2020 Exam One

"Trust" in corporate/finance context primarily means:

E - Confidence created by enforceable contracts, repeat interactions, and credible monitoring. In finance/governance, trust is institutional: contracts, enforcement, reputation, monitoring—rather than blind faith.

(a) Number of expected monthly payments declines, so annuity price falls. (b) Price rises as each payment is larger. (c) Purchaser expected to live longer, so number of expected payments rises and price rises.

Question 5 Class 02 Part 04 - Annuity pricing factors

(a) T-bill paying in three months is more valuable (sooner payment). (b) T-bill is more valuable (higher likelihood of U.S. government honoring debts). (c) Insurance policy paying when ill is more valuable (payment most needed then).

Question 14 Class 02 Part 04 - Asset valuation comparisons

(a) Tomatoes are perishable, won't serve as store of value. (b) Bricks are heavy, bulky, break easily, not easily divisible. (c) Cattle aren't standardized in weight and other characteristics.

Question 7 Class 02 Part 03 - Why items fail as money

A $1,000 payment will be received in 3 years. The annual discount rate is 6%. Which of the following statements is correct?

B - Its present value is $1,000 divided by (1.06)³. PV = FV ÷ (1 + i)^n. PV decreases as discount rate or time increases.

A 10-year zero-coupon bond and a 10-year coupon bond have the same face value. Which is more sensitive to changes in interest rates, all else equal?

A - With no coupons, all cash flow is pushed to maturity, giving longer duration and greater price sensitivity to interest-rate changes.

A bond has a 6% coupon rate and is trading above par. Which inequality must hold?

C - YTM < Current yield < Coupon rate. For premium bond, coupon rate is highest, current yield middle, YTM lowest.

A bond with most of its cash flows occurring far in the future is less sensitive to interest rate changes than a bond with earlier cash flows.

FALSE - Further into future cash flows occur, more sensitive their PVs are to interest rate changes. Longer-duration bonds are more price-sensitive.

A commercial bank offers a savings account with a 5% nominal annual interest rate, compounded quarterly. Which of the following calculations would correctly provide the Equivalent Annual Rate (EAR)?

B - EAR = (1 + .05/4)⁴ − 1 computes the effective annual rate from a 5% nominal rate compounded quarterly.

A core function of the board of directors is to monitor management on behalf of shareholders and hire/fire the CEO.

True - Oversight, CEO selection/removal, strategy approval, and fiduciary duties (care/loyalty) are central board responsibilities.

A dollar received today is worth more than a dollar received one year from now primarily because

D - You can invest the dollar today and earn interest (opportunity cost of waiting), so its present value is higher than an otherwise identical dollar received later.

A fixed-payment loan is not really a bond because payments include principal, not just interest.

FALSE - Although payments include principal, fixed-payment loan is still valued using bond math—PV of future cash flows.

A market order and a limit order can never execute at the same price.

False - While they serve different purposes, they can sometimes execute at same price. A marketable limit order placed at or above current ask (for buy) or at or below current bid (for sell) will execute immediately—like a market order—at same price. Key difference: limit order includes price constraint, market order doesn't.

A market order prioritizes speed of execution over price control, while a limit order prioritizes price control over the certainty of execution.

True - Market order executes immediately at best available price, used when speed is most important—but might get worse price if market is volatile or illiquid. Limit order only executes at specified price or better—gives price control but no guarantee it will be filled.

A nominal return of 8% is always preferable to a nominal return of 6%, regardless of inflation.

FALSE - What matters is real return r = i − πᵉ. If inflation is higher with 8% nominal return, real return could be lower.

A project costs $1,000 today and promises $300 per year for 5 years. The IRR is the discount rate at which:

B - The project's net present value (NPV) is zero. IRR is the discount rate that sets NPV = 0.

A rise in government deficits shifts the bond demand curve rightward, raising prices and lowering yields.

False - Rise in government deficits increases supply of bonds, shifting supply curve rightward, lowering prices and raising yields. Statement incorrectly describes as demand effect.

