Question Description

PART I:Numerical Exercises.You must show your work and label all graphs carefully and legibly.Not showing your work will get you zero points on the question, even if your answer is correct. (26 points)

  • a.Assume the nominal interest rate is 17 percent and the expected rate of inflation is
  • Do the following present value problems.You must set up all present value problems before
  • Draw and label the bond market graph covered in chapter 5.Then, using the graph,
  • Suppose the interest rate on a taxable corporate bond is 4 percent while a municipal, tax exempt bond has an interest rate of 3 percent, and they are similar in every other way.
    • Assuming the income tax rate is 30 percent, calculate the after tax interest rate on the corporate bond.Is it higher or lower than the after tax return on the municipal bond?
    • What is the income tax rate that equalizes the after tax return between the corporate bond and the municipal bond.

12 percent.Calculate real rate of interest.

b.Now assume instead that the nominal interest rate is 4 percent and the expected rate of

inflation is minus 1 percent.Calculate the real rate of interest.

c. Assume the expected rate of inflation is 3 percent per year.What nominal interest rate

should you charge to receive a real interest rate of 2 percent per year?

calculation.Merely writing down the answer (even if it is correct) is an automatic zero.

You must show your work.

  • Suppose we have a four year fixed-payment loan with $1000 payments made at the end of each year.Given a market interest rate of 12 percent, how much was initially borrowed?

b.Suppose you were considering purchasing a $5000 machine today that would generate additional net profit of $2000 booked at the end of each year.Assuming you need a 15 percent return to justify the investment, would the investment be worth doing if you had only three years of payouts?Would your answer change if you had four years of $2000 payouts?Why or why not?

c.Consider two zero coupon bonds in which you receive $100 at the maturity date, one maturing in three years and one maturing in five years.Both are currently priced to yield 6 percent.Calculate the current market value of each bond.

illustrate how the equilibrium price, yield to maturity, and quantity changes as a result of:

a. a decrease in expected inflation.Explain the movement from one equilibrium to another. increase in riskiness of bonds.Explain the movement from one equilibrium to another.

  • an increase in the profitability of business investment.Explain the movement from one equilibrium to another.

Use a different graph for each one and clearly label the axis and the shifting of curves.Explain clearly (in words and on the graph) whether the price and yield to maturity increased or decreased.

4. You buy a bond that pays annual interest payments of 7% of the bond’s face value of $1000.

You initially pay $950 for the bond.You receive an annual interest payment after one year,

then sell the bond for $880.What is your total rate of return on the investment, expressed as

a percentage of the purchase price?

Part II:Essay Question

Answer this question.Feel free to bring in graphs or data into your analysis.In any case, limit your answers to no more than 2 pages (not including graphs or tables).(14 points)

From the end of 2009 to the end of 2019, the size of the United States National Debt held by the public grew from $6.8 trillion to $17.2 trillion.During the same period, the 10 year US Treasury Bond yield to maturity fell from 3.59% in December 2009 to 1.86% in December of 2019.Explain how such an increase in the supply of government bonds can lead to a fall in the interest rate.Second, consider that the 10 year bond rate has fallen further in 2020 to 0.68 percent on October 1, despite a further increase in the national debt ($20.5 trillion as of June 30, 2020) due to the decline in the economy and increase in federal government spending.Why has this continued in 2020 during an economic crisis?

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