they require. A pur- chaser is allowed to submit multiple bids for different quantities at different interest rates. (A purchaser also can place a "noncompetitive" or "market" bid that is filled at the average interest rate as determined by the auction.) After observing all bids, the government determines the cutoff interest rate at which the volume of bids matched the volume of securities to be sold. The govern- ment accepts all bids at interest rates below this cutoff.

a. Until the 1990s, winning bidders received the interest rates they bid.

(i) Consider a bidder just willing to accept a 4.2 percent return (her reservation price). Will she bid 4.2 percent? Or a higher (or lower) interest rate?

(ii) Explain why the ability to submit multiple bids is valuable to buyers.

(iii) Are small investors (with little expertise in discerning likely interest rates) at a bidding disadvantage relative to sophisticated financial experts?

b. Current auction rules call for all winning bidders to receive the same interest rate-a rate equal to the highest accepted interest rate bid. If the cutoff interest rate turned out to be 4.5 percent, a buyer submitting 4.2 percent would receive the more favorable 4.5 percent interest rate (as would all the other winning bidders). In this respect, the uniform-price auction is analogous to a second-price auction.

(i) How does the uniform price rule affect bidding behavior? If a bidder requires a 4.2 percent interest rate, what interest rate will she bid?

(ii) Why might there be greater bidder participation under the uniform price rule? How might the uniform price rule affect the average interest rate the government pays (relative to the pre-1990s price rule)?