A typical US corporate bond with a 10% coupon rate (paid semi-annually) is trading at a premium. The yield to maturity is 9.5% and the bond has exactly 8 years until maturity. What is the bond's price per $100 face value?

D - Because the coupon rate (10%) exceeds the YTM (9.5%), the bond must trade at a premium; discounting the semiannual coupons ($5 for 16 periods) and $100 face value at 4.75% per half-year gives a price of about $103.52.

A unit of account can function even if physical cash is no longer used as a means of payment.

TRUE - A unit of account is a standard for quoting prices and recording debts and does not require physical cash to be used in transactions. Prices can still be denominated in dollars even in a fully electronic payments system.

A zero-coupon bond always sells at a discount to par.

TRUE - Zero-coupon bond makes no coupon payments, so price must be below face value until maturity.

Advantage: family/friends naturally have more information about you. Disadvantage: finding someone with funds available at that time. Financial institutions help bring borrowers and lenders together (Core Principle 4).

Question 19 - True statement from Class 02

Advantage: paper currency facilitates anonymity, protecting freedom and privacy. Issuing currency generates seignorage revenue for governments. Disadvantage: criminals benefit from anonymity, particularly with large-denomination notes.

Question 23 Class 02 Part 03 - Paper currency tradeoffs

Alternative payment methods include credit/debit cards and mobile payment services like Venmo and Apple Pay.

Question 5 - True statement from Class 02

An economy might revert to barter when the public loses confidence in fiat money issued by government, perhaps due to over-use of printing presses.

Question 11 Class 02 Part 03 - Barter reversion condition

An empirical approach to studying finance is far superior to a theoretical (normative) approach.

Uncertain - Both approaches are essential. Empirical work tests theories in real-world data. Theoretical models structure thinking and guide analysis. Each has weaknesses if used in isolation.

An increase in nominal interest rates ensures that investors' purchasing power grows faster.

UNCERTAIN - Higher nominal interest rates only increase purchasing power if they reflect higher real interest rates rather than higher expected inflation, so purchasing power may rise, fall, or remain unchanged depending on inflation.

Analyze bond market effects of various scenarios. a. New website increases relative liquidity of bonds, shifting demand curve right, increasing equilibrium price and reducing yields. Equilibrium quantity rises. b. Fall in inflationary expectations increases real interest rate, shifting supply curve left and demand curve right. If bond issuer response is relatively stronger, supply shift dominates and quantity falls. Regardless of relative shift sizes, equilibrium price rises and yields fall. c. Removal of tax incentives on investment makes investment more costly, reducing bond supply by corporations, shifting supply curve left. No change in government financing requirements, so government bond supply doesn't change. Equilibrium quantity falls. Bond prices rise, yields fall. d. Business cycle upturn increases business investment opportunities, shifting supply curve right. Wealth also increases, shifting demand curve r

Question 16 Class 04 Part 02 - Bond market scenario analysis

At present, the Federal Reserve directly controls:

A - The reserves of the major banks. The Federal Reserve influences money supply and short-term rates primarily through control of bank reserves and policy rates, not prime rate or long-term rates.

Automobile insurers need funds readily available when policyholders make claims; T-bills are highly liquid. Life insurance companies have much longer-horizon liabilities. A life policy expected to pay off in 30 years corresponds to longer-term liabilities. Insurers can limit risks by matching terms of liabilities with terms of assets.

Question 13 Class 02 Part 04 - Insurance asset allocation

Because U.S. Treasury bonds have no default risk, an investor who holds a Treasury bond until maturity is guaranteed to earn a positive real return regardless of changes in inflation or market interest rates.

FALSE - While U.S. Treasuries eliminate default risk, high or unexpected inflation can erode purchasing power, so holding a Treasury bond to maturity does not guarantee a positive real return.

Because a dollar today is worth more than a dollar tomorrow, higher market interest rates reduce the present value of future cash flows, which in turn causes asset prices to rise.

FALSE - Higher market interest rates increase the discount rate applied to future cash flows, which lowers their present value and therefore reduces asset prices rather than raising them.

