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Econ 111 – Winter 2002 Professor Marjorie Flavin
Problem set 1
1. On January 1, 1998 Sue buys a 3-year Treasury bond for $3,000. This bond has a yearly coupon payment of $180 and a face value of $3,000.
a) What is the coupon rate of this bond?
b) What is its yield to maturity?
On January 1, 1999 Sue sells her bond to Jack. The night before Jack has read in the Wall Street Journal that the current yield to maturity of 2-year Treasury bonds is 5.5%.
c) Since Sue’s bond has exactly 2 years remaining until maturity, Jack will only buy the bond if it offers the same yield to maturity as newly issued 2-year Treasury bonds. At what price would Sue’s bond (on Jan 1, l999) provide a 5.5% yield to maturity? Sue sells Jack the bond at that price.
d) What is the coupon rate of Jack’s bond? Is it equal to the yield to maturity or not? Why?
e) What rate of return has Sue obtained from her investment?
f) Does Sue make a capital gain or a capital loss? How much is it?
On January 1, 2000 Jack offers to sell the bond to Sam for $3,005. According to the Wall Street Journal, one-year discount Treasury bonds now offer a yield of 5.75%.
g) Will Sam accept Jack’s offer? Why?
h) If Jack manages to sell the bond for $3,005, will he make a capital gain? Will the rate of return on his investment be equal to 5.5%?
2. Below are two verbatim statements taken from the “Credit Markets” column of the Wall St. Journal. For each statement, use the appropriate equation or the supply and demand for bonds graph that we used in class to demonstrate the point made in the quote.
a) “Early yesterday, the 30-year bond had moved sharply higher, mostly in response to weaker stocks in Tokyo, where the Nikkei 225 index closed down about 2.3%, and in London, where stocks were down about 1%.” (Note: the Nikkei 225 is an index of stock prices comparable to the Dow Jones Index in the NY stock exchange.)
b) “Observers also said demand for short maturity Treasurys was helped by speculation about the possibility of a rate cut by the Fed before [the end of the month].”
3. Holding other factors constant, how would an increase in people’s expectations of future real estate prices affect interest rates?
4. Consider ATT coupon bonds with a coupon rate of 8.25%, which mature in 2022. Suppose that today, at 4 p.m., Alan Greenspan makes a statement in which he predicts that interest rates will be substantially higher next year and “the market” believes his prediction. What will be the effect of Greenspan’s statement on the price of the ATT coupon bonds? What will be the effect on their yield?
5. Who is Alan Greenspan, and why should anyone pay attention to his statements about future interest rates?