Short Answer Questions
100. Suppose a family member approaches you to borrow $2,000 for the down payment on an
automobile. You have the cash available in a savings account that currently earns 5% annual
interest. You and the family member consider the following repayment options:
(i) Borrower repays $259 each year over the next ten years
(ii) Borrower repays $300 each year over the next five years, plus a lump-sum payment of $895 in
the fifth year.
(iii) Borrower repays you $2,100 at the end of one year.
For each of the options above, show that the present values of each option are approximately
equal. Then, relate each of the options above to the four types of bonds, indicating which option
is equivalent to which type of bond. Explain why.
101. Consider a $1,000.00 face value bond with a $55 annual coupon and 10 years until
maturity. Calculate the current yield; the coupon rate and the yield to maturity under each of the
following:
a) The bond is purchased for $940.00
b) The bond is purchased for $1,130.00
c) The bond is purchased for $1,000.00
102. Calculate the holding period return for a $1,000 face value bond with a $60 annual coupon
purchased for $970.00 and sold three years later for $1,060.00.
103. Could the holding period return ever be less than the yield to maturity? Explain.
104. Use the example of a consol to show how bond prices and yields are inversely related.
105. Notice the following model of a bond market. In each situation given, explain what
happens to the bond price and yield and why.
a) Expected inflation increases
b) The return on bonds rises relative to other assets
c) The federal government deficit increases
106. Calculate the price of a zero coupon bond that has an interest rate of 6.65% (.0665), a face
value of $100.00 and six-months to maturity.
107. Calculate the monthly payment for a 30-year mortgage, where the amount borrowed is
$100,000 and the annual interest rate is 6.0%.
108. Calculate the price of a $1,000 face value bond that offers a $45 annual coupon, and has six
years to maturity, when the interest rate is 6.0% (0.060).
109. Which bond will have a higher yield to maturity, a $1,000 face value bond, with a 5.0%
coupon rate that sells for $900; or a $1,000 face value bond, with a $50 annual coupon that sells
for $1,050? Explain your choice.
110. Compute the change in the price of a five-year (until maturity) $1,000 face value zero-
coupon bond that currently yields 7% when expected inflation increases from 3% to 4%.
111. Suppose that the interest rate on a conventional 30-year mortgage is currently 8%. You
receive a call from a mortgage broker who offers you a 30-year adjustable rate mortgage at 2%
that is adjusted once each year. Evaluate each mortgage in terms of the following: risk that the
monthly payment will change over the next 30 years and interest-rate risk.
112. Explain the relationship between coupon rate (or coupon yield) and current yield.
113. Explain why the bid-ask spread on most municipal bonds would be greater than the spread
on U.S. Treasury bonds.
114. The U.S. Treasury offers several ways to purchase U.S. government bonds. There are the
traditional coupon bonds and Treasury Inflation-Indexed Securities. How do these bonds differ
from their traditional counterparts?
115. In the late 1990s, the U.S. government ran a surplus for the first time in decades. It
instituted a buyback program, whereby the Treasury bought outstanding government bonds. How
would this program affect the bond market price, yield, and quantity of bonds? How might
it
affect
the liquidity of government bonds?
116. Explain why holding period return, as an economic measure, does not have the same
significance as current yield or yield to maturity.
117. Suppose that a bond is purchased at a discount (meaning that it is sold for less than face
value). Could the yield to maturity ever be less than the coupon rate? Could the holding period
return be less than the coupon rate? Explain.
118. In mid-2004 there was speculation that the Federal Reserve would be raising interest rates
before the end of the year. How would this news affect the bond market and why?
119. Use our model of the bond market (supply and demand) to explain what happens if the U.S.
economy continues to grow at robust rates.
120. How can a bond mutual fund report a return of over 13% when the coupon rate of the
bonds they are holding are just 7% and interest rates are falling?
121. At the time the government of Bulgrovia issued new bonds, they issued them at a price that
reflected the risk-free rate because investors had no concerns regarding default risk, so did not
require a risk premium. That risk-free rate was 4%. These bonds currently have one year to
maturity and you notice the yield is 20%. Can you calculate the probability that the Bulgrovian
government will default?
122. Consider two investors: one is risk-neutral and the other is risk-averse. How do they each
assess a risk premium?
123. Explain why two countries with the same average rate of inflation may not present the
same inflation risk for holders of those countries’ bonds?
124. The text identified the various sources of risk for bonds. Are U.S. Treasury TIPS bonds
free from risk? Explain.
125. If you were going to issue bonds, would you prefer to be in a country where the average
inflation rate is 3% inflation but fluctuates wildly, or in a country with a higher, 4% expected
inflation rate that is stable (meaning it‘s always 4%). Explain.
Essay Questions
126. You win your state lottery. The lottery officials offer you the option of taking your
winnings in one lump-sum payment, or fixed annual payments for the next 20 years. The sum of
the 20 annual payments is larger than the lump-sum payment. Before deciding, what are the key
factors you will want to consider that could influence your decision?
127. Consider the factors that affect bond demand and bond supply. Describe how the following
are likely to change during a period of robust economic growth: wealth, default risk, and general
business conditions. For each, state how the factor is likely to change, and discuss the
implications for bond demand/supply, bond price, and yield. Bond prices tend to decrease during
periods of high economic growth. What does this reveal about which of these factors
i
s
important?
128. Many people are worried that, with the growing number of people that will retire in the US
over the next 40 years, the federal government will need to borrow large amounts of money to
finance the Social Security System. If we assume that Social Security taxes and the current
eligibility age remain constant, explain the likely impact this will have on bond markets.