Bond prices when government reduces military spending?

Government's need to issue bonds to finance military spending is reduced, so supply of government bonds falls, shifting supply curve left. Bond prices increase, yields fall.

Brad Katsuyama and Michael Lewis argued that U.S. stock markets were "rigged" because high-frequency traders were manipulating prices and engaging in illegal trading practices.

False - Katsuyama and Lewis argued markets were "rigged" because HFTs were exploiting advantages like speed, co-location, and fragmented markets to get ahead of slower traders—not necessarily illegal practices. The unfairness lay in system design, not overt criminal behavior. They thought behavior was extremely unethical and couldn't believe actions weren't illegal.

CPI = (Cost of basket in current year ÷ Cost of basket in base year) × 100. Year 1 (base): CPI = 100 Year 2: CPI = (42 ÷ 40) × 100 = 105 Year 3: CPI = (46 ÷ 40) × 100 = 115. Inflation Year 2 = (105 - 100) ÷ 100 × 100 = 5.0% Inflation Year 3 = (115 - 105) ÷ 105 × 100 = 9.5%

Question 24b Class 02 Part 03 - CPI and inflation calculation

Calculate FV of $100 at 7% and 4% for 5, 10, 15 years. At 7%: FV₅ = $100 × (1.07)⁵ = $140.26; FV₁₀ = $196.72; FV₁₅ = $275.90 At 4%: FV₅ = $100 × (1.04)⁵ = $121.67; FV₁₀ = $148.02; FV₁₅ = $180.09

FV is higher for any time horizon when interest rate is higher. FV at given rate increases further into future due to additional years earning interest. Additional benefit of longer horizon is greater when interest rate is higher, reflecting compounding.

Calculate PV of $100 in 6 months, 5 years, 10 years at 5%. PV₀.₅ = 100/(1.05)⁰·⁵ = $97.59; PV₅ = 100/(1.05)⁵ = $78.35; PV₁₀ = 100/(1.05)¹⁰ = $61.39

Further into future the investment is to be made, more time available to earn interest on current investment to reach $100 target, therefore lower the PV of $100.

Calculate PV of 5-year 5% coupon bond, $1,000 face value, at i = 3%, 4%, 2%. i = 3%: PV = $50/(1.03) + $50/(1.03)² + $50/(1.03)³ + $50/(1.03)⁴ + $1,050/(1.03)⁵ = $1,091.59 i = 4%: PV = $1,044.52 i = 2%: PV = $1,141.40

PV falls when rate rises to 4%. PV rises when rate falls to 2%.

Calculate PV of college education costs. a. PV = $125,000/(1.05)¹⁸ = $51,940.08 b. PV = $125,000/(1.10)¹⁸ = $22,482.35 c. If price rises 3% per year: $125,000 × (1.03)¹⁸ = $212,804.13 PV = $212,804.13/(1.08)¹⁸ = $53,254.03 d. $125,000 = x(1.05)¹⁸ + x(1.05)¹³

Question 9 Class 03 Part 01 - College costs PV

Calculate YTM for three bonds: (a) 6% coupon at $85, (b) 7% coupon at $100, (c) 8% coupon at $115. a. 85 = 6/(1 + i) + 100/(1 + i) → i = 24.71% b. 100 = 7/(1 + i) + 100/(1 + i) → i = 7% c. 115 = 8/(1 + i) + 100/(1 + i) → i = -6.1%

Option (a) has highest YTM. YTM depends on both coupon payment and capital gain/loss. (a) has lowest coupon but sells below face value (capital gain). (b) sells at face value (no capital gain). (c) sells above face value (capital loss).

