Homework Answers Week 1 - Chapter 1 Questions and Answers What is the typical relationship among - Studeersnel (2024)

Vak

Universiteit

Universiteit Utrecht

Geüpload door:

Aanbevolen voor jou

• 3Week 2 and 3 NotesFinancial Markets and InstitutionsWerkgroep uitwerkingen100% (3)
• 5Brian Sack and Robert ElsasserFinancial Markets and InstitutionsSamenvattingen100% (7)
• 10Chapter 1, 2 and 4 Questions and AnswersFinancial Markets and InstitutionsPractica94% (16)
• 7C. Borio Summary - Article Content Financial Markets and InstitutionsSamenvattingen100% (5)

Reacties

Andere studenten bekeken ook

• Week 2 and 3 Notes
• Ecbfmi coursemanual - The course is the first one in a series of level 3 courses in financial economics,
• Financial Markets and Institutions - Practical - ch11
• ECB2 Mfiep course manual 2021-22
• FMI Final Jan 2019 with answers
• Lelyveld and Liedorp article questions and answers

Gerelateerde documenten

• Exam 2013 questions and answers
• Exam January 20, 2014, questions and answers
• Sack and Elsasser article questions and answers
• Chapter 1, 2 and 4 Questions and Answers

Chapter 1 Questions and Answers

1. What is the typical relationship among interest rates on three-month Treasury bills, long- term Treasury bonds, and Baa corporate bonds? The interest rate on three-month Treasury bills fluctuates more than the other interest rates and is lower on average. The interest rate on Baa corporate bonds is higher on average than the other interest rates.

   See Also

   What Is the Federal Funds Rate? - NerdWallet

2. What effect does high volatility of financial markets have on people's willingness to spend? The high volatility of financial markets decreases people's willingness to spend, primarily because it directly affects their wealth, and also because high volatility indicates that there are considerable fluctuations in the prices of securities over a short time span. It increases insecurities about the future of an economy. Refer to Figure 2 to see the extremely volatile nature of stock prices between 1950 and 2020.

3. Explain the main difference between a bond and a common stock.

A bond is a debt instrument, which entitles the owner to receive periodic amounts ofmoney (predetermined by the characteristics of the bond) until its maturity date. Acommon stock, however, represents a share of ownership in the institution that has issuedthe stock. In addition to its definition, it is not the same to hold bonds or stock of a givencorporation, since regulations state that stockholders are residual claimants (i. thecorporation has to pay all bondholders before paying stockholders).

6. Can you think of a reason why people in general do not lend money to one another to buy a house or a car? How would your answer explain the existence of banks?

In general, people do not lend large amounts of money to one another because of severalinformation problems. In particular, people do not know about the capacity of other peopleof repaying their debts, or the effort they will provide to repay their debts. Financialintermediaries, in particular commercial banks, tend to solve these problems by acquiringinformation about potential borrowers and writing and enforcing contracts that encouragelenders to repay their debt and/or maintain the value of the collateral.

11. When interest rates decrease, how might businesses and consumers change theireconomic behavior?Businesses would increase investment spending because the cost of financing thisspending is now lower, and consumers would be more likely to purchase a house or a carbecause the cost of financing their purchase is lower.
12. Is everybody worse off when interest rates rise?No. It is true that people who borrow to purchase a house or a car are worse off becauseit costs them more to finance their purchase; however, savers benefit because they canearn higher interest rates on their savings.

Chapter 2 Questions and Answers

1. If Marco buys a laptop today for €1,000, and it will be worth €2,000 next year because it enables him to work remotely as an assistant, should he take out a loan from Prestiti Di Pasquale, a small Italian loan firm, at a 90% interest rate? Marco cannot get a loan from anyone else. Will he be better or worse off for taking out this loan? Would you consider this a shark loan? Yes, Marco should take out the loan, as he will be better off as a result of doing so. His interest payment will be €900 (90% of €1,000), but as a result, he will earn an additional €100 since he is able to collect €1,000 more in terms of earnings in the first year. This would be an example of a shark loan as it involves a lender charging an extremely high interest rate (probably doing so illegally).

2. Some economists suspect that one of the reasons economies in developing countries grow so slowly is that they do not have well-developed financial markets. Does this argument make sense? Yes, because the absence of financial markets means that funds cannot be channeled to people who have the most productive use for them. Entrepreneurs then cannot acquire funds to set up businesses that would help the economy grow rapidly.

