FIN 408 Fall 202113th Edition
The estimated current purchasing price of a discount bond with a face value of _______ and a yield to maturity of 10% is $1818.18. (Round your response to the nearest two decimal place)
$2000
You would prefer to accept $_______ ________ if the annual interest rate is 11%.
$5000 today
Calculate the expected returns for the following two assets: Asset A pays a return of $3,000 30% of the time and $500 70% of the time. Asset B pays a return of $2,400 60% of the time and $400 40% of the time. - The expected return for Asset A is ______________ - The expected return for Asset B is _______________
- $1250 - $1600
What is the approximate yield to maturity on a discount bond that matures one year from today with a maturity value of $10,400, and the price today is $9283.67?
12.0%
Given the nominal interest rate of 14% and the expected inflation of ______ then the value of the real interest rate is −1%. With the real interest rate equal to 3% and the expected inflation equal to _________, then the value of the nominal interest rate is 6%.
15% and 3%
The demand curve and supply curve for one-year discount bonds with a face value of $1,020 are represented by the following equations: Bd:Price=−0.8Quantity+1,140 Bs:Price= Quantity+680 - The expected equilibrium quantity of bonds is ______ The expected equilibrium price of bonds is ______ The expected interest rate in this market is____________
265 936 8.97
The spread between the interest rate on a one-year U.S. Treasury bond and a 20-year U.S. Treasury bond is known as the term premium. According to the expectations theory of the term structure of interest rates, if the one-year bond rate is 3%, and the two-year bond rate is 4%, next year's one-year rate is expected to be _____
5%
If a one-year discount bond that pays $1,000 at maturity, is held for the entire year, and the purchase price is $945, then the interest rate is _________% A one-year discount bond for which the owner pays $937, holds it for the entire one year, and receives $1,000 at maturity, generates an interest rate of _______%
5.82% 6.7%.
A coupon bond with a face value of $1200 that pays an annual coupon of $400 has a coupon rate equal to 33%. (Round your response to the nearest whole number) What is the approximate (closest whole number) yield to maturity on a coupon bond that matures one year from today, has a par value of $1010, pays an annual coupon of $80, and whose price today is $1014.50?
7%
Will a U.S. Treasury bill have a risk premium that is higher than, lower than, or the same as that of a similar security (in terms of maturity and liquidity) issued by the government of Colombia?
A U.S. Treasury bill will have a lower risk premium since U.S. government issued securities are usually considered to be default free.
Which of the following information would you need to take into consideration when deciding to receive $5,000 today or $5,500 one year from today?
Annual Interest rate and the present value of money.
Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?
As the economy enters an expansion, there is greater likelihood that borrowers will be able to service their debt.
The following two assets and payout data are given below: Asset A: Pays a return of $2,000 20% of the time and $500 80% of the time. Asset B: Pays a return of $1,000 50% of the time and $600 50% of the time. - If both assets can be acquired for the same price, as a risk-averse investor, you would prefer _____________
Asset B
Using the numbers 1, 2, 3, and 4, rank the following four assets from most liquid (1)to least liquid (4). A 10,000-square-foot office building ___ $2,000 in cash ___ A $10,000 Treasury bill ___ 100 shares of Google stock ___
A 10,000-square-foot office building 4 $2,000 in cash 1 A $10,000 Treasury bill 2 100 shares of Google stock 3
A U.S. Treasury bill is an example of a
Discount Loan
Would you be more or less willing to buy gold under the following circumstances: Gold again becomes acceptable as a medium of exchange. ________________ Prices in the gold market become more volatile. ________________ You expect inflation to rise, and gold prices tend to move with the aggregate price level. ________________ You expect interest rates to rise. ________________
Gold again becomes acceptable as a medium of exchange. More willing Prices in the gold market become more volatile. Less willing You expect inflation to rise, and gold prices tend to move with the aggregate price level. More willing You expect interest rates to rise. More willing
The demand curve and supply curve for one-year discount bonds with a face value of $1,000 are represented by the following equations: Bd: Price = −0.8Quantity+1,120 Bs:Price= Quantity+720 Suppose that, as a result of monetary policy actions, the Federal Reserve sells 60 bonds that it holds. Assume that bond demand and money demand are held constant. Which of the following statements is true? - The expected interest rate on a one-year discount bond will __________ to 9.17%.