Calculate minimum annual cash flow from $2,000 investment. a. $2,000 = x/(1 + i) + x/(1 + i)² + x/(1 + i)³ b. $2,000 = x/(1 + i) + x/(1 + i)² + x/(1 + i)³ + $250/(1 + i)³ c. x = $2,000/[1/(1.1) + 1/(1.1)² + 1/(1.1)³] = $804.23

Question 8 Class 03 Part 01 - Annuity cash flow calculation

Calculate monthly mortgage payment at 8% interest. Monthly rate: (1.08)^(1/12) - 1 = 0.006434 C = ($100,000 × 0.006434)/[1 - (1/1.006434)³⁶⁰] = $714 Payments rose by ($714 - $651)/$651 = 9.7%; interest rate rose by (8% - 7%)/7% = 14.3%

Question 10 Class 03 Part 01 - Mortgage payment calculation

Cash has advantages because no information is needed about the payer once cash is handed over. Information costs are negligible. Cash allows anonymity for one or both parties.

Question 6 - True statement from Class 02

Central banks moderate business cycles by adjusting interest rates and have tools to steady fragile financial systems. Reducing volatility reduces risks individuals can't eliminate, allowing investment in the future, promoting growth.

Question 20 - True statement from Class 02

Choose $1,000 today (Core Principle 1: time has value). By receiving money today, you can immediately put it to use—buy something or earn interest. Waiting involves opportunity cost.

Question 11 - True statement from Class 02

Commercial banks receive deposits and borrow, using funds to make loans and purchase government securities. Insurance companies receive premiums, investing in securities/assets to earn income until claims paid. Investment banks charge fees for advising on M&A and preparing new issues, may participate in IPOs they distribute. Pension funds receive regular contributions, investing in assets for retirement benefits.

Question 12 Class 02 Part 04 - Financial institution functions

Compare 30% return over 5 years vs. 0.5% per month for 5 years. First investment annual rate: (1.30)^(1/5) - 1 = 5.39% Second investment annual rate: (1.005)¹² - 1 = 6.17%

Choose second investment (0.5% per month for five years). Second investment 5-year rate: (1.005)⁶⁰ - 1 = 34.88%—higher than 30%.

Compare consol to 10-year coupon bond when both have same PV?

If i = 5%, PV of payment flows for both bonds would be $100. While consol makes coupon payments forever, 10-year bond pays back principal at maturity, which can be reinvested. Assuming no reason to believe rates will rise or fall over 10-year period, you'd be indifferent. If certain rates will be higher in ten years, prefer 10-year bond (reinvest proceeds at higher rate; consol value would fall). If certain rates will be lower, prefer consol.

Compare lending scenarios: nominal 6% with 4% inflation vs. nominal 5% with 2% inflation. First scenario: real rate = 2% (6% - 4%) Second scenario: real rate = 3% (5% - 2%)

Lender wants high real return, so would rather lend at 3% real (5% nominal). Borrower wants low real rate, so would rather borrow at 2% real (even though 6% nominal).

Considering two worlds, X (Production opportunity exists; no capital markets) and Y (Yes capital markets; no production opportunity), which statement is correct?

D - Not enough information to answer. It depends on the production frontier's attractiveness vs. the market rate and the individual's preferences/endowment.

Coordination improves information flow among regulatory agencies, enabling better decisions (Core Principle 3). Improved regulation brings greater stability to the financial system, improving welfare (Core Principle 5).

Question 21 - True statement from Class 02

Corporations are always preferable to partnerships because they provide better access to capital.

False - "Always" is too strong. Corporations have advantages (limited liability, perpetual life, easier capital raising) but also costs (double taxation, regulatory burden). Choice depends on goals, taxes, and control.

Cost of basket = 0.3(price of food) + 0.6(price of housing) + 0.1(price of transportation). Year 1: 0.3($30) + 0.6($50) + 0.1($10) = $40 Year 2: 0.3($32) + 0.6($52) + 0.1($12) = $42 Year 3: 0.3($38) + 0.6($55) + 0.1($16) = $46

Question 24a Class 02 Part 03 - CPI basket cost calculation

Country A has 8% nominal rates, Country B has 15%—which likely has 10% expected inflation?

Differences in nominal rates across countries largely reflect differences in expected inflation. Via Fisher equation, nominal rates are positively related to expected inflation, so more likely Country A has 10% expected inflation. This implies ex-ante real rate in Country A is negative at -2%.

