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Econ 111 – Winter 2002Professor Marjorie Flavin

Problem set 1: Sketch of solutions

1.a) Coupon rate

b)Yield to maturitycoupon rate

Proof:

c)

d) Coupon rate

Reason: . Specifically, < coupon rate.

e) RET

f) capital gain

g) Sam accepts Jack’s offer

Reason: Jack’s price is cheaper than current price for a one-year bond that yields 5.75%.

h) capital loss

RET

  1. a) The statement that the “30 year bond had moved sharply higher” means that bond prices moved higher. The statement refers to stock prices falling in Tokyo and London, so I would interpret the analyst as saying that there was a decline in the attractiveness of stocks, either because the expected return to stocks had fallen or because the risk associated with stocks had risen, and therefore investors reallocated their portfolios away from stocks and toward bonds. That is, the demand curve for bonds shifted right because an alternative asset, stocks, was perceived as less attractive.

b) This statement says that market participants speculated that sometime between now and the end of the month, the Fed would reduce interest rates. The speculation that the Fed will reduce interest rates in the near future is speculation that bond prices will rise in the near future. Holding constant the bond’s face value and coupon rate, higher expected future bond prices imply a higher expected holding period return. As we showed in class, higher expected holding period returns (in this case because of an expected capital gain) shift the bond demand curve to the right.

  1. Real estate (houses, office buildings, land, etc), bonds, and stocks are among the various assets people can invest in. An increase in people’s expectations of future real estate prices causes an increase in the expected return to housing as an asset, and shifts to the right the demand for real estate. In terms of the market for bonds, an increase in the expected return to an alternative asset (real estate) shifts the demand for bonds to the left. Since the supply of bonds is one of the factors held constant, the price of bonds falls, and hence the interest rate rises.
  1. In this kind of problem, it is useful to consider, first, what is happening (or expected to happen) in the future, then consider the present. At the point in the future that interest rates rise, bond prices will fall (the famous inverse relation). Thus Greenspan’s announcement causes people to reduce their expectations of the future price of bonds. For a given ATT bond, with fixed coupon rate, face value, and maturity date, a reduction in the expected future value of the bond reduces its expected return (or expected holding period return). The lower expected return causes the demand for the bonds to shift left, so that their price falls and yield rises.
  1. Alan Greenspan is the Chairman of the Board of Governors of the Federal Reserve System. Since he, together with the other Governors of the Federal Reserve System, determine US monetary policy, his decisions have enormous influence on the path of interest rates.