If the Fed increases the supply of bonds in the market by 60, at any given price, the bond supply equation will become Price=Quantity+660. - increase
If the price of bonds is below the equilibrium price, there occurs an excess
If the price of bonds is below the equilibrium price, there occurs an excess
Prior to 2008, mortgage lenders required a house inspection to assess its value, and often used the same one or two inspection companies in the same geographical market. Following the collapse of the housing market in 2008, mortgage lenders required a house inspection, but this was arranged through a third party. How does this illustrate a conflict of interest similar to the role that credit-rating agencies played in the global financial crisis?
Inspection companies may have provided overly optimistic assessments of home values to ensure continued work in the future.
What will happen to interest rates on a corporation's bonds if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future?
Interest rates on corporate bonds will decrease
How might a sudden increase in people's expectations of future real estate prices affect interest rates?
Interest rates would increase because real estate would have a relatively higher rate of return compared to bonds, which would cause the demand for bonds to decrease.
What effect would reducing income tax rates have on the interest rates of municipal bonds?
Interest rates would rise because the reduction in income tax rates would make the tax-exempt privilege for municipal bonds less valuable and reduce the demand for municipal bonds.
Suppose the interest rates on one-, five-, and ten-year U.S. Treasury bonds are currently 3%, 6%, and 6%, respectively. Investor A chooses to hold only one-year bonds, and Investor B is indifferent with regard to holding five- and ten-year bonds. Which theories best explain the behavior of Investors A and B?
Investor A's preferences are best explained by the segmented markets theory, while Investor B's preferences are more consistent with the expectations theory.
What will happen in the bond market if the government imposes a limit on the amount of daily transactions? Which characteristic of an asset would be affected?
Liquidity of bonds relative to other assets will decrease, increasing the interest rate and lowering bond's prices.
Do you think that it will then make sense for municipal bonds to be exempt from income taxes?
No. If this were to happen, then municipal bonds will be even better than U.S. government bonds.
Suppose that a commercial bank wants to buy Treasury bills. These instruments pay $6,000 in one year and are currently selling for $6,100. The yield to maturity of these bonds is - 1.64%. (Round your response to two decimal places.) Is this a typical situation?
No. In normal times banks will not choose to pay more than the face value of a discount bond, since that implies negative yields to maturity.
Should we always trust credit-rating agencies?
No. Sometimes there are conflicts of interests in credit-rating agencies.
If the interest rate is 10%, what is the present valueLOADING... of a security that pays you $1,100 next year, $1,210 the year after, and $1,345 the year after that?
Present value is $3010.52
Raphael observes that at the current level of interest rates there is an excess supply of bonds, and therefore he anticipates an increase in the price of bonds. Is Raphael correct?
Raphael is incorrect. The supply and demand analysis tells us that interest rates will increase, creating a movement along both the demand curve (in the southeast direction) and the supply curve (in the southwest direction) in order to reach the equilibrium interest rate (and price). The bond's price will therefore fall.
Assume the segmented markets theory of the term structure holds. If bond investors decide that 30-year bonds are no longer as desirable an investment, the yield curve would:
Result in a jump in the 30th year rate and steepen slightly along the smaller rates.
What would happen to the risk premiums of municipal bonds if the federal government guarantees today that it will pay creditors if municipal governments default on their payments.
Risk premium on municipal bonds will decrease.
Suppose you are in charge of the financial department of your company and you have to decide whether to borrow short or long term. Checking the news, you realize that the government is about to engage in a major infrastructure plan in the near future. Predict what will happen to interest rates. - Will you advise borrowing short or long term?
Since the government is a major player in the market for bonds, this will most likely result in a shift to the right in the supply curve, lowering the price of bonds and increasing interest rates. - You would recommend locking in a long-term loan at the current interest rate.
If the next chair of the Federal Reserve Board has a reputation for advocating an even slower rate of money growth than the current chair, what will happen to interest rates?
Slower money growth will lead to a liquidity effect, which will raise interest rates; however, the lower income, price level, and inflation will tend to lower interest rates.
Suppose that your marginal tax rate is 30%. Your after-tax return from holding (to maturity) a one-year corporate bond with a yield to maturity of 5% is 3.5%. (Round your response to the nearest whole number). Suppose your marginal income tax rate is 35%. If a corporate bond pays 15%, then the interest rate that an otherwise identical municipal bond have to pay in order for you to be indifferent between holding the corporate bond and the municipal bond is 9.75%. (Round your response to the nearest whole number). In which of the following situations would you choose to hold the corporate bond over the municipal bond, assuming that corporate and municipal bonds have the same maturity, liquidity, and default risk?