Credit scoring standardizes assessment of loan applicants and reduces information costs. This allows institutions to lend to broader range of borrowers and facilitates creation of asset-backed securities. Objective criteria reduce subjectivity and discrimination, leading to more efficient resource allocation.

Question 11 Class 02 Part 04 - Credit scoring benefits

Derivatives transfer risk from one party to another. The more volatile the price of the underlying instrument, the higher the risk. The derivative based on the more volatile underlying asset has more value. An option to buy an asset at a predetermined price would have little value if that asset's price never changed.

Question 16 Class 02 Part 04 - Derivatives and volatility

Do lenders always prefer higher nominal interest rates?

Lenders care about real return. If higher nominal rate represents higher real rate, it's more attractive. If higher nominal merely reflects higher expected inflation, may not benefit lender. Example: 10% nominal with 8% expected inflation and 2% real rate is not preferred over 5% nominal with 1% expected inflation and 4% real rate. Real rate, not nominal, matters.

During a recession, the supply of corporate bonds falls and the demand for safe assets like Treasuries rises, both pushing interest rates downward.

True - In recessions, firms issue fewer bonds (supply decreases) and investors rush into safe Treasuries (demand increases), both putting downward pressure on rates. Consistent with historical pattern of yields falling in downturns.

During deflation, paper currency increases in value. Overall prices fall, so currency has more purchasing power. During falling prices, asset prices often fall too, so currency might be attractive as store of value.

Question 15 Class 02 Part 03 - Deflation and currency value

Economics studies how societies allocate scarce resources; finance focuses on how money is raised, allocated, and managed over time under risk.

True - This captures the standard scope difference. Finance borrows tools from economics but narrows to intertemporal allocation, valuation, and risk management.

Examples: (a) paycheck electronic transfer, (b) automatic electric bill payment, (c) scheduled credit card payments, (d) automatic car payment deduction.

Question 5 Class 02 Part 03 - Electronic payment examples

Explain Fisher equation components. Fisher equation: i = r + πᵉ, where r = real interest rate, πᵉ = expected inflation.

Borrower compensates lender for expected inflation (reduces purchasing power of dollars) and pays real interest rate to compensate for use of lender's money. Lender foregoes use of money for loan duration and needs compensation for opportunity cost.

Extensive high-frequency trading (HFT) improves overall market efficiency, reduces transaction costs, and makes financial markets more stable.

Uncertain - HFT has benefits and drawbacks. Can improve efficiency by narrowing bid-ask spreads, increasing liquidity, reducing transaction costs. However, may introduce instability, contribute to flash crashes, disadvantage traditional investors through latency arbitrage or front-running. Net effect depends on implementation and regulation.

Finance applies economic principles to decisions involving time, risk, and capital allocation, making it a specialized branch of economics rather than an unrelated discipline.

True - Finance uses core economic tools (opportunity cost, marginal analysis, equilibrium theory) but focuses on valuation, risk-return trade-offs, and capital market functioning.

Finance can be studied using both a normative (theoretical) and positive (empirical) approaches.

True - Normative finance asks "What should rational investors do?" Positive finance studies what people actually do using real-world data. Both are valuable.

Finance is a bad place for non-conformist thinkers to work.

False - Non-conformist thinking is rewarded in FinTech, venture capital, hedge funds, and startups. Spotting inefficiencies and creating new products requires creative, independent thinking.

Finance is an interdisciplinary field that includes only economics and math.

False - Finance draws from economics, math, psychology, statistics, law, ethics, computer science, history, and philosophy.

Finance is considered an interdisciplinary field primarily because it draws on ideas from multiple academic areas to understand markets, incentives, and decision-making.

TRUE - Finance integrates concepts from economics, psychology, mathematics, law, statistics, ethics, and technology to analyze real-world financial decisions.

Finance is interdisciplinary because it relies on ideas from multiple academic areas to understand markets and decision making.

True - Understanding markets requires tools from math/stats (quantify), economics (model), psychology (explain irrational behavior), law (understand constraints), and more.

