《Financial Markets》课后习题解答

ANSWERS TO QUESTIONS FOR CHAPTER 1

(Questions are in bold print followed by answers.)

1. What is the difference between a financial asset and a tangible asset?

A tangible asset is one whose value depends upon certain physical properties, e.g. land, capital equipment and machines. A financial asset, which is an intangible asset, represents a legal claim to some future benefits or cash flows. The value of a financial asset is not related to the physical form in which the claim is recorded.

2.What is the difference between the claim of a debtholder of General Motors and an equityholder of General Motors?

The claim of the debt holder is established by contract, which specifies the amount and timing of periodic payments in the form of interest as well as term to maturity of the principal. The debt holder stands as a creditor and in case of default, he has a prior claim on firm assets over the equity-holder.

The equity holder has a residual claim to assets and income. He can receive funds only after other claimants are satisfied. Income is in terms of pidends, the amount and timing of which are not certain.

3. What is the basic principle in determining the price of a financial asset?

The price of any financial asset is the present value of the expected cash flows or a stream of payments over time. Thus, the basic variables in determining the price are: expected cash flows, discount rate and the timing of these cash flows.

4. Why is it difficult to determine the cash flow of a financial asset?

The estimation and determination of cash flows is difficult because of several reasons. These include accounting measures, possibility of default of the issuer, and embedded options in the security. Interest payments can also change over time. There is uncertainty as to the amount and the timing of these payments.

5. Why are the characteristics of an issuer important in determining the price of a financial asset?

The characteristics of the issuer are important because these determine the riskiness or uncertainty of the expected cash flows. These characteristics, which determine the issuer?s creditworthiness or default risk, have an impact on the required rate of return for that particular financial asset.

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6. What are the two principal roles of financial assets?

The first role of financial assets is to transfer funds from surplus spending units (i.e. persons or institutions with funds to invest) to deficit spending units (i.e. persons or firms needing funds to invest in tangible assets).

The second role is to redistribute risk among persons or institutions seeking and providing funds. Funds providers share the risks of expected cash flows generated by tangible assets.

7. In September 1990, a study by the U.S. Congress, Office of Technology Assessment, entitled ―Electronic Bulls & Bears: U.S. Securities Markets and Information Technology,‖ included this statement:

Securities markets have five basic functions in a capitalistic economy:

a.They make it possible for corporations and governmental units to raise capital.

b.They help to allocate capital toward productive uses.

c.They provide an opportunity for people to increase their savings by investing in

them.

d.They reveal investors’ judgments about the potential earning capacity of

corporations, thus giving guidance to corporate managers.

e.They generate employment and income.

For each of the functions cited above, explain how financial markets (or securities markets, in theparlance of this Congressional study) perform each function.

The five economic functions of a financial market are: (1) transferring funds from those who have surplus funds to invest to those who need funds to invest in tangible assets, (2) transferring funds in such a way that redistributes the unavoidable risk associated with the cash flow generated by tangible assets, (3) determining the price of financial assets (price discovery), (4) providing a mechanism for an investor to sell a financial asset (to provide liquidity), and (5) reducing the cost of transactions.

The five economic functions stated in the Congressional Study can be classified according to the above five functions:

1.“they make it possible for corporations and governmental units to raise capital”

--functions 1 and 2;

2.“they help to allocate capital toward productive uses” -- function 3;

3.“they provide an opportunity for people to increase their savings by investing in them”

-- functions 1 and 5;

4.“they reveal investors? judgments about the potential earning capacity of corporations,

thus giving guidance to corporate m anagers” --function 3;

5.“they generate employment and income” -- follows from functions 1 and 2 allowing Copyright ? 2010 Pearson Education, Inc. Publishing as Prentice Hall.1-2

those who need funds to use these funds to create employment and income

opportunities.

8. Explain the difference between each of the following:

a.money market and capital market

b.primary market and secondary market

c.domestic market and foreign market

d.national market and Euromarket

a.The money market is a financial market of short-term instruments having a maturity of one

year or less. The capital markets contain debt and equity instruments with more than one year to maturity;

b.The primary market deals with newly issued financial claims, whereas the secondary market

deals with the trading of season issues (ones previously issued in the primary market);

c.The domestic market is the national market wherein domestic firms issue securities and

where such issued securities are traded. Foreign markets are where securities of firms not domiciled in the country are issued and traded;

d.In a national market securities are traded in only one country and are subject to the rules of

that country. In the Euromarket, securities are issued outside of the jurisdiction of any single country. For example, Eurodollars are dollar-denominated financial instruments issued outside the United States.

