ECON 3311: MONEY & BANKING

HOMEWORK #6

Define the following:

Answer the following:

1. Assume that the average level of market interest rates is 10%. Use present value calculations to answer the following:

1. Would you rather have $200 today or receive $215 in one year?

1. Would you rather have $200 today or $220 in one year?

1. Would you rather receive $500 in one year or $575 in two years?

2. Consider a two-year debt instrument with a face value of $5,000 and an annual coupon payment of $125. Suppose prevailing interest rates in the economy are 4.0%.

1. Calculate the predicted price of this instrument. Does it sell for more (a premium) or less (a discount) than $5,000?

4. Calculate the nominal yield of this bond. How does it compare to the prevailing market interest rate of 4.0%? How does this comparison relate to whether the bond is sold at a premium or discount?

1. Calculate the current yield on this bond. Is the current yield higher or lower than the nominal yield?

1. Redo parts a – c if interest rates are 1.0%.

3. Now consider a four-year bond with a face value of $5,000 and an annual coupon payment of $125. Suppose prevailing interest rates in the economy are 4.0%.

1. Calculate the predicted price of this bond. Did the price change by more or less than what you found in part a of the previous question?

1. Given your answer to part a, which would you rather hold if interest rates in the economy are expected to decrease: long-term bonds or short-term bonds? Why?

4. We have seen that bond prices can be affected by changes in interest rates. Bond prices can also be affected by changes in inflation. Specifically, bond prices tend to decline with high inflation. Can you offer a reason for why this might happen? (HINT: Does a bond’s coupon payment change over time or stay fixed?)