ECON 433

PROBLEM SET 1
Chapters 2, 3, 4, 5
Due date: 1 Nov 2017

MULTIPLE CHOICES. Choose the one alternative that best completes

the statement or answers the question.
1) (I) A bond is a debt security that promises to make payments
periodically for a specified period of time. (II) A stock is a security that
is a claim on the earnings and assets of a corporation. 1) _____
A) (I) is true, (II) false. B) (I) is false, (II) true.
C) Both are true. D) Both are false.
2) A stronger TL benefits ________ and hurts ________. 2) _____
A) Turkish consumers; Turkish businesses B) foreign businesses;
Turkish consumers
C) Turkish businesses; foreign businesses D) Turkish businesses;
Turkish consumers
3) A rising stock market index due to higher share prices 3) _____
A) increases the amount of funds that business firms can raise by
selling newly issued stock.
B) increases people's wealth and as a result may increase their
willingness to spend.
C) decreases the amount of funds that business firms can raise by
selling newly issued stock.
D) both A and B of the above.
4) The purpose of diversification is to 4) _____
A) reduce the volatility of a portfolio's return. B) raise the volatility
of a portfolio's return.
C) raise the average return on a portfolio. D) reduce the average
return on a portfolio.

5) When the potential borrowers who are the most likely to default are
the ones most actively seeking a loan, ________ is said to exist. 5)
_____

A) asymmetric information B) adverse selection

C) moral hazard D) fraud

6) The Deposit Insurance Corporation in Turkey (Tasarruf Mevduatı

Sigorta Fonu, TSMF) insures each depositor at a commercial banks and
participattion banks up to a loss of ________ per account. 6) _____

A) 500,000 B) 1,000,000 C) 250,000 D) 100,000

7) The DAX (Germany) and the FTSE 100 (London) are examples of
________. 7) _____
A) foreign currencies B) foreign mutual funds
C) foreign stock exchanges D) foreign stock price indexes
8) A bond's future payments are called its 8) _____
A) discounted present values. B) cash flows.
C) maturity values. D) yields to maturity.

9) (I) A simple loan requires the borrower to repay the principal at the
maturity date along with an interest payment.
(II) A discount bond is bought at a price below its face value, and the
face value is repaid at the maturity date. 9) _____

A) (I) is true, (II) false. B) (I) is false, (II) true.

C) Both are true. D) Both are false.

10) (I) A discount bond requires the borrower to repay the principal at
the maturity date plus an interest payment.
(II) A coupon bond pays the lender a fixed interest payment every year
until the maturity date, when a specified final amount (face or par
value) is repaid. 10) _____

A) (I) is true, (II) false. B) (I) is false, (II) true.

C) Both are true. D) Both are false.

,
11) With an interest rate of 10 percent, the present value of a security
that pays $1,100 next year and $1,460 four years from now is
approximately 11) _____

A) $2,560. B) $1,000. C) $3,000. D) $2,000.

12) The yield to maturity of a one-year, simple loan of $500 that

requires an interest payment of $40 is 12) _____
A) 12.5 percent. B) 12 percent. C) 5 percent. D) 8 percent.

13) Which of the following are true for a coupon bond? 13) _____
A) When the coupon bond is priced at its face value, the yield to
maturity equals the coupon rate.
B) The price of a coupon bond and the yield to maturity are negatively
related.
C) The yield to maturity is greater than the coupon rate when the bond
price is above the par value.
D) All of the above are true.
E) Only A and B of the above are true.

14) If you expect the inflation rate to be 5 percent next year and a one-
year bond has a yield to maturity of 7 percent, then the real interest rate
on this bond is 14) _____

A) 2 percent. B) 12 percent. C) -12 percent. D) -2 percent.

15) What is the return on a 5 percent coupon bond that initially sells for
$1,000 and sells for $1,200 one year later? 15) _____

A) 5 percent
B) 25 percent
C) -5 percent
D) 10 percent
E) None of the above

16) The real interest rate is actually the ex ante real interest rate
because it is adjusted for ________ changes in the price level. 16)
_____

A) real B) nominal C) actual D) expected

17) When the government's budget deficit decreases, the ________

curve for bonds shifts to the ________. 17) _____
A) supply; left B) demand; right C) demand; left D) supply;
right

18) When bond prices become less volatile, the demand for bonds
________ and the interest rate ________. 18) _____
A) increases; falls B) decreases; rises C) decreases; falls D)
increases; rises
19) An increase in the expected rate of inflation will ________ the
expected return on bonds relative to that on ________ assets, and shift
the ________ curve to the left. 19) _____

A) raise; real; supply B) reduce; real; demand

C) reduce; financial; demand D) raise; financial; supply
20) In Figure 4.2, one possible explanation for a decrease in the interest
rate from i2 to i1 is 20) _____
A) a decrease in the riskiness of bonds relative to other investments.
B) an increase in government budget deficits.
C) a decrease in economic growth.
D) an increase in expected inflation.

