Financial Market and Institutions extra questions

If you expect inflation rate to be 5% next year and a one-year bond has a yield to maturity of 7%, then the real interest rate on this bond is?

2%

Consider a coupon bond that has a $1,000 par value and a coupon rate of 10%. The bond is currently selling for $1,150 and has eight years to maturity? What is the bond's yield to maturity?

N=8 I=?=7.44 PV = 1150 PMT = 1000*.1=-100 FV=1000

A financial advisor has just given you the following advice: "Long-term bonds are a great investment because their interest rate is over 20%." Is the financial advisor necessarily correct?

No. If interest rates rise sharply in the future, long-term bonds may suffer such a sharp fall in price that their return might be quite low, possibly even negative.

which of the following can be described as involving indirect finance?

a pension fund manager buys commercial paper a bank buys a U.S treasury bill from one of its depositors

the presence of transaction costs in financial markets explains, in part, why?

financial intermediaries and indirect finance play such an important role in financial market.

When a bonds price falls its YTM______________ and its current yield_________.

increase; increase

which of the following is a contractual savings institution?

life insurance company

when yield curves are steeply upward-sloping, long term are _________ short term rates

long term interest rates are above short term rates

9. Which bond will produce a greater return if the expectations theory were to hold true, a two-year bond with an interest rate of 15% or two 1-year bonds with sequential interest payments of 13% and 17%?

*15%==>13+17/2 = 15%==>so they will both produce the same*

The one year interest rate over the next 10 years will be 3%, 4.5%, 6%, 7.5%, 9%, 10.5%, 13%, 14.5%, 16% and 17.5%. Using the expectations theory, what will be the interest rates on a 3-year, 6-year and 9-year bond added in 10 basis points

*4.5+.3 = 4.8 6.75+.6 = 7.35 9.33+.9 = 10.253*

the duration of a ten-year, 10% bond when the interest rate is 10% is 6.76 years. what happens to the price of the bond if the interest rate falls to 8%

-6.76*(.08-.1/1+.1) = 12.29%

which are generally true of all bonds?

-even though a bond has substantial initial interest rate, its return can turnout to be negative if interest rates rise. -the longer bonds maturity the lower is the rate of return that occurs as a result of the increase in the interest rate. - price and returns for long-term bonds are more volatile than those for shorter -term bonds.

the return on a 5% coupon bond that initially sells for $1000 and sells for $1100 one year later is?

1000*.05 = 50 50+1100-1000/1000 = 15%

A 10-year, 7% coupon bond with a face value of $1,000 is currently selling for $871.65. Coupon your rate of return if you sell the bond next year for $880.10.

1000*.07 = 70 70+880.10-871.65/871.65 = 9%

Assume you just deposited $1,000 into a bank account. The current real interest rate is 2%, and inflation is expected to be 6% over the next year. What nominal rate would you require from the bank over the next year? How much money will you have at the end of 1 year? If you are saving to buy a stereo that currently sells for $1,050, will you have enough to buy it?

2=?-6 = 8 for nominal rate 1000*1.08 = 1080 1050*1.06 = 1113 1113-1080=33 So you will be short 33 dollars

Government economists have forecasted one-year T-bill rates for the following 5 years: Year 1-year rate %: /1 4.25/2 5.15/3 5.50/4 6.25/5 7.10/ You have a liquidity premium of 0.25% for the next two years and 0.50% thereafter. Would you be willing to purchase a 4-year T-Bond at a 5.75% interest rate?

4.25+5.15+5.50+6.25/4 = 5.29+ .5 = 5.79. just below your required rate so you should not purchase the bond

long term debt and equity instruments are traded in the?

Capital market

which of the follow long term bonds should have the highest interest rate?

Corp BBB bonds

Risk premiums on corporate bonds are usually anti-cyclical; that is they decrease during business cycle expansions and increase during recessions? Why?

During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms.

You are willing to pay $15,625 now to purchase a perpetuity that will pay you and your heirs $1,250 each year, forever, starting at the end of this year. If your required rate of return does not change, how much would you be willing to pay if this were a 20-year, annual payment, ordinary annuity instead of perpetuity?

I=1250/15625=0.08 N=20 PV=?=12,272.68 FV=0 PMT=1250

What effect will a sudden increase in the volatility of gold prices have on interest rates?

Interest rates fall. The increased volatility of gold prices makes bonds relatively less risky relative to gold and causes the demand for bonds to increase.

