Financial Markets and Monetary Policy, Chapter 3, Homework 3

if the market price of a ​$1 comma 200​-face-value discount bond changes from ​$900 to ​$875​, the yield to maturity increases by

3.81%

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.

In the theory of portfolio​ choice, which of the following will decrease the quantity demanded of an​ asset? If a​ one-year discount bond that pays ​$1 comma 000 at​ maturity, is held for the entire​ year, and the purchase price is ​$950​, 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 comma 000 at​ maturity, generates an interest rate of

An increase in the risk of the asset relative to alternative assets 5% 6.7%

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.

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 decreasing. As a​ result, the yield curve becomes flatter.

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 - 4 ​$2,000 in cash - 1 A​ $10,000 Treasury bill - 2 100 shares of Google stock - 3

Match each of the following theories with its description. ​(Enter a​ value: 1-4.)

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. 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.

Using the information given the​ text, match the following descriptions of risk to the corresponding Standard and​ Poor's rating​ (i.e., AAA,​ AA, A,​ BBB, ...​ D).

High grade high quality - AA Highly speculative - D Upper medium grade - A Prime maximum safety - AAA Speculative - B

The demand curve and supply curve for​ one-year discount bonds with a face value of ​$1 comma 030 are represented by the following​ equations:

If the Fed increases the supply of bonds in the market by 70​, at any given​ price, the bond supply equation will become Price=Quantity+620. The expected interest rate on a​ one-year discount bond will increase to 11.23​%

Which of the following statements is true​?

Interest rates on bonds of different maturities tend to move together over time. According to the segmented markets theory of the term structure of interest​ rates, if bondholders prefer​ short-term bonds to​ long-term bonds, the yield curve will be upward sloping.

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.

If junk bonds are​ "junk," then why would investors buy​ them?

Junk bonds can provide high yields.

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.

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. 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.

The demand curve and supply curve for​ one-year discount bonds with a face value of ​$1 comma 050 are represented by the following​ equations: The expected equilibrium price of bonds is ​$

The expected equilibrium quantity of bonds is 276. $966 8.7%

Suppose that many big corporations decide not to issue​ bonds, since it is now too costly to comply with new financial market regulations.

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.

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.

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.

The ------- is the spread between the interest rates on bonds with default risk and those of the​ default-free bonds when both types of bonds have the same maturity. The following three characteristics of a bond are collectively embedded in the risk structure of interest rates except

risk premium Difference in maturity