M&B ECN 205 Problem Set # 2

(4.3)

Find the present value of a 4-year coupon bond when the interest rate is 6 percent, the annual coupon payments are $50, and the face value is $500. What will happen if the interest rate rises to 7 percent? What will happen if the interest rate falls to 5 percent?

(Extra1) You are considering buying a new house, and have found that a $100,000, 30-year fixed-rate mortgage is available with an interest rate of 7 percent. This mortgage requires 360 monthly payments of approximately $651 each. If the interest rate rises to 8 percent, what will happen to your monthly payment? Compare the percentage change in the monthly payment with the percentage change in the interest rate. (4.8) Your firm has three investment options. First, it could buy at par a $10,000 government bond with a $500 annual coupon that matures in three years. Second, it could use the $10,000 to buy Machine A, which generates revenue of $3,800 per year for 3 years, at which point it has a scrap value of $0. Third, it could use the $10,000 to buy Machine B, which generates revenues of $11,600 in year three, but nothing in years one and two. Machine B also has a scrap value of $0 after year 3. Rank the options from the highest return to the lowest. (5.13) Suppose you undertake an investment in which in exchange for $100 today, you will receive either $90 or $120 in a year, with equal probability. First, find the expected value and standard deviation of the investment. Second, suppose you borrow an additional $100 and double the investment. After repaying the loan, find the expected value along with the standard deviation of this investment. Third, find the expected value and standard deviation if you borrow enough to triple the investment. What pattern do you observe? (Ignore any interest on the borrowing you undertake to leverage the investment.) (5.14) Consider again the investment in problem 13. What amount of borrowing do you need to double your money if the good result occurs? At this level of borrowing, what happens if the bad outcome occurs? (6.2) Which of these $100 face value one-year bonds will have the highest yield to maturity and why? a. 6 percent coupon bond selling for $85. b. 7 percent coupon bond selling for $100. c. 8 percent coupon bond selling for $115. (6.10) Consider a one-year, 10-percent coupon bond with a face value of $1,000 issued by a private corporation. The one-year risk-free rate is 10%. The corporation has hit on hard times, and the consensus is that there is a 20% probability that it will default on its bonds. If an investor were willing to pay $775 for the bond, is that investor risk-neutral or risk averse?

(6.14) Consider the follow scenarios. Predict whether the bond supply and/or demand curves will shift and, if so, in what direction. Based on these predictions, in the domestic economy will the immediate effects be for interest rates to rise or fall? a. Due to aggressive monetary policy, the central bank raises expectations of inflation among investors. b. The government raises tax rates. c. The government of a foreign country announces that it may default on its debt. d. Housing markets become less liquid.