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.