The corporate bond pays 10%, the municipal bond pays 7%, and your marginal income tax rate is 25%.
Suppose that many big corporations decide not to issue bonds, since it is now too costly to comply with new financial market regulations. Can you describe the expected effect on interest rates?
The impact will translate into a shift to the left in the supply curve, increasing bond's prices (lowering interest rates) and lowering the quantity of bonds bought and sold in the market.
During 2008, the difference in yield (the yield spread) between 3-month AA-rated financial commercial paper and 3-month AA-rated nonfinancial commercial paper steadily increased from its usual level of close to zero, spiking to over a full percentage point at its peak in October 2008. Which of the following explains this sudden increase?
The increase in the yield spread was a result of the decrease in demand for financial commercial paper due to the uncertainty and soundness of financial companies and banks.
Segmented markets
The interest rate for each bond with a different maturity is determined by the supply of and demand for that bond, with no effects from expected returns on other bonds with other maturities.
Expectations theory
The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond.
Preferred habitat
The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium (also referred to as a term premium) that responds to supply and demand conditions for that bond.
The U.S. Treasury offers some of its debt as Treasury Inflation Protected Securities, or TIPS, in which the price of bonds is adjusted for inflation over the life of the debt instrument. TIPS bonds are traded on a much smaller scale than nominal U.S. Treasury bonds of equivalent maturity. What can you conclude about the liquidity premium between TIPS and nominal U.S. bonds?
The liquidity premium for a TIPS bond is usually smaller than inflation compensation in nominal U.S. bond yields of equal maturity.
In the fall of 2008, AIG, the largest insurance company in the world at the time, was at risk of defaulting due to the severity of the global financial crisis. As a result, the U.S. government stepped in to support AIG with large capital injections and an ownership stake. How would this affect, if at all, the yield and risk premium on AIG corporate debt?
The yield and risk premium will fall since demand for AIG corporate debt will increase.
Following a policy meeting on March 19, 2009, the Federal Reserve made an announcement that it would purchase up to $300 billion of longer-term Treasury securities over the following six months. What effect might this policy have on the yield curve?
The yield curve would shift down, but mostly on medium- and long-term maturities.
Suppose Maria prefers to buy a bond with a 7% expected return and 2% standard deviation of its expected return, while Jennifer prefers to buy a bond with a 4% expected return and 1% standard deviation of its expected return. Can you tell if Maria is more or less risk-averse than Jennifer?
There is not enough information to tell. In order to decide whether Maria or Jennifer is more risk averse, one will need to compare two bonds with the same expected return and different standard deviations of their expected returns.
Suppose that people in France decide to permanently increase their savings rate. Predict what will happen to the French bond market in the future. Can France expect higher or lower domestic interest rates?
There will be an increase in wealth, creating a shift to the right in the demand curve for bonds in France. France can therefore expect permanent lower interest rates in the future.
M1 money growth in the U.S. was about 16% in 2008, 7% in 2009, and 9% in 2010. Over the same time period, the yield on 3-month Treasury bills fell from almost 3% to close to 0%. Given these high rates of money growth, why did interest rates fall, rather than increase?
The income, price-level, and expected-inflation effects were small relative to the liquidity effect.
To pay for college, you have just taken out a $1,000 government loan that makes you pay $126 per year for 25 years. However, you don't have to start making these payments until you graduate from college two years from now. Why is the yield to maturity necessarily less than 12% (this is the yield to maturity on a normal $1,000 fixed-payment loan in which you pay $126 per year for 25 years)?
This is the case because the first payment due begins at a future date.
The U.S. Treasury issues some bonds as Treasury Inflation Indexed Securities, or TIIS, which are adjusted for inflation, and hence the yields can be roughly interpreted as real interest rates. Go to the St. Louis Federal Reserve FRED database and find yields on the following five TIIS securities in order to compare them to their nominal counterparts (given later in the exercise) for September 24, 2021. TIIS 5 Year TIIS 7 Year TIIS 10 Year TIIS 20 Year TIIS 30 Year TIIS Series ID DFII5 DFII7 DFII10 DFII20 DFII30 Following the Great Recession in 2008-2009, the 5, 7, 10, and even the 20 year TIIS yields became negative for a period of time. How is this possible?