9. Indicate whether each of the following instruments trades in the money market or the capitalmarket:

a.General Motors Acceptance Corporation issues a financial instrument with

four months to maturity.

b.The U.S. Treasury issues a security with 10 years to maturity.

c.Microsoft Corporation issues common stock.

d.The State of Alaska issues a financial instrument with eight months to

maturity.

a.GMAC issue trades in the money market.

b.U.S. security trades in the capital market.

c.Microsoft stock trades in the capital market.

d.State of Alaska security trades in the money market.

10. A U.S. investor who purchases the bonds issued by the government of France made the following comment: ―Assuming that the French government does not default, I know what the cash flow of the bond will be.‖ Explain why you agree or disagree with this statement. Copyright ? 2010 Pearson Education, Inc. Publishing as Prentice Hall.1-3

One would tend to disagree with this statement. Even though there is no default risk with French bonds issued by the government, some other risks include price risk and foreign exchange risk.

11. A U.S. investor who purchases the bonds issued by the U.S. government made the following statement: ―By buying this debt instr ument I am not exposed to default risk or purchasing power risk.‖ Explain why you agree or disagree with this statement.

This is not true. There is no default (credit) risk of U.S. government securities. However, it is not free of purchasing power or inflation risk. There is also price risk, which is related to maturity of any bond.

12. In January 1992, Atlantic Richfield Corporation, a U.S.-based corporation, issued $250 million of bonds in the United States. From the perspective of the U.S. financial market, indicate whether this issue is classified as being issued in the domestic market, the foreign market, or the offshore market.

The corporate bonds issued by Atlantic Corporation are in the domestic market, but the investors can also be from foreign markets.

13. In January 1992, the Korea Development Bank issued $500 million of bonds in the United States.From the perspective of the U.S. financial market, indicate whether this issue is classified as beingissued in the domestic market, the foreign market, or the offshore market.

This issue can be classified as a domestic issue.

14. 14.Give three reasons for the trend toward greater integration of financial markets throughout the world.

There are several reasons. These include:

a.Deregulation and/or liberalization of financial markets to permit greater participants from

other countries;

b.Technological innovations to provide globally-available information and to speed

transactions;

c.Institutionalization -- financial institutions are better able to persify portfolio and exploit

mis-pricings than are inpiduals.

15. What is meant by the ―institutionalization‖ of capital markets?

The term “institutionalization” refers to the dominance of large institutional investors such as pension funds, investment companies, banks, insurance companies, etc. in the money and capital markets.

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16.a. What are the two basic types of derivative instruments?

b. ―Derivative markets are nothing more than legalized gambling casinos and serve no

economic function.‖ Co mment on this statement.

a.The two basic types of derivative instruments are futures and options contracts. They are

called derivatives because their values are derived from the values of their underlying stocks or bonds.

b.The statement implies that derivative instruments can be used only for speculative purposes.

Actually, derivatives serve an important economic function by permitting hedging, which involves shifting risks on those inpiduals and institutions (speculators) that are willing to bear them.

17. What is the economic rationale for the widespread use of disclosure regulation?

The economic rationale is that disclosure mitigates the potential for fraud by the issuer. Typically, there information asymmetry between the issuer (management) and the investors, and disclosure regulation mitigates the harm to investors that could result from this informational disadvantage. As a result, there is confidence in the market and the pricing mechanism of the market.

18. What is meant by market failure?

Market failure occurs when the market cannot produce its goods or services efficiently. In the context of financial market failure, it occurs when the pricing mechanism fails and thus the supply and demand equilibrium is disrupted. This results in failure to price securities efficiently and reduced liquidity.

19. What is the major long-term regulatory reform that the U.S. Department of the Treasury has proposed?

The long-term proposal is to replace the prevailing complex array of regulators with a regulatory system based on functions. Specifically, there would be three regulators: (1) market stability regulator, (2) prudential regulator, (3) business conduct regulator.

20. Why does increased volatility in financial markets with respect to the price of financial assets, interest rates, and exchange rates foster financial innovation?

Increased volatility of the prices of financial assets has fostered innovation as investors and institutions seek ways to mitigate financial risk. Among other things, these innovations include the advancement of the modern derivatives markets.