Financial instruments used to store value include bank accounts, stocks and bonds. Instruments used to transfer risk include car insurance and life insurance.

Question 4 - True statement from Class 02

Financial markets exist primarily to control prices rather than to allocate resources efficiently.

FALSE - Financial markets exist to allocate resources efficiently through price discovery, not to control prices. Prices emerge from supply and demand rather than being set to achieve specific outcomes.

Fisher's Separation Theorem requires which critical market condition?

B - Equal borrowing and lending rates for all agents at the market rate. A single rate (borrow=lend) lets owners adjust timing without changing the firm's project set.

Fixed-rate or adjustable-rate mortgage?

Factors: (1) Fixed-rate payments are fixed over loan life; higher rate because lender assumes interest rate risk. ARM has lower rate because you assume risk (payments rise if rates rise). Given rates currently relatively low, more likely they'll rise, pushing up payments—bigger issue the longer you stay in house. (2) Converting later from ARM to fixed often involves restrictions and fees. (3) Payment caps may limit monthly payment rises but may associate with negative amortization if payments don't cover interest costs; shortages added to principal, pushing up costs.

For an amortized mortgage, each monthly payment is split evenly between interest and principal repayment over the life of the loan.

FALSE - In an amortized mortgage, early payments are mostly interest while later payments are mostly principal, so the split is not even over the life of the loan.

For assets as stores of value, consider: (a) gold—potential price rise, ability to buy/sell easily, storage/security costs; (b) real estate—appreciation rate, ease of sale, housing services; (c) stock—potential appreciation, volatility, liquidity; (d) bonds—rate of return including capital gain and interest; (e) cryptocurrencies—extreme volatility, tax classification of gains. Primary considerations: risk, return, and liquidity.

Question 14 Class 02 Part 03 - Store of value assets

Friedman argued that the social responsibility of business is to increase its profits, so long as it stays within the 'rules of the game' (law and ethical norms).

True - In his 1970 essay, managers are agents of shareholders; profit maximization—lawfully and honestly—is their remit.

Friedman endorsed corporate charitable spending that reduces profits even when shareholders have not authorized it.

False - He opposed managers using corporate funds for social aims that shareholders didn't authorize, framing it as an implicit 'tax'.

Friedman's 1970 article on corporate responsibility and Gordon Gekko's 'Greed is Good' speech from the movie Wall Street aren't relevant today.

False - Debates around DEI/ESG, stakeholder vs. shareholder primacy, and corporate purpose make these ideas more salient today. Firms still grapple with profit-purpose tradeoffs and how to align them with long-run value.

Friedman's 1970 position implies managers should:

A - Maximize long-run shareholder value within the rules of the game. Profit maximization subject to law/ethics; discretionary social spending without owner consent is not the manager's mandate.

Front-running refers to a broker or trader executing orders on a security for their own account while taking advantage of advance knowledge of pending client orders that are likely to affect the price of the security.

True - Front-running is unethical (often illegal) trading practice where broker/trader uses non-public information about client's large pending order to profit. If broker knows client will buy large block that will push price up, broker may buy first for themselves, then sell at profit after client's trade moves market.

Gold (or some other precious metal) functioned as money in early civilizations because:

D - a and b (divisible and beautiful). Gold was divisible (could be made into coins of various sizes) and aesthetically appealing, giving it cultural and symbolic value. Plentifulness would reduce value.

Good grades are the most crucial part of getting interviews for positions in finance.

False - Networking and referrals are often more important in competitive finance roles. Many jobs are filled via informal networks before official interviews are posted.

Greater access to finance boosts economic growth by lowering transaction costs, facilitating channeling of savings to most productive uses, and enabling greater specialization.

Question 23 Class 02 Part 04 - Finance access benefit

Greater economic and financial stability encourages households and firms to make long-term decisions.

TRUE - Stability reduces uncertainty and makes planning, saving, and investment easier for households and firms. When conditions are stable, long-term decisions become more attractive.