Very high demand for TIIS to protect against inflation increased prices for TIIS to the point where yields on TIIS became negative for a period of time.
Just before the collapse of the subprime mortgage market in 2007, the most important credit-rating agencies rated mortgage-backed securities with Aaa and AAA ratings. Explain how it was possible that a few months into 2008, the same securities had the lowest possible ratings.
When housing prices began to fall and subprime mortgages began to default, many AAA-rated products had to be downgraded over and over again.
If you borrow $125 from a friend and in 3 years that friend wants $175 back from you, what is the yield to maturity in the loan?
Yield to maturity = 11.87%
Would you be more or less willing to buy a house under the following circumstances: You just inherited $100,000. _______________ Real estate commissions fall from 6% of the sales price to 5% of the sales price. _______________ You expect Microsoft stock to double in value next year. _______________ Prices in the stock market become more volatile. _______________ You expect housing prices to fall. _______________
You just inherited $100,000. More willing Real estate commissions fall from 6% of the sales price to 5% of the sales price. More willing You expect Microsoft stock to double in value next year. Less willing Prices in the stock market become more volatile. More willing You expect housing prices to fall. Less willing
Would you be more or less willing to buy a share of Microsoft stock in the following situations: Your wealth falls. ___________________ You expect the stock to appreciate in value. ___________________ The bond market becomes more liquid. ___________________ You expect gold to appreciate in value. ___________________ Prices in the bond market become more volatile. ___________________
Your wealth falls. Less willing You expect the stock to appreciate in value. More willing The bond market becomes more liquid. Less willing You expect gold to appreciate in value. Less willing Prices in the bond market become more volatile. More willing
A plot of the yields on bonds with different terms to maturity but the same risk, liquidity, and tax considerations is known as
a yield curve
In the theory of portfolio choice, which of the following will decrease the quantity demanded of an asset?
an increase in the risk of the asset relative to alternative assets
If the yield to maturity on a bond exceeds its coupon rate, the price of the bond will be __________ its face value.
below
Suppose you visit with a financial adviser, and you are considering investing some of your wealth in one of three investment portfolios: stocks, bonds, or commodities. Your financial adviser provides you with the following table, which gives the probabilities of possible returns from each investment: - To maximize your expected return, you should choose: ___________________ - If you are risk-averse and had to choose between the stock or the bond investments, you would choose:
commodities and the bond portfolio because there is less uncertainty over the outcome.
In the long run, if the output, price-level, and expected inflation effects outweigh the liquidity effect, to reduce interest rates the Federal Reserve should
decrease the growth rate of the money supply.
If the nominal interest rate was originally 17% while the expected inflation rate was 10%, and then both changed to 5% and 4%, respectively, then the real interest rate ______________
decreased
Using the formula given below: Rbonds = F − P/P, if the market price of a $1,200-face-value discount bond changes from $950 to $975, the yield to maturity ____________ by 3.24%
decreases
Along the supply curve for bonds, an increase in the price of bonds
decreases the interest rate and increases the quantity of bonds supplied.
Suppose you observe a change in the relationship between short-term and long-term bonds. Specifically, you note that although interest rates on both short-term and long-term bond are rising together, as expected, the rate on long-term bonds is not rising by as much as has been observed in the past. - Assuming the liquidity premium theory of term structure, you conclude that the liquidity premium is __________ - As a result, the yield curve becomes _______
decreasing flatter
The interest rate that is adjusted for actual changes in the price level is called the
ex-post real interest rate
The difference between the nominal and TIIS yields for each pair represents ___________ over the relevant bond horizon.
expected inflation
When the Federal Reserve increases the growth rate of the money supply, the income effect causes the interest rate to rise while the liquidity effect drives the interest rate __________. Continuing on the same train of thought, when the Fed decreases the growth rate of the money supply, the price level effect drives the interest rate down while the expected inflation rate pushes the interest rate down. Suppose there is an increase in the growth rate of the money supply. If the liquidity effect is smaller than the income, price-level, and expected inflation effects, and if inflationary expectations adjust slowly, then in the short run, interest rates
fall
The president of the United States announces in a press conference that he will fight the higher inflation rate with a new anti-inflation program. Predict what will happen to interest rates if the public believes him. - As a result of the president's announcement, people's expectations of inflation will ______, which causes the demand for bonds to shift to the _______. However, the lower expected inflation rate causes the cost of borrowing to _________, so the supply of bonds will _______, which causes the supply curve for bonds to shift to the _______. The impact of this change in bond demand and supply will cause equilibrium interest rates to __________.