Predict what will happen to interest rates if the public suddenly expects a large increase in stock prices?

Interest rates will rise. The expected increase in stock prices raises the expected return on stocks relative to bonds and so the demand for bonds falls.

Predict what will happen to interest rates if prices in the bond market become more volatile.

Interest rates will rise. When bond prices become volatile and bonds become riskier, the demand for bonds will fall.

How might a sudden increase in people's expectations of future real estate prices affect interest rates?

Interest rates would rise. A sudden increase in people's expectations of future real estate prices raises the expected return on real estate relative to bonds, so the demand for bonds falls.

An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public. Using a supply-and-demand analysis for bonds, show what effect this action has on interest rates.

P decreases I increases

If mortgage rates rise from 5% to 10%, but the expected rate of increase in housing prices rises from 2% to 9%, are people more or less likely to buy houses?

People are more likely to buy houses because the real interest rate when purchasing a house has fallen from 3% to 1%.

when the default risk on corporate bonds decreases, the demand curve for the corporate bonds shifts to the_________, and the demand for treasury bonds shifts to the ______________

Right; left

Which should have the higher risk premium on its interest rates, a corporate bond with a Moody's Baa rating or a corporate bond with a C rating? Why?

The bond with a C rating should have a higher risk premium because it has a higher default risk, which reduces its demand and raises its interest rate relative to that of the Baa bond.

Using a supply and demand analysis for bonds, show what the effect is on interest rates when the riskiness of bonds rises.

The increased riskiness of bonds lowers the demand for bonds. The demand curve Bd shifts to the left, the equilibrium bond price falls and the interest rate rises.

Explain what effect a large federal deficit might have on interest rates.

The increased riskiness of bonds lowers the demand for bonds. The demand curve shifts to the left and the equilibrium bond price falls and the interest rate rises.

The chairman of the Fed announces that interest rates will rise sharply next year, and the market believes him. What will happen to today's interest rate on AT&T bonds, such as the 8 1/8s of 2022?

The interest rate on the AT&T bonds will rise. Because people now expect interest rates to rise, causing the demand for the bonds to decrease.

What effect would reducing income tax rates have on the interest rates of municipal bonds? Would interest rates of Treasury securities be affected, and, if so, how?

The reduction in income tax rates would make the tax-exempt privilege for municipal bonds less valuable, and they would be less desirable than taxable Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise interest rates on municipal bonds while causing interest rates on Treasury bonds to fall.

Using the supply-and-demand for bonds framework show why interest rates are pro-cyclical (rising when the economy is expanding and falling during recessions).

When the economy booms, the demand for bonds increases: The public's income and wealth rises while the supply of bonds also increases, because firms have more attractive investment opportunities. Similarly, when the economy enters a recession, both the supply and demand curves shift to the left, but the demand curve shifts less than the supply curve so that the bond price rises and the interest rate falls.

Will there be an effect on interest rates if brokerage commissions on stocks fall? Explain your answer.

Yes, interest rates will rise. The lower commission on stocks makes them more liquid than bonds, and the demand for bonds will fall. The demand curve Bd will therefore shift to the left, and the equilibrium bond price falls and the interest rate will rise.

If there is a decline in interest rates, which would you rather be holding, long-term bonds or short-term bonds? Why? Which type of bond has the greater interest-rate risk?

You would rather be holding long-term bonds because their price would increase more than the price of the short-term bonds, giving them a higher return.

when the potential borrowers who are the most likely to default are the ones most actively seeking a loan_______________, is said to exist

adverse selection

when the lender and the borrower have different amounts of information regarding a transaction,________________ is said to exists.

asymmetric information

what interest rates do you prefer to borrow/ lend at?

borrow - low lend - high

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.

demand for bonds will increase and interest rates will fall.

Every Market performs the following function

it channels funds from lenders-savers to borrow-spenders

a corporation suffering big losses might be more likely to suspend interest payments on its bonds thereby

raising the default risk and causing the demand for its bonds to fall

the term structure of interest is

the relationship among interest rates on bonds with different maturities but similar risk

If income tax rates were lowered then

the interest rates on muni bonds would rise

the risk premium on corporate bonds becomes smaller if?

the liquidity of corp bonds increases the riskiness of corporate bonds decrease

the government regulates financial markets for two main reasons

to ensure soundness of the financial system and to increase the information available to investors

the interest rate that equates the present value of the cash flow received from a debt instrument with its market price today is the?

yield to maturity