T/F 1. Financial markets connect production needs for money with consumption’s available savings. 2. How can...

T/F 1. Financial markets connect production needs for money with consumption’s available savings.

2. How can the FED react to higher prices ( inflation) ?

3. How long does it take money earning 14% to do double?

4. Explain the effects of increasing interest rates on short term and long term bonds. Which is better and why?

5. If you own 3 stocks A, B, and C. What is your total return of your portfolio?

Stock $ invested Return

A $ 6,000 6 %

B 9,000 9 %

C 15,000 11 %

6. Carstairs Inc. issued a $ 1,000, 25-year bond 5 years ago at 11 % interest. Comparable bonds yield 8 % today. What should Carstairs’ bond sell for now?

Solutions

Expert Solution

(1): TRUE

(2): FED reacts to higher prices (inflation) through its monetary policy. When inflation occurs then Fed makes use of contractionary monetary policy. This helps it slow down economic growth and hence slow down the pace of price rise. When contractionary monetary policy is used by FED then it leads to tightening the money supply and this reduces liquidity in the financial system.

(3): Let the period be “n”. Thus 2 = 1*(1.14)^n

Or 2 = 1.14^n

Solving the above we get n = 5.2864. This can be rounded to 5.29 years

(4): Bond prices go down when interest rate rises. This is because when interest rate changes then bonds go through an adjustment so as to be fairly priced. Long term bonds will be subject to greater interest rate risk than short term bonds. There is a greater chance or a higher probability that interest rates will rise within a longer time period when compared to a shorter time period. Short term bonds are better when interest rates are increasing because they are easier to hold until maturity and this removes the concern of the bond holders with regards to impact of interest-rate driven changes in the price of the bonds.

(5): Portfolio return = 6% of 6000 + 9% of 9000 + 11% of 15000

= $2,820

(6): Here nper = (25-5)*2 = 40, PMT = (11% of 1000)/2 = 55 and rate = 8%/2 = 4%. FV = 1000. We have to find PV. Formula in excel will be: PV( 4%, 40, 55, 1000). This will give a value of $1,296.89

Thus Carstairs’ bond will sell for $1,296.89.

jeff jeffy answered 2 years ago

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