Fina 4000

Multiple Choice 

Highlight, or otherwise prominently indicate the best response.

1. ________ real rates are almost always positive; _______real rates may be negative.

a.        Realized; expected

b.        Expected; realized

c.        Government; private

d.        Expected; expected

1. Which among the following is least likely to affect the supply of loanable funds?

a.        the level of income

b.        the investment opportunities in the economy. (this affects demand for LF)

c.        the savings rate

d.        Federal Reserve monetary policy actions.

1. If the real rate of interest is 4%, actual inflation for the last year was 5%, and expected inflation is 8%, the Fisher effect predicts what current level of nominal interest rates?

a.           9%

b.          8%

c.          13%

d.          12%

1. A decrease in the money stock by the Federal Reserve

a.        shifts the supply of loanable funds to the left, decreasing interest rates.

b.        shifts the demand for loanable funds to the left, increasing interest rates.

c.        shifts the supply of loanable funds to the left, increasing interest rates.

d.        shifts the supply of loanable funds to the right, increasing interest rates.

1. An increase in income tax rates

a.        will decrease the savings rate.

b.        will decrease the supply of loanable funds.

c.        will increase interest rates.

d.        all of the above.

1. If market interest rates fall after a bond is issued, the

a.        face value of the bond increases.

b.        investor will sell the bond.

c.        market value of the bond is increasing.

d.        market value of the bond is decreasing.

1. If a $1000 par value bond has an 8% coupon (annual payments) rate, a 4-year maturity, and similar bonds are yielding 11%, what is the price of the bond?

a.          $1,000.00                

b.          $880.22        

c.          $906.93        

d.          $910.35

1. Which of the following statements is true?

 a.        Bond prices and interest rates move together.

b.        Coupon rates are fixed at the time of issue.

c.        Short-term securities have large price swings relative to long-term securities.

d.        The higher the coupon, the lower the price of a bond.

1. Which of the following risks will not affect zero coupon bonds?

a.          price risk        

b.          reinvestment risk        

c.          credit risk        

d.          default risk

1. If three-year securities are yielding 6% and two-year securities are yielding 5.5%, future short-term rates are expected to _____, and outstanding security prices are expected to _____.

a.        fall; fall.

b.        fall; rise.

c.        rise; fall.

d.        rise; rise.

1. A two-year interest rate is 7% and a one-year forward rate one year from now is 8%. According to the expectations theory, what is the current one-year rate?

a.        6.0%

b.        6.5%

c.        7.0%

d.        8.0%

e.        9.0%

Short Answer Questions: Provide brief responses to the following questions

1. The following annual inflation rates have been forecast for the next 5 years:

Year 1                3%

Year 2                4%

Year 3                5%

Year 4                5%

Year 5                4%

Use these inflation rate forecasts and an assumed 3% real rate to calculate the appropriate contract rate for a 1-year and a 5-year loan.  How would your contract rates change if the Year 1 inflation forecast increases to 5%?  Discuss the difference in the impact on the contract rates from the change in inflation.

Use the Fisher equation to determine the “appropriate” contract rates. The Fisher equation says:

[pic 1]

For the 1-year contract rate, just plug in the real rate and inflation forecast for year 1:

[pic 2]

For the 5-year contract rate, we need to find the (annualized) inflation rate over the next 5 years:

[pic 3]

Now just use the Fisher equation:

[pic 4]

If expected inflation next year increases to 5%, all else equal, the one-year rate will increase to 8.15% (same method as above), while the five year expected inflation rate becomes:

[pic 5]

And the resulting rate is 7.73%. The impact on the one-year rate is higher, because over a five-year period the change in next year’s expected inflation does not have as dramatic an impact.

1. David Hoffman purchases a $1,000 20-year bond with an 8% coupon rate (annual payments).  Yields on comparable bonds are 10%.   David expects that, two years from now, yields on comparable bonds will have declined to 9%.  Find his expected yield, assuming the bond is sold in two years.

Based on the YTM of 10% at the time of purchase, the purchasing price is $829.73:

Calculator:          1000 FV        20 N        10 I        80 PMT        PV = $829.73.

[pic 6]

In two years, based on 18 years remaining to maturity and the YTM of 9%, the bond price is expected to be $912.44:

[pic 7]

Finally, for the expected yield we have: