ECON 209 Lecture Notes - Lecture 8: Ceteris Paribus, Economic Equilibrium, Root Mean Square

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copperotter197

23 Nov 2017

School

McGill University

Department

Economics

Course

ECON 209

Professor

Mayssun El- Attar Vilalta

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Chapter 28 -money, interest rates, and economic activity. Suppose a bond pays 10% at the end of each of three years, at which point it is redeemed. A more risky investment will have a yield greater than the interest rate in the market. Consider a competitive market for bonds: buyers should be prepared to pay no more than the bond"s pv, sellers should not be prepared to accept no less than the bond"s pv. The equilibrium market price of a bond should be the pv of the stream of income generated by the bond. As the bond price falls, its yield or return rises and thus the demand for that bond increases. Bond riskiness: an increase in the riskiness of an bond leads to a decline in its expected pv, and thus a decline in the bond"s price and an increase in the yield (the interest payed by the bond)

Related Questions

1) Assets can be classified in 3 ways according to its liquidity. However, such assets do not include homes, jewelry, vehicles, etc. Why? (use three sentences maximum)

2) People often like to visit flea markets to look for unexpected opportunities. Flea markets also typically use cash. Explain why this is an example of the liquidity demand for money.

3) What would happen to the supply of money if a central bank purchased long-term government bonds held by the public?

4) If investors began to think the stock market is becoming less risky, how will this belief affect the demand for money? Would this more likely affect M1 or M2?

5) Suppose the interest rate on a two-year bond was higher than the interest rate on a one-year bond. What does the market believe will happen next year to one-year interest rates?

This assignment requires the following knowledge: For k different events, if the probability that each of them happens is p (0 < p < 1) and all events happen independently, the probability that all events happen together is p^k.
1. Five firms, namely A, B, C, D and E, issue discounted bonds with face value $1,000 and maturity 5 years in the market. All firms are pretty risky and each of them has a chance of 0.5 of collapse during the five years (thus bankrupted and can not pay back the bond accordingly). The bonds are all sold at an interest rate of 50% (the value is not surprising due to the extremely high risk of default).
(1) What is the present value of the bond given the interest rate, the face value and the maturity? Hint: we temporarily do not consider the issue of default.
(2) Say now you buy one bond from each of the five firms, what is the total amount you lend out today? Eventually only one firm does not fail and pays back the bond, what is the money you collect back 5 years later? You gain or loss in this case? If more than one firm pays back the bond, will you get more money back?
(3) What is the chance (probability) that you get nothing back assuming that firms fail independently? Together with the answer in (2), is it a good deal to buy one bond from each of the five firms?
(4) Repeat (2) and (3) with the only difference that now you buy 5 bonds from a single firm.
(5) Now we assume that the five firms all have similar businesses in Greece (and those are their only businesses), therefore, all firm fail together if the economy in Greece fails. Will you answer in (3) change?

1) A $1,000 par value bond, paying $50 semiannually, with an 8 percent yield to maturity and five years remaining to maturity should sell for ________.

2) Your investment has a 40% chance of earning a 12% rate of return, a 50% chance of earning an 8% rate of return, and a 10% chance of losing 3%. What is the standard deviation of this investment?

3) You purchased a share of stock for $59. One year later you received $5.25 as a dividend and sold the share for $58. Your holding-period return was _________.

4) An insurance company purchases corporate bonds in the secondary market with six years to maturity. The total par value is $55 million. The coupon rate is 11 percent, with annual interest payments. If the expected required rate of return in 4 years is 9 percent, what will the market value of the bonds be then?

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ECON 209 Lecture Notes - Lecture 8: Ceteris Paribus, Economic Equilibrium, Root Mean Square

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