Exercise 1
a) Discuss the following claim "In a world without transaction costs, information costs, financial intermediaries would not exist"
b) In 2008, as the financial crisis started to develop in the US, the US government FDIC raised the limit on insured losses to bank depositors from $100,000 to 200,000 per account. How would this help stabilize the financial system
Exercise 2:
Suppose you have just inherited $10 000 and are considering the following options for investing the money to maximize your return:
Option 1 - Put the money in an interest-bearing chequing account that earns 2%. The CDIC insures the account against bank failure
Option 2 - Invest the money in a corporate bond with a stated return of 5%, although there is a 10% chance the company could go bankrupt
Option 3 - Loan the money to one of your friend's roommates, Mike, at an agreed-upon interest rate of 8%, even though you believe there is a 7% chance that Mike will leave town without repaying you
Option 4 - Hold the money in cash and earn zero interest
a) If you are risk-neutral (that is, neither seek out nor shy away from risk), which of the four options should you choose to maximize your expected return? (Hint: To calculate the expected return of an outcome, multiply the probability that an event will occur by the outcome of that event)
b) Suppose Option 3 is your only possibility. If you could pay your friend $100 to find out extra information about Mike that would indicate with certainty whether he will leave town without paying, would you pay the $100? What does this say about the value of better information regarding risk?
Exercise 3 This exercise consists of independent questions. Justify your answers
a) What is the price of a consol bond that has a coupon of $50 and a yield to maturity of 2.5%, and a face value of $1500?
b) Consider a bond with a 4% annual coupon and a face value of $1000. Complete the following table. What relationships do you observe between years to maturity, yield to maturity, and the current price?
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Years to Maturity
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Yield to Maturity
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Current Price
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2
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2%
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2
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4%
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3
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4%
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5
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2%
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5
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6%
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c) Property taxes in a particular district are 4% of the purchase price of a home every year. If you just purchased a $250 000 home, what is the present value of all the future property tax payments? Assume that the house remains worth $250 000 forever, property tax rates never change, and a 6% interest rate is used for discounting
d) If there is a decline in interest rates, which would you rather be holding, long or short term bonds? Why? Which type has the greatest interest rate risk
Optional
e) When the current yield is a good approximation to the yield to maturity?