Ch5-Q4 Assume that the economy can experience high growth, normal growth, or recession.

Your expectation is that, under these conditions, the stock market return for the coming year: State of the Economy Probability Return High Growth 0.2 +30% Normal Growth 0.7 +12% Recession 0.1 -15% a. Compute the expected value of a $1000 investment both in dollars and as a percentage over the coming year. b. Compute the standard deviation of the return as a percentage over the coming year. c. If the risk-free return is 7%, what is the risk premium for a stock market investment? Answer: a. Expected Value = 0.2($1000)(1+30%) + 0.7($1000)(1+12%) + 0.1($1000)(1-15%) = $1129 Expected Return = 0.2(30%) + 0.7(12%) + 0.1(-15%) = 12.9% b. Standard Deviation = 0.2(30 12.9%) 2 + 0.7(12 12.9%) 2 + 0.1(15 12.9%) 2 = 11.7% c. Risk Premium = 12.9% - 7% = 5.9% Ch5-Q17 Consider an investment that pays off $800 or $1400 per $1000 invested with equal probability. Suppose you have $1000 but are willing to borrow to increase your expected return. What would happen to the expected value and standard deviation of the investment if you borrowed an additional $1000 and invested a total of $2000? What if you borrowed $2000 to invest a total of $3000? Answer: If you just invest your own $1000, the EV = 0.5(800)+0.5(1400)=1,100 or 10% and the SD = 300 If you borrow an additional $1000, the EV = 0.5(1600-1000) +0.5(2800-1000) = 1,200 or 20%. You have doubled the expected return. The SD = [.5(600-1200)2+.5(1800-1200)2 ]1/2 = 600. The standard deviation has also doubled. If you borrowed $2000 to invest a total of $3000, the EV = 0.5(2400-2000) +0.5(4200-2000) = 1,300 or 30%. You have tripled the expected return versus the un-

leveraged investment. The SD = [.5(400-1300)2+.5(2200-1300)2 ]1/2 = 900. The standard deviation has tripled versus the un-leveraged investment. *You can confirm your answer using the leverage ratio. Ch6-Q6 A 10-year zero-coupon bond has a yield of 6 percent. Through a series of unfortunate circumstances, expected inflation rises from 2 percent to 3 percent. a. Compute the change in the price of the bond. b. Suppose that expected inflation is still 2 percent, but the probability that it will move to 3 percent has risen. Describe the consequences for the price of the bond. Answer: a. Price (with 2% expected inflation) = 100/(1.06)10 = $55.84 Price (with 3% expected inflation) = 100/(1.07)10 = $50.83 The price has fallen by $5.01 b. There is increased inflation risk. Investors will require compensation for taking on additional risk, so the price will fall and the yield will rise. Ch6-Q14 Use the model of supply and demand for bonds to illustrate and explain the impact of each of the following on the equilibrium quantity of bonds outstanding and on equilibrium bond prices and yields: a. A new web site is launched facilitating the trading of corporate bonds with much more ease than before. b. Inflationary expectations in the economy fall evoking a much stronger response from issuers of bonds than investors in bonds. c. The government removes tax incentives for investment and spends additional funds on a new education program. Overall, the changes have no affect on the governments financing requirements. d. All leading indicators point to stronger economic growth in the near future. The response of bond issuers dominates that of bond purchasers. Answer: a) The new web site would increase the relative liquidity of bonds, shifting the bond demand curve to the right, increasing the equilibrium price of bonds and reducing yields. The equilibrium quantity of bonds outstanding rises.

b) For a given nominal interest rate, a fall in inflationary expectations increases the real interest rate, shifting the bond supply curve to the left and the bond demand curve to the right. If the response of the bond issuers is relatively stronger, the supply curve shift will dominate and the quantity of bonds outstanding will fall. Regardless of the relative size of the shifts, the equilibrium price of bonds will rise and yields will fall.
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c) The removal of tax incentives on investment would make investment more costly, reducing the supply of bonds by corporations and shifting the supply curve to the left. As there is no change in the financing requirements of the government, the supply of government bonds doesnt change. Equilibrium quantity falls. Equilibrium bond prices rise and yields fall. d) A business cycle upturn increases business investment opportunities, shifting the bond supply curve to the right. Wealth also increases, shifting the bond demand curve to the right. If the supply shift dominates, equilibrium bond prices fall and yields rise. The equilibrium quantity of bonds outstanding increases.

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Ch6-Q17 Suppose there is an increase in investors willingness to hold bonds at a given price. Use the model for the demand and supply of bonds to show that the impact on the equilibrium bond price depends on how sensitive the quantity supplied of bonds is to

the bond price. Answer: The sensitivity of bond supply to changes in the price of bonds is reflected in the slope of the supply curve. The more sensitive quantity supplied is to a movement in the price, the flatter the supply curve and the smaller the impact on the equilibrium price for any given shift in the demand curve.