21) When comparing the loanable funds and liquidity preference

frameworks of interest rate determination, which of the following is
true? 21) _____

A) The liquidity preference framework is easier to use when analyzing

the effects of changes in expected inflation.
B) In most instances, the two approaches to interest rate determination
yield the same predictions.
C) The loanable funds framework provides a simpler analysis of the
effects of changes in income, the price level, and the supply of money.
D) All of the above are true.
E) Only A and B of the above are true.
22) In Figure 4.3, an increase in the interest rate from i2 to i1 can be
explained by 22) _____
A) an increase in the expected price level. B) an increase in money
growth.
C) a decline in the price level. D) a decrease in money growth.

23) As expected inflation falls for the coming year, we expected the
price of gold to ________ due to a leftward shift the in ________
curve. 23) _____

A) decrease; supply B) increase; demand

C) increase; supply D) decrease; demand
24) (I) If a corporation suffers big losses, the demand for its bonds will
rise because of the higher interest rates the firm must pay.
(II) The spread between the interest rates on bonds with default risk and
default-free bonds is called the risk premium. 24) _____

A) (I) is true, (II) false. B) (I) is false, (II) true.

C) Both are true. D) Both are false.

25) As a result of the subprime collapse, the demand for low -quality
corporate bonds ________, the demand for high-quality Treasury bonds
________, and the risk spread ________. 25) _____

A) increased; decreased; decreased B) decreased; increased;

increased
C) increased; decreased; was unchanged D) decreased; increased;
was unchanged

26) If municipal bonds were to lose their tax-free status, then the
demand for Treasury bonds would shift ________, and the interest rate
on Treasury bonds would ________. 26) _____

A) rightward; rise B) leftward; rise C) leftward; fall D)

rightward; fall

27) According to the expectations theory of the term structure, 27)

_____
A) interest rates on bonds of different maturities move together over
time.
B) the interest rate on long-term bonds will exceed the average of
expected future short-term interest rates.
C) buyers of bonds prefer short-term to long-term bonds.
D) all of the above.
E) only A and B of the above.

28) If the expected path of one-year interest rates over the next four
years is 5 percent, 4 percent, 2 percent, and 1 percent, then the pure
expectations theory predicts that today's interest rate on the four-year
bond is 28) _____

A) 4 percent. B) 1 percent.
C) 2 percent. D) none of the above.

29) If the yield curve slope is flat, the liquidity premium theory
indicates that the market is predicting 29) _____
A) a mild decline in short-term interest rates in the near future and a
continuing mild decline further out in the future.
B) constant short-term interest rates in the near future and a mild
decline further out in the future.
C) constant short-term interest rates in the near future and further out in
the future.
D) a mild rise in short-term interest rates in the near future and a mild
decline further out in the future.
30) A bond with default risk will always have a ________ risk
premium, and an increase in its default risk will raise the risk premium.
30) _____

A) negative B) minimal C) unpredictable D) positive

LONG QUESTIONS:
1) Make list of foreign exchange rates between U.S. dollars and
Turkish Lira in March (Oct 1- Oct 20)
Which day would have been the best day to convert $200 to Turkish
Lira?
Which day would have been the worst day? What would be the
difference in Turkish Liras?
2) Plot the Yield curve in Turkey. Explain why it has this special shape
and how the shape changed compared to previous months and weeks.

3) A lottery claims its grand prize is $10 million, payable over 20 years
at $500,000 per year. If the first payment is made immediately, what is
this grand prize really worth? Use a discount rate of 6%.

4) Lucia just bought two coupon bonds, one with a face value of
$1,000 and the other with a face value of $5,000. Both bonds have a
coupon rate of 5% and sold at par today. Calculate both bonds ́ current
yield and both bonds rate of return if Lucia is able to sell these bonds
one year later for $100 more of the buying price. Can you estimate
what happened to the interest rate over that year?