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ANSWERS TO QUESTIONS FOR CHAPTER 2

(Questions are in bold print followed by answers.)

1. Why is the holding of a claim on a financial intermediary by an investor considered an indirect investment in another entity?

An inpidual?s account at a financial intermediary is a direct claim on that intermediary. In turn, the intermediary pools inpidual accounts and lends to a firm. As a result, the intermediary has a direct contractual claim on that firm for the expected cash flows. Since the inpidual?s funds have in essence been passed through the intermediary to the firm, the inpidual has an indirect claim on the firm. Two separate contracts exist. Should the inpidual lend to the firm without the help of an intermediary, he then has a direct claim.

2. The Insightful Management Company sells financial advice to investors. This is the only service provided by the company. Is this company a financial intermediary? Explain your answer.

Strictly speaking, the Insightful Management Company is not a financial intermediary, because it lacks the function of deposit taking and creating liabilities.

3. Explain how a financial intermediary reduces the cost of contracting and information processing.

Financial intermediaries can reduce the cost of contracting by its professional staff because investing funds is their normal business. The use of such expertise and economies of scale in contracting about financial assets benefits both the intermediary as well as the borrower of funds. Risk can be reduced through persification and taking advantage of fund expertise.

4. ―All financial intermediaries provide the same economic functions. Therefore, the same investment strategy should be used in the management of all financial intermediaries.‖ Indicate whether or not you agree or disagree with this statement.

Disagree. Although each financial intermediary more or less provides the same economic functions, each has a different asset-liability management problem. Therefore, same investment strategy will not work.

5. A bank issues an obligation to depositors in which it agrees to pay 8% guaranteed for one year. With the funds it obtains, the bank can invest in a wide range of financial assets. What is the risk if the bank uses the funds to invest in common stock?

Practically, it is not a valid statement as banks are not allowed to hold stocks. The bank has a funding risk. On the liability side, amount of cash outlay and timing are known with certainty (Type I). However, on the asset side, both factors are unknown. Thus, there is liquidity risk and price risk.

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6. Look at Table 2-1 again. Match the types of liabilities to these four assets that an inpidual might have:

a.car insurance policy

b.variable-rate certificate of deposit

c.fixed-rate certificate of deposit

d. a life insurance policy that allows the holder’s beneficiary to receive $100,000

when the holder dies; however, if the death is accidental, the beneficiary will

receive $150,000

a.Car insurance: neither the time nor the amount of payoffs are certain, which is Type IV

liability

b.Variable rate certificates of deposit: times of payments are certain, the amounts are not,

which is Type II liability.

c.Fixed-rate certificate of deposit: both times of payments and cash outflows are known, which

is Type I liability.

d.Life insurance policy: time of payout is not known, but the amount is certain, which is Type

III liability.

7. Each year, millions of American investors pour billions of dollars into investment companies, which use those dollars to buy the common stock of other companies. What do the investment companies offer investors who prefer to invest in the investment companies rather than buying the common stock of these other companies directly?

In investing funds with the investment companies, investors are reducing their risk via persification and the cost of contracting and information. These companies also provide liquidity to the investor.

8. In March 1996, the Committee on Payment and Settlement Systems of the Bank for International Settlements published a report entitled ―Settlement Risk in Foreign Exchange Transactions‖ that offers a practical app roach that banks can employ when dealing with settlement risk. What is meant by settlement risk?

Counterparty risk is that risk that a counterparty to a transaction cannot fulfill its obligation. It is related to settlement risk in that counterparty party risk bears on the question of whether settlement can take place or not.

9. The following appea red in the Federal Reserve Bank of San Francisco’s Economic Letter, January 25, 2002:

Financial institutions are in the business of risk management and reallocation, and they have developed sophisticated risk management systems to carry out these tasks.

The basic components of a risk management system are identifying and defining the risks the firm is exposed to, assessing their magnitude, mitigating them using a variety of procedures, and setting aside capital for potential losses. Over the past twenty years or so, financial institutions have been using economic modeling in Copyright ? 2010 Pearson Education, Inc. Publishing as Prentice Hall.1-8

earnest to assist them in these tasks. For example, the development of empirical models of financial volatility led to increased modeling of market risk, which is the risk arising from the fluctuations of financial asset prices. In the area of credit risk, models have recently been developed for large-scale credit risk management purposes.