Having a "majority independent" board guarantees that directors will act in shareholders' best interests.

FALSE - A majority independent board reduces conflicts of interest but does not guarantee effective oversight or shareholder-aligned behavior due to information asymmetry, incentives, and human factors.

Having a "majority independent" board guarantees that directors will act in shareholders' best interests.

False - Independence is necessary but not sufficient. Information asymmetry, social ties, expertise gaps, and "board capture" can still undermine effective oversight.

Higher expected returns on alternative assets, such as equities, shift the demand curve for bonds to the left.

True - If equities are expected to yield more than bonds, investors substitute away from bonds. This reduces demand for bonds, pushing prices down and yields up.

Holding period return depends on both coupon income and the change in price when the bond is sold.

TRUE - HPR is determined by both coupon income and capital gain/loss when bond is sold.

Holding period return on 2-year bond?

Total HPR over two years = two $5 coupon payments + capital gain from interest rate fall. Selling price after two years: (5/1.04) + (100/1.04) = $100.96 HPR over two years = (10/100) + [(100.96 - 100)/100] = 10.96% Total payoff: $110.96 on $100 paid Annual rate of return: [(110.96/100)^(1/2) - 1] = 5.34%. Because interest rate fell during holding period and you made capital gain, annual HPR is higher than coupon rate.

How did Warren Buffett accumulate over 80% of his wealth after the age of 50?

D - Buffett earned modest but consistent returns over many decades, allowing compounding to generate the majority of his wealth later in life.

How did Warren Buffett accumulate over 80% of his wealth after the age of 50?

D - He achieved modest but consistent returns over a very long period of time. Buffett's success is largely due to compounding at ~20% annually for decades. His net worth skyrocketed after age 50 because of exponential compounding.

How do expected and actual inflation compare?

Expected inflation tends to move with actual inflation but varies somewhat less. Actual inflation often includes temporary price disturbances (like energy price changes) not expected to persist.

How does 1% increase in expected inflation affect 10-year bond price? a. Price (2% expected inflation) = 100/(1.06)¹⁰ = $55.84 Price (3% expected inflation) = 100/(1.07)¹⁰ = $50.83 Price fallen by $5.01 b. Increased inflation risk. Investors require compensation for additional risk, so price falls and yield rises.

Question 10 Class 04 Part 02 - Inflation and bond prices

How does expected real estate weakness affect bond market?

If real estate is alternative investment to bonds, expected weakness in real estate implies increase in relative return on bonds. Bond demand shifts right, increasing equilibrium prices and lowering yields.

How does supply curve slope affect equilibrium?

Sensitivity of bond supply to price changes is reflected in slope of supply curve. More sensitive quantity supplied is to price movement, flatter the supply curve and smaller the impact on equilibrium price for any given demand curve shift.

How does time horizon affect variation in PV estimates?

From PV = FV/(1 + i)ⁿ, PV of given FV varies with discount rate i. Higher number of years n into future, larger the impact on PV of using different interest rates. Therefore, variation in PV estimates gets wider as n increases at specified interest rates.

How has securitization benefited people?

If borrower: may have received lower mortgage rate due to increased liquidity from securitization. If from small town: may have found it easier to get mortgage as securitization broadened potential funding sources. If investor: opportunities for diversification from securitization.

IRR of machine costing $1,000,000 generating $75,000/year forever?

Using perpetuity formula: PV = C/i i = C/P = $75,000/$1,000,000 = 0.075 or 7.5%

If Velocity (V) is constant, a rise in the real value of transactions (T) means that:

C - The money supply must rise or the price level must fall. If V is constant, then MV = PT. A rise in T means either M must rise or P must fall to keep the equation balanced.

If a bond's current yield is greater than its coupon rate, the bond must be at a discount.

TRUE - If current yield > coupon rate, then price must be below par, defining a discount bond.

If a firm takes all positive-NPV projects under perfect markets, what follows?

C - Each owner can reach their preferred consumption by borrowing/lending at the market rate. That's the separation logic: investment by NPV; consumption timing adjusted personally.