5) A bank has two, 3-year commercial loans with a present value of $70
million. The first is a $30 million loan that requires a single payment of
$37.8 million in 3 years, with no other payments until then. The second
is for $40 million. It requires an annual interest payment of $3.6
million. The principal of $40 million is due in 3 years.
a) What is the duration of the bank’s commercial loan portfolio?
b) What will happen to the value of its portfolio if the general level of
interest rates increased from 8% to 8.5%?

6) You own a $1,000-par zero-coupon bond that has 5 years of

remaining maturity. You plan on selling the bond in one year and
believe that the required yield next year will have the following
probability distribution:

What is your expected price when you sell the bond? What is the
standard deviation?

7) Last month, corporations supplied $250 billion in bonds to investors

at an average market rate of 11.8%. This month, an additional $25
billion in bonds became available, and market rates increased to 12.2%.
Assuming a Loanable Funds Framework for interest rates, and that the
demand curve remained constant, derive a linear equation for the
demand for bonds, using prices instead of interest rates.
8) a)Short term (one year) interest rates over the next 6 years will be
0.5%, 0.6%, 0.7%, 0.76%, 0.80% and 0.84%. Using the expectations
theory, what will be the interest rates on a three, four and six-year
bonds?
b) Using the information from the previous question, now assume that
the investor prefers holding short-term bonds. A liquidity premium of
10 basis points is required for each year of a bond’s maturity. What will
be the interest rates on a 3-year bond, 6-year bond, and 9-year bond?
 ECON 433
PROBLEM SET 1

MULTIPLE CHOICES. Choose the one alternative that best completes

the statement or answers the question.
1) (I) A bond is a debt security that promises to make payments
periodically for a specified period of time. (II) A stock is a security that
is a claim on the earnings and assets of a corporation. 1) _____
A) (I) is true, (II) false. B) (I) is false, (II) true.
C) Both are true. D) Both are false.
2) A stronger TL benefits ________ and hurts ________. 2) _____
A) Turkish consumers; Turkish businesses B) foreign businesses;
Turkish consumers
C) Turkish businesses; foreign businesses D) Turkish businesses;
Turkish consumers
3) A rising stock market index due to higher share prices 3) _____
A) increases the amount of funds that business firms can raise by
selling newly issued stock.
B) increases people's wealth and as a result may increase their
willingness to spend.
C) decreases the amount of funds that business firms can raise by
selling newly issued stock.
D) both A and B of the above.
4) The purpose of diversification is to 4) _____
A) reduce the volatility of a portfolio's return. B) raise the volatility
of a portfolio's return.
C) raise the average return on a portfolio. D) reduce the average
return on a portfolio.

5) When the potential borrowers who are the most likely to default are
the ones most actively seeking a loan, ________ is said to exist. 5)
_____

A) asymmetric information B) adverse selection

C) moral hazard D) fraud

6) The Deposit Insurance Corporation in Turkey (Tasarruf Mevduatı

Sigorta Fonu, TSMF) insures each depositor at a commercial banks and
participattion banks up to a loss of ________ per account. 6) _____

A) 500,000 B) 1,000,000 C) 250,000 D) 100,000

7) The DAX (Germany) and the FTSE 100 (London) are examples of
________. 7) _____
A) foreign currencies B) foreign mutual funds
C) foreign stock exchanges D) foreign stock price indexes
8) A bond's future payments are called its 8) _____
A) discounted present values. B) cash flows.
C) maturity values. D) yields to maturity.

9) (I) A simple loan requires the borrower to repay the principal at the
maturity date along with an interest payment.
(II) A discount bond is bought at a price below its face value, and the
face value is repaid at the maturity date. 9) _____

A) (I) is true, (II) false. B) (I) is false, (II) true.

C) Both are true. D) Both are false.

10) (I) A discount bond requires the borrower to repay the principal at
the maturity date plus an interest payment.
(II) A coupon bond pays the lender a fixed interest payment every year
until the maturity date, when a specified final amount (face or par
value) is repaid. 10) _____

A) (I) is true, (II) false. B) (I) is false, (II) true.

C) Both are true. D) Both are false.

,
11) With an interest rate of 10 percent, the present value of a security
that pays $1,100 next year and $1,460 four years from now is
approximately 11) _____

A) $2,560. B) $1,000. C) $3,000. D) $2,000.

12) The yield to maturity of a one-year, simple loan of $500 that

requires an interest payment of $40 is 12) _____
A) 12.5 percent. B) 12 percent. C) 5 percent. D) 8 percent.