Yet, not all of the risks faced by financial institutions can be so easily categorized and modeled. For example, the risks of electrical failures or employee fraud do not lend themselves as readily to modeling.

What type of risk is the above quotation referring to?

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.

10. What is the source of income for an asset management firm?

The sources of income are a fee based on assets under management, and sometimes a performance fee based on returns that meet certain benchmarks or targets.

11. What is meant by a performance-based management fee and what is the basis for determining performance in such an arrangement?

Performance based management fees are typically seen in hedge funds. Increasingly, they are also used by managers of asset management firms. These fees are fees based on performance that meet specified criteria.

12. a. Why is the term hedge to describe ―hedge funds‖ misleading?

b. Where is the term hedge fund described in the U.S. securities laws?

a.Hedge denotes hedging risk. Many hedge funds, however, do not use hedge as a strategy, and

these funds take significant risk in their attempt to achieve abnormal returns.

b.The term is not described in US securities laws, and hedge funds are not regulated by the

SEC.

13. How does the management structure of an asset manager of a hedge fund differ from that of an asset manager of a mutual fund?

Asset management firms are compensated by a fee on asset under management. Hedge funds are compensated by a combination of assets under management and a performance fees. Clearly, investment strategies of these firms will be different since hedge funds seek to generate abnormal returns.

14. Some hedge funds will refer to their strategies as ―arbitrage strategies.‖ Why would this be misleading?

Arbitrage means riskless profit. These opportunities are few and fleeting. Hedge funds take great Copyright ? 2010 Pearson Education, Inc. Publishing as Prentice Hall.1-9

risk. The arbitrage typically taken is where there is a disparity between the risk and the return, such as pricing disparities across markets.

15. What is meant by a convergence traded hedge fund?

A convergence trading hedge fund uses a strategy to take advantage of misalignment of prices or yields.

16. Wha t was the major recommendation regarding hedge funds of the President’s Working Group on Financial Markets?

The major recommendation was that commercial banks and investment banks that lend to hedge funds improve their credit risk management practices.

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ANSWERS TO QUESTIONS FOR CHAPTER 3

(Questions are in bold print followed by answers.)

1. Explain the ways in which a depository institution can accommodate withdrawal and loan demand.

A depository institution can accommodate loan and withdrawal demands first by having sufficient cash on hand. In addition it can attract more deposits, borrow from the Fed or other banks, and liquidate some of its other assets.

2. Why do you think a debt instrument whose interest rate is changed periodically based on some market interest rate would be more suitable for a depository institution than a long-term debt instrument with a fixed interest rate?

This question refers to asset-liability management by a depository institution. An adjustable rate can eliminate or minimize the mismatch of maturity risk. As interest rates rise, the institution would have to pay more for deposits, but would also receive higher payments from its loan.

3. What is meant by:

a.inpidual banking

b.institutional banking

c.global banking

a.Inpidual banking is retail or consumer banking. Such a bank emphasizes inpidual

deposits, consumer loans and personal financial trust services.

b.An institutional bank caters more to commercial, industrial and government customers. It

issues deposits to them and tries to meet their loan needs.

c. A global bank encompasses many financial services for both domestic and foreign customers.

It is much involved in foreign exchange trading as well as the financial of international trade and investment.

4.

a.What is the Basel Committee for Bank Supervision?

b.What do the two frameworks, Basel I and Basel II, published by the Basel

Committee for Bank Supervision, address regarding banking?

a.It is the organization that plays the primary role in establishing risk and management

guidelines for banks throughout the world.

b.The frameworks set forth minimum capital requirements and standards.

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5. Explain each of the following:

a.reserve ratio

b.required reserves

a.The reserve ratio is the percentage of deposits a bank must keep in a non-interest-bearing

account at the Fed.

b.Required reserves are the actual dollar amounts based on a given reserve ratio.

6. Explain each of the following types of deposit accounts:

a.demand deposit

b.certificate of deposit

c.money market demand account

a.Demand deposits (checking accounts) do not pay interest and can be withdrawn at any time

(upon demand).

b.Certificates of Deposit (CDs) are time deposits which pay a fixed or variable rate of interest

over a specified term to maturity. They cannot be withdrawn prior to maturity without a substantial penalty. negotiable CDs (large business deposits) can be traded so that the original owner still obtains liquidity when needed.

c.Money Market Demand Accounts (MMDAs) are basically demand or checking accounts that

pay interest. Minimum amounts must be maintained in these accounts so that at least a 7-day interest can be paid. Since many persons find it not possible to maintain this minimum (usually around $2500) there are still plenty of takers for the non-interest-bearing demand deposits.

