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Chapter 4

SMG FE 442 Chapter Notes - Chapter 4: Business Cycle, Economic Equilibrium, Real Interest Rate


Department
Finance
Course Code
SMG FE 442
Professor
Mark Williams
Chapter
4

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3. Explain the relationship between risk-loving and risk-averse investors, and the strategy of
diversification.
A risk-averse person prefers stock in the sure thing to the riskier asset, even though the stock have the
same expected return. By contrast, a person who prefers risk is a risk- prefer or risk lover.
4. Amanda, a financial analyst, wants to hedge against the low interest rates charged by banks on her
saving account. Advise Amanda.
11. In the aftermath of the global financial crisis, U.S government budget deficits increased dramatically,
yet interest rates on U.S Treasury debt fell sharply and stayed low for many years. Does this make
sense? Why or why not?
After a recession, which is accompanied by deflation, the demand for bonds rises because the expected
return on real assets fell and thereby, raises the expected return on bonds and causes the demand curve
to shift to the right. The negative inflation also raises the real interest rate and therefore, the real cost of
borrowing for any given nominal rate, thereby causing the supply of bonds to contract and the supply
curve to shift to the left. The rightward shift of demand curve and leftward shift of the supply curve led
to a rise in the bond price and a fall in interest rates.
It makes sense because it is a fallacy to believe that lower interest rates are better. It shows that the
economy is in real trouble with falling prices
Chapter 4
Why Do Interest Rates Change?
Holding everything else constant, an increase in wealth raises the quantity demand of an asset
o Because of more resources available with which to purchase asset and so the quantity
of asset we demand increases
The expected return on an asset is the weighted average of all possible returns, where the
weights are the probabilities of occurrence of that return.
A irease i a asset’s epeted retur relative to that of a alterative asset, holdig
everything else unchanged, raises the quantity demanded of the asset.
Holdig everthig else ostat, if a asset’s risk rises relative to that of alternative assets, its
quantity demanded will fall.
The more liquid an asset is relative to alternative assets, holding everything else unchanged, the
more desirable it is, the greater will be the quantity demanded.
All these determining factors can be assembled in the theory of portfolio choice, which tells us
how much an asset people want to hold their portfolio.
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