13) Which of the following are true for a coupon bond? 13) _____
A) When the coupon bond is priced at its face value, the yield to
maturity equals the coupon rate.
B) The price of a coupon bond and the yield to maturity are negatively
related.
C) The yield to maturity is greater than the coupon rate when the bond
price is above the par value.
D) All of the above are true.
E) Only A and B of the above are true.

14) If you expect the inflation rate to be 5 percent next year and a one-
year bond has a yield to maturity of 7 percent, then the real interest rate
on this bond is 14) _____

A) 2 percent. B) 12 percent. C) -12 percent. D) -2 percent.

15) What is the return on a 5 percent coupon bond that initially sells for
$1,000 and sells for $1,200 one year later? 15) _____

A) 5 percent
B) 25 percent
C) -5 percent
D) 10 percent
E) None of the above

16) The real interest rate is actually the ex ante real interest rate
because it is adjusted for ________ changes in the price level. 16)
_____

A) real B) nominal C) actual D) expected

17) When the government's budget deficit decreases, the ________

curve for bonds shifts to the ________. 17) _____
A) supply; left B) demand; right C) demand; left D) supply;
right

18) When bond prices become less volatile, the demand for bonds
________ and the interest rate ________. 18) _____
A) increases; falls B) decreases; rises C) decreases; falls D)
increases; rises
19) An increase in the expected rate of inflation will ________ the
expected return on bonds relative to that on ________ assets, and shift
the ________ curve to the left. 19) _____

A) raise; real; supply B) reduce; real; demand

C) reduce; financial; demand D) raise; financial; supply
20) In Figure 4.2, one possible explanation for a decrease in the interest
rate from i2 to i1 is 20) _____
A) a decrease in the riskiness of bonds relative to other investments.
B) an increase in government budget deficits.
C) a decrease in economic growth.
D) an increase in expected inflation.

21) When comparing the loanable funds and liquidity preference

frameworks of interest rate determination, which of the following is
true? 21) _____

A) The liquidity preference framework is easier to use when analyzing

the effects of changes in expected inflation.
B) In most instances, the two approaches to interest rate determination
yield the same predictions.
C) The loanable funds framework provides a simpler analysis of the
effects of changes in income, the price level, and the supply of money.
D) All of the above are true.
E) Only A and B of the above are true.
22) In Figure 4.3, an increase in the interest rate from i2 to i1 can be
explained by 22) _____
A) an increase in the expected price level. B) an increase in money
growth.
C) a decline in the price level. D) a decrease in money growth.

23) As expected inflation falls for the coming year, we expected the
price of gold to ________ due to a leftward shift the in ________
curve. 23) _____
A) decrease; supply B) increase; demand
C) increase; supply D) decrease; demand

24) (I) If a corporation suffers big losses, the demand for its bonds will
rise because of the higher interest rates the firm must pay.
(II) The spread between the interest rates on bonds with default risk and
default-free bonds is called the risk premium. 24) _____

A) (I) is true, (II) false. B) (I) is false, (II) true.

C) Both are true. D) Both are false.

25) As a result of the subprime collapse, the demand for low -quality
corporate bonds ________, the demand for high-quality Treasury bonds
________, and the risk spread ________. 25) _____

A) increased; decreased; decreased B) decreased; increased;

increased
C) increased; decreased; was unchanged D) decreased; increased;
was unchanged

26) If municipal bonds were to lose their tax-free status, then the
demand for Treasury bonds would shift ________, and the interest rate
on Treasury bonds would ________. 26) _____

A) rightward; rise B) leftward; rise C) leftward; fall D)

rightward; fall
27) According to the expectations theory of the term structure, 27)
_____
A) interest rates on bonds of different maturities move together over
time.
B) the interest rate on long-term bonds will exceed the average of
expected future short-term interest rates.
C) buyers of bonds prefer short-term to long-term bonds.
D) all of the above.
E) only A and B of the above.

28) If the expected path of one-year interest rates over the next four
years is 5 percent, 4 percent, 2 percent, and 1 percent, then the pure
expectations theory predicts that today's interest rate on the four-year
bond is 28) _____

A) 4 percent. B) 1 percent.
C) 2 percent. D) none of the above.

29) If the yield curve slope is flat, the liquidity premium theory
indicates that the market is predicting 29) _____
A) a mild decline in short-term interest rates in the near future and a
continuing mild decline further out in the future.
B) constant short-term interest rates in the near future and a mild
decline further out in the future.
C) constant short-term interest rates in the near future and further out in
the future.
D) a mild rise in short-term interest rates in the near future and a mild
decline further out in the future.