7. How did the Glass-Steagall Act impact the operations of a bank?

The Glass-Steagall Act prohibited banks from carrying out certain activities in the securities markets, which are principal investment banking activities. It also prohibited banks from engaging in insurance activities.

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8. The following is the book value of the assets of a bank:

Asset Book Value (in millions)

U.S. Treasury securities $ 50

Municipal general obligation

bonds

50

Residential mortgages 400

Commercial loans 200

Total book value $700

a.Calculate the credit risk-weighted assets using the following information:

Asset Risk Weight

U.S. Treasury securities 0%

Municipal general obligation

bonds

20

Residential mortgages 50

Commercial loans 100

b.What is the minimum core capital requirement?

c.What is the minimum total capital requirement?

a.The risk weighted assets would be $410

b.The minimum core capital is $28 million (.04X700) i.e., 4% of book value.

c.Minimum total capital (core plus supplementary capital) is 32.8 million, .08X410, which is 8%

of the risk-weighted assets.

9. In later chapters, we will discuss a measure called duration. Duration is a measure of the sensitivity of an asset or a liability to a change in interest rates. Why would bank management want to know the duration of its assets and liabilities?

a.Duration is a measure of the approximate change in the value of an asset for a 1% change in

interest rates.

b.If an asset has a duration of 5, then the portfolio?s value will change by approximately 5% if

interest rate changes by 100 basis points.

10.

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a.Explain how bank regulators have incorporated interest risk into capital

requirements.

b.Explain how S&L regulators have incorporated interest rate risk into capital

requirements.

a.The FDIC Improvement Act of 1991, required regulators of DI to incorporate interest rate

risk into capital requirements. It is based on measuring interest rate sensitivity of the assets and liabilities of the bank.

b.The OST adopted a regulation that incorporates interest rate risk for S&L. It specifies that if

thrift has greater interest rate risk exposure, there would be a deduction of its risk-based capital. The risk is specified as a decline in net profit value as a result of 2% change in market interest rate.

11. When the manager of a bank’s portfolio of securities considers alternative investments, she is also concerned about the risk weight assigned to the security. Why?

The Basel guidelines give weight to the credit risk of various instruments. These weights are 0%, 20%, 50% and 100%. The book value of the asset is multiplied by the credit risk weights to determine the amount of core and supplementary capital that the bank will need to support that asset.

12. You and a friend are discussing the savings and loan crisis. She states that ―the whole mess started in the early 1980s.When short-term rates skyrocketed, S&Ls got killed—their spread income went from positive to negative. They were borrowing short and lending long.‖

a.What does she mean by ―borrowing short and lending long‖?

b.Are higher or lower interest rates beneficial to an institution that borrows short

and lends long?

a.In this context, borrowing short and lending long refers to the balance sheet structure of

S&Ls. Their sources of funds (liabilities) are short-term (mainly deposits) and their uses (assets) are long-term in nature (e.g. residential mortgages).

b.Since long-term rates tend to be higher than short-term ones, stable interest rates would be

the best situation. However, rising interest rates would increase the cost of funds for S&Ls without fully compensating higher returns on assets. Hence a decline in interest rate spread or margin. Thus lower rates, having an opposite effect, would be more beneficial.

13. Consider this headline from the New York Times of March 26, 1933: ―Bankers will fight Deposit Guarantees.‖ In this article, it is stated that bankers argue that deposit guarantees will encourage bad banking. Explain why.

The barrier imposed by Glass-Steagall act was finally destroyed by the Gramm-Leach Bliley Act of 1999. This act modified parts of the BHC Act so as to permit affiliations between banks and insurance underwriters. It created a new financial holding company, which is authorized to engage in underwriting and selling securities. The act preserved the right of state to regulate insurance activities, but prohibits state actions that have would adversely affected bank-affiliated Copyright ? 2010 Pearson Education, Inc. Publishing as Prentice Hall.1-14

firms from selling insurance on an equal basis with other insurance agents.

