14.

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?
Simply compute real interest rates (r = i ) in both periods:
Before
After

r = 5% - 2% = 3%
r = 10% - 9% = 1%

People are more likely to buy houses now because the real interest rate they have to pay has
fallen from 3% to 1%. People are paying back more in terms of dollars, but the values of their
houses have risen at such a rate that the real cost of financing their homes has actually fallen.
8. 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 dont 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%, the yield to maturity on a normal $1,000 fixed payment loan in which you pay $126 per
year for 25 years?
If the interest rate were 12 percent, the present discounted value of the payments on the
government loan are necessarily less than the $1,000 loan amount because they do not start for
two years. Thus the yield to maturity must be lower than 12 percent in order for the present
discounted value of these payments to add up to $1,000.

13)Assumeyoujustdeposited$1,000intoabankaccount.Thecurrentrealinterestrateis2%and
inflationisexpectedtobe6%overthenextyear.Whatnominalinterestratewouldyourequirefrom
thebankoverthenextyear?Howmuchmoneywillyouhaveattheendofoneyear?Ifyouare
savingtobuyastereothatcurrentlysellsfor$1,050,willyouhaveenoughtobuyit?
Solution: Therequirednominalratewouldbe:
iire
2%6%8%.
Atthisrate,youwouldexpecttohave$1,0001.08,or$1,080attheendoftheyear.Can
youaffordthestereo?Intheory,thepriceofthestereowillincreasewiththerateof
inflation.So,oneyearlater,thestereowillcost$1,0501.06,or$1,113.Youwillbe
shortby$33.

3.

Considerabondwitha7%annualcouponandafacevalueof$1,000.Completethefollowingtable:
YearstoMaturity
3
3
6
9
9

DiscountRate
5
7
7
7
9

CurrentPrice

Whatrelationshipdoyouobservebetweenyieldtomaturityandthecurrentmarketvalue?
Solution:
YearstoMaturity
3
3
6
9
9

YieldtoMaturity
5
7
7
5
9

CurrentPrice
$1,054.46
$1,000.00
$1,000.00
$1,142.16
$880.10

Whenyieldtomaturityisabovethecouponrate,thebandscurrentpriceisbelowitsface
value.Theoppositeholdstruewhenyieldtomaturityisbelowthecouponrate.Fora
givenmaturity,thebondscurrentpricefallsasyieldtomaturityrises.Foragivenyield
tomaturity,abondsvaluerisesasitsmaturityincreases.Whenyieldtomaturityequals
thecouponrate,abondscurrentpriceequalsitsfacevalueregardlessofyearsto
maturity.

2.

Alotteryclaimsitsgrandprizeis$10million,payableover20yearsat$500,000peryear.Ifthefirst
paymentismadeimmediately,whatisthisgrandprizereallyworth?Useadiscountrateof6%.
Solution: Thisisasimplepresentvalueproblem.Usingafinancialcalculator:
N20;PMT500,000;FV0;I6%;PmtsinBEGINmode.
ComputePV:PV$6,079,058.25

9. Which $1000 bond has the higher yield to maturity? A 20 year bond selling for $800
with a current yield of 15% or a oneyear bond with a current yield of 5% that sells
for $800.
For the 20 year bond the current yield will be approximately equal to the yield to
maturity (current yield will be a good approximation for the yield to maturity for long
term bonds).
So the yield to maturity for the 20 year bond is approximately 15%.
For the 1 year bond
i

1000 800
0.25 25%
800

if there was no coupon payment. The existence of the coupon payment makes the yield
to maturity greater than 25%, so the yield to maturity on the 1 year bond is greater than
for the 20 year bond.

3. Suppose you have just inherited $10,000 and are considering the following options for
investing the
money to maximize your return:
Option 1: Put the money in an interest-bearing checking account, which earns 2%. The FDIC
insures
the account against bank failure.
Option 2: Invest the money in a corporate bond, with a stated return of 5%, but there is a 10%
chance the company could go bankrupt.
Option 3: Loan the money to one of your friends roommates, Mike, at an agreed-upon interest
rate
of 8%, but you believe there is a 7% chance that Mike will leave town without repaying you.
Option 4: Hold the money in cash and earn zero return.
a. If you are risk-neutral (that is, neither seek out nor shy away from risk), which of the four
options
should you choose to maximize your expected return? (Hint: To calculate the expected return of
an
outcome, multiply the probability that an event will occur by the outcome of that event). (5')
Answer:
Expected Net Return Rate
Option 1 2%
Option 2 5%*0.9-1*0.1=-5.5%
Option 3 8%*0.93-1*0.07=0.44%
Option 4 0
Hence I would choose option 1.
b. Suppose Option 3 is your only possibility. If you could pay your friend some money to find
out
extra information about Mike that would indicate with certainty whether he will leave town
without
paying or not, how much (at most) are you willing to pay? (5)
Answer: The expected net return if you pay x is
93%*(10000*8%-x)+7%(-x)=744-x
The expected net return if you do not pay this money is this is higher than 0, so you will still
lend
Mike the money
93%*10000*8%-7%(-10000)=44
Hence the maximum amount of money you are willing to pay is
x = 744-44=700.

The M1 money supply is the sum of rows A, E, and G for each year. The M2 money supplyis the
sum of all components AG for each year. Note that 3-month treasury bills are notconsidered
part of the M1 or M2 money supply, even though they are fairly liquid assets. Thetable below
shows the M1 and M2 money supplies, along with the growth rates from theprevious year. Note
that while the M1 money supply is relatively flat (and slightly negativefor 2010), the M2 money
supply grows at a much higher, positive rate. This is because thecomponents of M2 are rising
much more rapidly compared to the components of M1 (whichare also included in M2). In
particular, small denomination time deposits increase 30% from2010 to 2011, and 39% from
2011 to 2012, driving much of the growth in M2. Moreover, thenarrower components which
make up just the M1 money supply represent less than 20%(1904/10128) of the broader M2
indicators. Thus movements in the money market, savingsaccount, and time deposit measures
will have a much bigger impact on M2 growth than thenarrower M1 components will