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Ch7-Q5 Suppose that the interest rate on one-year bonds is 4 percent today, and is expected to be 5 percent one year from now and 6 percent two years from now. Using the Expectations Hypothesis, compute the yield curve for the next 3 years. Answer: Yield for one-year bond = 4% Yield for two-year bond = (4% + 5%)/2 = 4.5% Yield for three-year bond = (4% + 5% + 6%)/3 = 5%
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Ch7-Q15

Suppose a country with struggling economy suddenly discovered vast quantities of valuable minerals under government-owned land. How might the governments bond rating be affected? Using the model of demand and supply for bonds, what would you expect to happen to the bond yields of that countrys government bonds? Answer: The ratings of the bonds would likely be upgraded, as the economic outlook for the economy would improve and the reduction in the perceived riskiness of the bonds would shift the demand curve to the right. Revenues from the minerals could also mitigate the governments need to borrow, shifting the supply of bonds to the left. Bond prices would increase and yields would fall. Ch8-Q3 A stock that sells for $100 entitles you to a dividend payment of $4 today. You estimate that the growth rate of the firms dividends is about 2 percent per year, and that the risk-free rate is 3 percent. What is the risk premium suggested by the price of this stock? Does it strike you as high or low? How would your answer change if the stock price were $150 instead of $100? Answer: If the price is $100: $100 = $4(1.02) 3.5% + rp 2% rp = 2.58%

The risk premium is lower than the historical average of 4%. $4(1.02) If the price is $150: $150 = rp = 1.22% 3.5% + rp 2% The risk premium is much lower than the historical average of 4%. Ch8-Q11 You are thinking about investing in stock in a company who paid a dividend of $10 this year and whose dividends you expect to grow at 4% a year. The risk free rate is 3% and you require a risk premium of 5%. If the price of the stock in the market is $200 a share, should you buy it? Answer: Yes. Using the dividend discount model, you are willing to pay: P = 10(1.04)/(0.08-.04) = $260 per share. As the asking price in the market is below this, you should buy the stock. Ch10-Q4 The same television set costs $500 in the United States, 450 in France, 300 in United Kingdom, and 100,000 in Japan. If the law of one price holds, what are the

euro-dollar, pound-dollar, and yen-dollar exchange rates? Why might the law of one price fail? Answer: If the law of one price holds, then the euro/dollar exchange rate should be 450/$500 = 0.9/$, the pound/dollar exchange rate should be 300/$500 = 0.6/$, and the yen/dollar exchange rate should be 100,000/$500 = 200/$. The law of one price may fail because of transportation costs, tariffs, and technical specifications. Ch10-Q13 Using the model of demand and supply for U.S. dollars, what would you expect to happen to the U.S. dollar exchange rate if, in light of a worsening geopolitical situation, Americans viewed foreign bonds as more risky than before? (You should quote the exchange rate as number of units of foreign currency per U.S. dollar.) Answer: If Americans view foreign bonds as more risky than before, they will reduce their demand for these bonds. There will be a fall in the supply of dollars Americans use to purchase foreign assets, shifting the supply curve to the left. The exchange rate, quoted as the number of units of foreign currency per U.S. dollar, will rise, reflecting an appreciation of the U.S. dollar. Ch10-Q14 In recent times, the Chinese central bank has been buying US dollars in the market in an effort to keep its own currency, the yuan, weak. Use the model of demand and supply for dollars to show what the immediate effect would be on the yuan/dollar exchange rate of a decision by China to allow its currency to float freely. Answer: If the Chinese central bank stopped purchasing US dollars in the market, there would be a shift to the left in the demand curve for dollars, leading to a fall in the number of yuans per dollar in equilibrium. In other words, the yuan would appreciate against the US dollar. Ch10-Q15 In the aftermath of the World Baseball Classic, demand for US-produced baseball paraphernalia skyrocketed in Italy and the Netherlands. What impact would this have on the euro-dollar exchange rate in the short run? Answer: The increase in foreign preference for American goods would shift the demand curve for dollars to the right and the US dollar would appreciate.

Ch10-Q16 Suppose consumers across the world (including in the US), driven by a wave of national pride, decided to buy home-produced products where possible. How would demand and supply for dollars be affected? What can you say about the impact on the equilibrium dollar exchange rate? Answer: A fall in foreign demand for US goods would shift the demand curve for dollars to the left while the fall in US demand for foreign goods would shift the supply curve for dollars to the left. The overall impact on the dollar exchange rate depends on which shift dominates. As the economy of the world outside the US is larger than the US economy, you might expect the demand shift to dominate, leading to a depreciation of the dollar.
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