3. If you suspect that a company will go bankrupt next year, which would you rather hold, bonds issued by the company or equities issued by the company? Why? You would rather hold bonds, because bondholders are paid off before equity holders, who are the residual claimants.

4. Suppose that the government of Albania issues a euro-denominated bond in Albania (Note: the currency of Albania is the Albanian Lek.). Is this debt instrument considered to be a Eurobond? How would you answer change if the bond were issued in London? The euro-denominated bond issued in Albania and the one issued in London would be considered to be Eurobonds because the denomination differs from the local currencies.

5. Describe who issues each of the following instruments:

a. Stocks Corporate organizationsb. Mortgage-backed securities Government agenciesc. Corporate bonds Corporate organizationsd. State and local government bonds Municipalitiese. Consumer and bank commercial loans Banks and financial companies

the best investment.

b. This option implies the very real possibility of either receiving nothing (if she actually leaves town), or £10,800 (if she indeed pays as promised). If he doesn’t pay Anne, he has an expected return of £10,044 as shown above. If he paid Anne the £100 and learned that Agatha would leave without paying, then obviously he wouldn’t loan Agatha the money, and he would be left with £9900. However, if he paid Anne £100 and learned that Agatha would pay, he would have £10,700 (=

£10,000  1 - £100). After paying his friend Anne, but before knowing the true

outcome, his expected return would be £10,644 (£9900  0 + £10,700  0).

Paying his friend £100 is definitely worth it because it increases his expectedreturn and also dramatically reduces the risk that he makes a bad loan andincreases the certainty of the payoff amount. That is, with asymmetric information(not paying Anne), he has a range of payoffs of £0 to £10,800, as opposed to£to £10,700 without asymmetric information. Thus, paying a small amount toimprove risk assessment can be very beneficial, a task for which financialintermediaries are well suited.

Chapter 4 Questions and Answers:

Consider the following terms and define and compare them (use present value formulas for

better understanding). Make sure you understand the differences

a. Maturityb. Face valuec. Yield to maturityd. Current yielde. Holding period yield (holding period return)f. Simple loang. Discount bondh. Coupon bondi. Consolj. Annuity (fixed payment loan)

- Maturity is the time from now till the final cash flow of the asset (there is also a concept called

duration which takes into account the timing of the cash flows: we will return to this in a later

tutorial).

- Face value is the nominal (principal) value of the loan.

- Interest rate is a general concept, typically used for <yield-of maturity= (which is the average

annual interest rate on a debt asset until its maturity (expiration)). An alternative equivalent

term for the yield to maturity is <internal rate of return= (as defined in a NPV formula). It is

the discount rate that equates the current price to the net present value of all future cash flows.

- Current yield applies to coupon bonds only and is computed as the (annual) coupon divided

by the price (times 100 to make it a percentage).

- Holding period returns (HPR) are defined as the return over any specific period. In case the

maturity of the bond is the period for the HPR, HPR equals the yield to maturity, but generally

HPR is computed over shorter periods than the maturity.

- A simple loan is a loan with two cash flows, one at the start (the borrower receives the

principal (F) and one at the end (the borrower repays the principal plus all interest due.

- A discount bond has the same payoff structure as the simple loan, but now the final cash flow

is equal to the principal F and the borrower receives a lower (discounted) amount to make sure

the lender makes a positive return. The interest rate (yield to maturity) on a discount bond

typically equals (F-P)/P for a 1 year bond.

- A coupon bond is a (longer term) bond which pays out a fixed percentage of the principal F

as coupon every year or half year. At the time of maturity the principal F is repaid.

- Consols are coupon bonds with an infinite maturity. That is the principal is never repaid. Also

called perpetuities.

- An annuity is a loan which is repaid through a series of fixed amounts, which combine interest

payment and repayments of the principal.

Note: in all examples and exercises, we abstract (unless explicitly stated otherwise) from bid-

ask spreads (buy/sell spreads) which in reality do play a role especially for retail (consumer)

deals.

Note: in general, it is wise to compute all returns and rates on an annual basis.

1. (Changes in ) yields to maturity, bond prices and holding returns are tightly connected. To practice consider the following example. On July 15 2009, the Dutch government issued a 10 year bond with a 4% coupon (to be paid annually at the end of each year) and a face value of €100 (per piece). On October 15, 2010 the market price of the bond equalled 112.

a. Determine the remaining maturity of the bond on October 15, 2010..

On 15 October 2010, the remaining maturity is 8 year (till 15 July 2019).

b. Compute the current yield for the bond (in percent per year).