fall right rise decrease left decrease
Suppose there is a/an decrease in the growth rate of the money supply. If the liquidity effect is smaller than the output, price-level, and expected inflation effects, then in the long run, interest rates
fall compared to their initial value
If expectations of future short-term interest rates suddenly fall, what would happen to the slope of the yield curve?The yield curve would become ______ .
flatter
According to the liquidity premium theory of the term structure of interest rates, if the one-year bond rate is expected to be 3%, 5%, and 7% over each of the next three years, and if the liquidity premium on a three-year bond is 1%, then the interest rate on a three-year bond is 77%. According to the liquidity premium and preferred habitat theories of the term structure of interest rates, a flat yield curve indicates that _____________________________________
future short-term interest rates are expected to fall.
Based on your answers above, are there significant variations in the differences in the bond pairs? Interpret the magnitude of the variation in differences among the pairs. The difference, which roughly represents inflation expectations:
grows slightly as you move farther out, implying that market participants expect average inflation to be somewhat lower in the near term.
A lender prefers a ____________ real interest rate while a borrower prefers a ____________ real interest rate.
higher, lower
If the income tax exemption on municipal bonds were abolished, the interest rates on these bonds would______
increase
If the yield curve suddenly becomes steeper, how would you revise your predictions of interest rates in the future? - you would _____ your predictions of future interest rates.
raise
When the federal government sells a Treasury bond in the primary market—via Treasury auction, it is:
seeking to finance government spending as an alternative to raising taxes.
When an individual or institution buys a corporate bond in the primary market:
she is making a loan to the corporation issuing the bond.
If the supply of bonds shifts to the left, the price of bonds increases, and the interest rate decreases. When the wealth of individuals decreases,f the supply of bonds shifts to the left, the price of bonds increases, and the interest rate decreases.
the price of bonds increases while the interest rates decrease.
Interest rates were lower in the mid-1980s than in the late 1970s, yet many economists have commented that real interest rates were actually much higher in the mid- 1980s than in the late 1970s. Consider the diagram to the right that shows the nominal interest rate and the inflation rate. The real interest rate...
was higher in 1985 than 2005, when the real interest rate was zero.
Suppose you take out a loan at your local bank. The bank expects to earn an annual real interest rate equal to 3%. Assuming that the annualized expected rate of inflation over the life of the loan is 1%, determine the nominal interest rate that the bank will charge you. The bank will charge you a nominal interest rate of 4%. What happens if, over the life of the loan, actual inflation is 0.5%? If actual inflation turns out to be 0.5% (lower than expected 1%), the real interest rate earned by the bank was 3.5%. If the actual inflation turns out to be lower than the expected inflation:
you will be worse off than originally planned, since the real cost of borrowing turned out to be higher.
"According to the expectations theory of the term structure, it is better to invest in one-year bonds, reinvested over two years, than to invest in a two-year bond, if interest rates on one-year bonds are expected to be the same in both years." Is this statement true, false, or uncertain?
False: These investments are almost of the same profitability.
If interest rates decline, which would you rather be holding, long-term bonds or short-term bonds?
Long-term bonds because their price would increase more than the price of short-term bonds
True or False: With a discount bond, the return on a bond is equal to the rate of capital gain.
True: A discount bond has no coupon payments so the return on the bond is equal to the rate of capital gain.
Would interest rates of Treasury securities be affected by the tax rate change?
Yes, because the reduction in the tax-exempt privilege in municipal bonds would raise the relative value of Treasury securities, making Treasury securities more desirable.
Will there be an effect on interest rates if brokerage commissions on stocks fall?
Yes, interest rates would rise because stocks become more liquid than before, which would reduce the demand for bonds
In the aftermath of the global economic crisis that started to take hold in 2008, U.S. government budget deficits increased dramatically, yet interest rates on U.S. Treasury debt fell sharply and stayed low for quite some time. Does this make sense?
Yes, the decrease in investment opportunities and known risk factors significantly offset the wealth effect on demand and the deficit effect on supply.
If the demand for bonds shifts to the left, the price of bonds
decreases, and interest rates rise.
Is it better for bondholders when the yield to maturity increases or decreases? Bondholders are better off when the yield to maturity:
decreases, since this represents an increase in the price of the bond and a decrease in potential capital losses.