14. How did the Gramm-Leach-Bliley Act of 1999 expand the activities permitted by banks?

a.Deposit insurance provides a safety net and can thus make depositors indifferent to the

soundness of the depository recipients of their funds. With depositors exercising little discipline through the cost of deposits, the incentive of some banks owners to control risk-taking accrue to the owners. It becomes a “heads I win, tails you lose” situation.

b.One the positive side, deposit insurance provides a comfort to depositors and thus attracts

depositors to financial institutions. But such insurance carries a moral hazard, it can be costly and, unless premiums are risk-based, it forces the very sound banks to subsidize the very risky ones.

15. The following quotation is from the October 29, 1990 issue of Corporate Financing Week:

Chase Manhattan Bank is preparing its first asset-backed debt issue, becoming

the last major consumer bank to plan to access the growing market, Street

asset-backed officials

Said…Asset-backed offerings enable banks to remove credit card or other loan

receivables from their balance sheets, which helps them comply with capital

requirements.

a.What capital requirements is this article referring to?

b.Explain why asset securitization reduces capital requirements.

a.The capital requirements mentioned are risk based capital as specified under the Basel

Agreement, which forces banks to hold minimum amounts of equity against risk-based assets.

b.Securitization effectively eliminates high risk based loans from the balance sheet. The capital

requirements in the case of asset securitization are lower than for a straight loan.

16. Comment on this statement: The risk-based guidelines for commercial banks attempt to gauge the interest rate risk associated with a bank’s balance sheet.

This statement is incorrect. The risk-based capital guidelines deal with credit risk, not interest-rate risk, which is the risk of adverse changes of interest rates on the portfolio position.

17.

a.What is the primary asset in which savings and loan associations invest?

b.Why were banks in a better position than savings and loan associations to

weather rising interest rates?

a.Savings and Loans invest primarily in residential mortgages.

b.During 1980's, although banks also suffered from the effects of deregulation and rising

interest rates, relatively they were in a better position than S&L association because of their Copyright ? 2010 Pearson Education, Inc. Publishing as Prentice Hall.1-15

superior asset-liability management.

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18. What federal agency regulates the activities of credit unions?

The principal federal regulatory agency is the National Credit Union Administration. Copyright ? 2010 Pearson Education, Inc. Publishing as Prentice Hall.1-17

ANSWERS TO QUESTIONS FOR CHAPTER 9

(Questions are in bold print followed by answers.)

1. Your broker is recommending that you purchase U.S. government bonds. Here is the explanation: Listen, in these times of uncertainty, with many companies going bankrupt, it makes sense to play it safe and purchase long-term government bonds. They are issued by the U.S. government, so they are risk free. How would you respond to the broker?

U.S. Government bonds may be free of default risk, but they are not free from interest rate risk, which may cause the bond price to decline, resulting in a capital loss should the holder of bond sell it before maturity. Even then there is the inflation premium risk, which means that the principal may have less purchasing power at maturity than it does today.

2. You just inherited 30,000 shares of a company you have never heard of, ABD Corporation. You call your broker to find out if you have finally struck it rich. After several minutes, she comes back on the telephone and says: ―I don’t have a clue about these shares. It’s too bad they are not traded in a financial market. That would make life a lot easier for you. ‖What does she mean by this?

If the shares are traded on the market, and if the market is efficient, the current price would denote the value of the stock. Without market price information, share value would have to be approximated through other time-consuming and less reliable methods.

3. Suppose you own a bond that pays $75 yearly in coupon interest and that is likely to be called in two years (because the firm has already announced that it will redeem the issue early). The call price will be $1,050.What is the price of your bond now, in the market, if the appropriate discount rate for this asset is 9%?

P O= $75 (PVIFA) 2.09 + $1050 (PVIF) 2.09

= $75 X 1.7591 + $1050 X .8417 = $1015.72

4. Your broker has advised you to buy shares of Hungry Boy Fast Foods, which has paid a pidend of $1.00 per year for 10 years and will (according to the broker) continue to do so for many years. The broker believes that the stock, which now has a price of $12, will be worth $25 per share in five years. You have good reason to think that the discount rate for this firm’s stock is 22% per year, because that rate compensates the buyer for all pertinent risks. Is the stock’s present price a good approximation of its true financ ial value?

P O= $1 (PVIFA) 5.22 + $25 X (PVIF) 5.22 =.3715 = $12.15

The price is right, in fact the stock is slightly undervalued.