Clearly, the current yield equals (4/112)*100% = 3% (note that we abstract from bid-

ask spreads: typically, if you want to buy a bond, you need to pay the <asked= price. Current

yield then equals coupon divided by asked price (times 100 to make it a percentage).

c. Compute the yield to maturity of the bond using (and solving) the appropriate net present value formulas. Do it both using a year as the unit of times and using a quarter as a unit of time.

yield (C/P) and also the lower the yield to maturity(C/P + ΔP/P). The higher the price, the

lower the first term and the more negative the second term

e. On January 15, 2011 the bond price had dropped to 109. Again use the appropriate formulas (based on years and quarters to compute the new yield to maturity.

On an annual basis, the formula becomes:

0 1 2 8 8.

0* 4 4 4 4 100

109. .....

(1 ) (1 ) (1 ) (1 ) (1 )

P

i i i i i

= = + + + + +

+ + + + +

Note that the maturity has dropped from 8 years to 8 years while the First coupon now

only counts for 50% rather than 75%. The solution is i=2%.

On a quarterly basis it is

2 3 34 34

1 1 1 1 100

109. .....

(1 ) (1 ) (1 ) (1 ) (1 )

P

i i i i i

= = + + + + +

+ + + + +

The solution is that i=0 (quarterly), which is 2% annually.

f. Compute an investor’s holding return on an annual basis between October 15 2010 and January 15 2011.

Remember to be careful with quarterly and annual percentages. If you bought the bond at

112 and sell it 3 months later for 109, you lose 100%*(109-112)/112=2%.

However, this is the capital loss on a quarterly basis. Measured annually, the loss is four times

as high (or11%). In addition, you are entitled to €1 of the annual coupon, which is

100%*1/112=0% (the quarterly current yield) which partly compensate for the capital

loss. So on an annual basis, your total holding return on the bond (over the 3-month period) is

3-11 = -7%. On a quarterly basis, it is 0-2 = -1%.

2. Suppose on October 15, 2010 a 1 year US T-bill (discount bill) with face value $1, has a published yield of 0% (annual basis).

a. Compute the price at which this bill can be bought in the market.

The NPV formula (in reverse) says that F=P*(1+i). Then, P=$ 996.

b. Suppose on November 15, 2010 the bill’s price has changed to 994. Compute themonthly holding return (on an annual basis) as well as the new yield to maturity.

There are no coupon payments so that the price change is the only return component. The price

falls by 100%*(994-996)/996 = -% in a month. The annual percentage return then is

12*-0=-2%.

The new yield to maturity can be computed from the formula:

11/

1000

994

(1 i )

=

+

; the solution is i=0%(a rising i leads to a falling price).

3. Use table 2 (p. 128) – and/or your findings under questions 2 and 3 – to discuss the relation between (changes in) the yield to maturity, the maturity itself and the bond return.

Suppose the YTM now on a long term bond equals 5 percent. If the market suddenly receives

new information that convinces it the correct long term yield should be 6 percent, the current

holders of the bond suffer a strong loss. After the news (shock) has been absorbed, the new

yield to maturity is higher than before (from 5 to 6), implying the price of the bond must have

declined. For a given coupon, the only way the yield in the future can be higher is a drop in the

price now. The holding period return computed from before the shock till after is strongly

negative because the price fall is a capital loss for the bond holders. Note that the longer the

maturity, the stronger the capital loss component and the more negative the total return.

Finally, while so far we have referred to nominal interest rates and returns, real interest rates

or real returns may be more interesting. However, with real figures inflation starts playing a

role too: realized real returns depend on realized inflation. Expected real returns and expected

inflation sum to the given nominal interest rate.

4. To discuss the consequences of unexpected inflation for real and nominal returns on Treasury bonds, we start from the following simple situation. Consider a 1 year nominal bond which has a 5% interest rate to be paid at the end of the year. The face value (and current price) of the bond is €1,000. Assume at the start the expected inflation over the year is 2%; then – approximating – the expected real yield is 3%.

a. Compare the expected purchasing power of the investment at the end with the initial investment.

Instead of investing in the bond, a consumer can buy goods and services valued €1,now. After one year, the investor (who has bought the bond rather than consume directly)receives €1,050. However, all goods and services have risen in price on average by 2%.Therefore, the purchasing power now is €1,050/1 = €1,029,41. That is, the purchasingpower has risen by 2%. In real terms this is the reward the investor gets for