1. Assume that the current interest rate is 8%. Let’s say that investors know that normally interest rates are 10%. How would this affect investors’ decisions with regard to how much money and bond holdings to keep? Investors will want to hold more cash instead of bonds.
Because the investors know that normally interest rates are 10% which is more than the current interest 8%. That is to say investors expect the interest rates would increase in the future which will cause the decrease of value of bonds. 2. By the middle of 2008 the Fed had driven the short-term interest rate close to zero, and it remained at essentially zero through the middle of 2010. How do you think this affected people's decision of whether to hold on to money or hold bonds instead? There is no difference between holding money and holding bonds. Because the opportunity cost of holding money is the interest rates that bonds earns. But when the interest rate is nearly zero, the OC of holding money is essentially zero. So there is no difference between holding money and holding bonds. 3. Suppose that you own a $1000 bond which earns 5% interest. Furthermore, assume that interest rates on newly issued bonds rise to 10%. Explain why no one would be willing to buy your bond for a $1000. In addition, calculate the price that you could reasonably expect to receive for your bond. a) Explain why no one would be willing to buy your bond for a $1000. Because they can buy the newly issued ones which earns a higher interest rate with $1000. b) Calculate the price that you could reasonably expect to receive for your bond. The coupon of our bond $50 and the bond must earn 10%. So the proper price = $50/10%=$500 which will provide a same yield of 10%.
1. Suppose that you own a $1000 bond which earns 20% interest. Now assume that interest rates on newly issued bonds fall to 10%. How much could you reasonably expect to receive for your bond if you were to sell it? According to the question, the...
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