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5. You have been considering a zero-coupon bond, which pays no interest but will pay a principal of $1,000 at the end of five years. The price of the bond is now $712.99, and its required rate of return is 7.0%. This morning’s news contained a surprising development. The government announced that the rate of inflation appears to be 5.5% instead of the 4% that most people had been expecting. (Suppose most people had thought the real rate of interest was 3%.) What would be the price of the bond, once the market began to absorb this new information about inflation?

The nominal required rate of return is (real rate plus inflation) i r + i f or currently 3% plus 4% = 7%. If i f becomes 5.5% then the new required rate of return becomes 8.5%. The price of the bond would then be $1000/(1.085)5 or $665.05.

6. State the difference in basis points between each of the following:

a. 5.5% and 6.5%

b.7% and 9%

c. 6.4% and 7.8%

d.9.1% and 11.9%

a.100 basis points

b.200 basis points

c.140 basis points

d.280 basis points

7.

a.Does a rise of 100 basis points in the discount rate change the price of a 20-year

bond as much as it changes the price of a four-year bond, assuming that both bonds have the same coupon rate and offer the same yield?

b.Does a rise of 100 basis points in the discount rate change the price of a 4% coupon

bond as much as it changes the price of a 10% coupon bond, assuming that both

bonds have the same maturity and offer the same yield?

c.Does a rise of 100 basis points in the discount rate change the price of a 10-year

bond to the same extent if the discount rate is 4% as it does if the discount rate is

12%?

a.The price of the 20-year bond will fall more than that of the 4-year bond because there are

more years for the new discount to apply to the cash flows of the 20-year bond.

b.The price of the low coupon bond will change more due to the low amount of cash flows that

can be reinvested at the higher rate.

c. A change from the 4% base will lead to a larger change in price.

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8.

During the early 1980s, interest rates for many long-term bonds were above 14%. In the early 1990s, rates on similar bonds were far lower. What do you think this dramatic decline in market interest rates means for the price volatility of bonds in response to a change in interest rates?

Since the direction of the interest rate change is downward, price volatility should increase.

9.

a.What is the cash flow of a 6% coupon bond that pays interest annually, matures in

seven years, and has a principal of $1,000?

b.Assuming a discount rate of 8%, what is the price of this bond?

c.Assuming a discount rate of 8.5%, what is the price of this bond?

d.Assuming a discount rate of 7.5%, what is the price of this bond?

e.What is the duration of this bond, assuming that the price is the one you calculated

in part (b)?

f.If the yield changes by 100 basis points, from 8% to 7%, by how much would you

approximate the percentage price change to be using your estimate of duration in

part (e)?

g.What is the actual percentage price change if the yield changes by 100 basis points?

a.$60 a year interest for 7 years plus $1000 principal in year 7 for a total of $1420 in cash flow.

b. 5.2064 X $60 + .583 X $1000 = $895.38

c. 5.119 X $60 + .565 X $1000 = $872.14

d. 5.297 X $60 + .603 X $1000 = $920.82

e. D = $920-.82-$872.14

=$48.68/8.95=5.44

$895.38 (0.85-.075)

f.Applying the formula-D (change in yield) = -5.44 (.01) or a price increase of 5.42%.

g.Price at 8% =$895.88, at 7% = $946.06, so actual percentage change is ($946.06 -

$895.88)/$895.88=5.6%.

10. Why is it important to be able to estimate the duration of a bond or bond portfolio?

To answer this question, we must understand that duration is related to percentage price change.

A simple formula can be used to calculate the approximate duration of a bond or bond portfolio. All we are interested in is the percent price change of a bond when interest rates change by a small amount. To control interest rate risk, it is thus necessary to be able to measure it. Duration provides that measure.

Copyright ? 2010 Pearson Education, Inc. Publishing as Prentice Hall.1-20

11. Explain why you agree or disagree with the following statement: ―Determining the duration of a financial asset is a simple process.‖

Disagree. Determining the duration of a financial asset is not simple process. Because for most assets, the cash flow can change when interest rates change. Therefore, if a change in the cash flow is not considered, duration calculations can be misleading.

12. Explain why the effective duration is a more appropriate measure of a complex financial instrument’s price sensitivity to interest rate changes than is modified duration. Modified duration is derived with the assumption that cash flows do not change as interest rates change. Effective duration is calculated with the assumption of changing cash flows. For complex financial instruments? price sensitivity to interest rate changes could be very large. Hence, the importance of effective duration becomes sig

Copyright ? 2010 Pearson Education, Inc. Publishing as Prentice Hall.1-21

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