Question

Answer the following questions:

1.)You own a $ 1,000 par zero –coupon bond that has five years of remaining maturity. You plan on selling the bond in one year, and believe that the required yield next year will have the following probability distribution.

Probability Required Yield %
0.1                 6.60%
0.2                 6.75%
0.4                 7.00%
0.2                 7.20%
0.1                 7.45%

a.)What is your expected price when you sell the bond?
b.)What is the standard deviation of the bond price?


3.)Last month corporations supplied $ 250 billion in one year discount bonds to investors at an average market rate of 11.8%.This month an additional $25 billion in one year discount bonds became available and market rates increased to 12.2%.Assuming that the demand curve remained constant., derive a linear equation for the
demand for bonds, using prices instead of interest rates.


5.)The demand curve and supply curve for one year discount bonds were estimated using the following equations

Bd:Price=-2/5Quantity +940
BS:Price=Quantitty +500

Following a dramatic increase in the value of the stock market, many retires started moving money out of the stock market and into bonds. This resulted in a parallel shift in the demand for bonds, such that the price of the bonds at all quantities increased $50.Assuming no change in the supply equation for bonds, what is the new equilibrium price and quanatity?What is the new market interest rate?


Page 114

2.)Government economists have forecasted one year T-bill rates for the following five years as follows:

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 four year T-bond at a 5.75% interest rate?


4.)Consider the decision to purchase either a five year corporate bond or a five year municipal bond.The corporate bond is a 12% annual coupon bond with a par value of $ 1,000.It is currently yielding 11.5%.The municipal bond has an 8.5%annual coupon and a par value of $1,000.It is currently yielding 7%.Which of the two bonds would be more beneficial to you?
Assume that your marginal tax rate is 35%.


6.)One year T-bill rates are expected to steadily increase by 150basic points per year over the next six years.Determine the required interest rate on a three year T-bond and a six year T bond if the current one-year interest rate is 7.5%Assume that the expectations hypothesis for interest rates holds.


8.)Using the information from the previous question, now assume that investors prefer holding short term bonds. A liquidity premium of 10 basis points is required for each year of the bond’s maturity. What will be the interest rates on a three year bond, six year bond and nine year bond?


10.)Little Monsters Inc,borrowed $ 1,000,000 for two years from Northernbank,Inc at an 11.5% interest rate. The current risk free is 2% and Little Monster’s financial condition warrants a default risk premium of 3% and a liquidity risk premium of 2%.The maturity risk premium for a two year loan is 1% and inflation is expected to be 3% next year. What does this information imply about the rate of inflation in the second year?


12.) One year T-bills rates over the next four years are expected to be 3%,4%, 5%,and 5.5%.If four year T-bonds are yielding 4.5%,what is the liquidity premium on the bond?


Page 133.

1.)A company has just announced a 3 for 1 stock split, effective immediately. Prior to the split the company had a market value of $5 billion with 100 million shares outstanding. Assuming that the split conveys no new information about the company what is the value of the company, the number of shares outstanding and price per share after the split? If the actual market price immediately following the split is $17.00 per share, what does this tell us about the market efficiency?

2.)If the public expects a corporation to lose $ 5 a share this quarter and it actually loses $ 4 ,which is still the largest loss in the history of the company, what does the efficient market hypothesis say will happen to the price of the stock when the $ 4 loss is announced?


Page 162.

1.) You are in the market for a used car. At a used car lot, you know that the blue book value for the cars you are looking at is between $ 20,000 and $ 24,000.If you believe the dealer knows as much about the car as you, how much are you willing to pay?Why?Assume that you only care about the expected value of the car you buy and that the car values are symmetrically distributed?


2.)Now you believe the dealer knows more about cars than you. How much are you willing to pay?Why?How can this be resolved in a competitive market?


3.)You wish to hire Ricky to manage your Dallas operations. The profits from the operations depend partially on how hard Ricky works, as follows.

                      Profit =$10,000 Profit=$50,000
Lazy                      60%                         40%
Hard worker          20%                         80%


If Ricky is lazy, he will surf the Internet all day, and he views this as a zero cost opportunity. However Ricky would view working hard as a personal cost’ ‘valued at
$ 1,000. What fixed percentage of the profits should you offer Ricky? Assume Ricky only cares about his expected payment less any personal cost?


4.)You own a house worth $ 400,000 that is located on a river. If the river floods moderately the house will be completely destroyed.Thsi happens about once every 50 years. If you build a seawall, the river would have to flood heavily to destroy your house, which only happens about once every 200 years. What would be the annual premium for the insurance policy that offers full insurance? For a policy that only pays 75% of the home value, what are your expected costs with and without a seawall? Do the different policies provide an incentive to be safer (I,e to build the seawall)?

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