30) A bond with default risk will always have a ________ risk
premium, and an increase in its default risk will raise the risk premium.
30) _____

A) negative B) minimal C) unpredictable D) positive

1) C

2) A

3) D

4) A

5) B

6) D
7) D

8) B

9) C

10) B

11) D

12) D

13) E

14) A

15) B

16) D

17) A
18) A

19) B

20) C

21) B

22) D

23) D

24) B

25) B

26) D

27) A

28) D
29) A

30) D

LONG QUESTIONS:
1) Make list of foreign exchange rates between U.S. dollars and
Turkish Lira in March (March 1- March 17)
Which day would have been the best day to convert $200 to Turkish
Lira?
Which day would have been the worst day? What would be the
difference in Turkish Liras?
2) Plot the Yield curve in Turkey. Explain why it has this special shape
and how the shape changed compared to previous months and weeks.

3) A lottery claims its grand prize is $10 million, payable over 20 years
at $500,000 per year. If the first payment is made immediately, what is
this grand prize really worth? Use a discount rate of 6%.

Solution: This is a simple present value problem. Using a financial

calculator, N = 20; PMT = 500,000; FV = 0; I = 6%; Pmts in BEGIN
mode. Compute PV: PV = $6,079,058.25

4) Lucia just bought two coupon bonds, one with a face value of
$1,000 and the other with a face value of $5,000. Both bonds have a
coupon rate of 5% and sold at par today. Calculate both bonds ́ current
yield and both bonds rate of return if Lucia is able to sell these bonds
one year later for $100 more of the buying price. Can you estimate
what happened to the interest rate over that year?
. Solution: The current yield (CY) is calculated as the coupon
payment over the selling price of the bond. When a coupon bond
sells at par, its current yield equals the coupon rate, since the
numerator of the CY is: Face Value x Coupon Rate (always) and
the denominator is Face Value (in this particular situation only in
which Price = FV). Both bonds have a CY = 5%. If Lucia is able
to sell the $1,000 FV coupon bond for $1,100, then the rate of
return is: 5% + 10% (since the rate of capital gain is 100/1,000
=10%). The same reasoning yields a RET = 5% + 2% (g =
100/5,000) for the other bond. The interest rate must have fallen
over that year for bond ́s prices to increase. Note, however, that it
is unlikely that both bond ́s prices increased by the same amount.
Other determinants of bond ́s prices (see chapters 4 and 5) likely
explained this effect.
5) A bank has two, 3-year commercial loans with a present value of $70
million. The first is a $30 million loan that requires a single payment of
$37.8 million in 3 years, with no other payments until then. The second
is for $40 million. It requires an annual interest payment of $3.6
million. The principal of $40 million is due in 3 years.
a) What is the duration of the bank’s commercial loan portfolio?
b) What will happen to the value of its portfolio if the general level of
interest rates increased from 8% to 8.5%?

Solution: The duration of the first loan is 3 years since it is a zero-

coupon loan. The duration of the second loan is as follows:
6) You own a $1,000-par zero-coupon bond that has 5 years of
remaining maturity. You plan on selling the bond in one year and
believe that the required yield next year will have the following
probability distribution:

What is your expected price when you sell the bond? What is the
standard deviation?

7) Last month, corporations supplied $250 billion in bonds to investors

at an average market rate of 11.8%. This month, an additional $25
billion in bonds became available, and market rates increased to 12.2%.
Assuming a Loanable Funds Framework for interest rates, and that the
demand curve remained constant, derive a linear equation for the
demand for bonds, using prices instead of interest rates.
 8) a)Short term (one year) interest rates over the next 6 years will be
0.5%, 0.6%, 0.7%, 0.76%, 0.80% and 0.84%. Using the expectations
theory, what will be the interest rates on a three, four and six-year
bonds?
Solution: Three-year bond = (0.5% + 0.6% + 0.7%) / 3 = 0.6%. Four-
year bond = (0.5% + 0.6% + 0.7% + 0.76%) / 4 = 0.64%. Six-year bond
= (0.5% + 0.6% + 0.7% + 0.76% + 0.80% + 0.84%) / 6 = 0.7%.

b) Using the information from the previous question, now assume that
the investor prefers holding short-term bonds. A liquidity premium of
10 basis points is required for each year of a bond’s maturity. What will
be the interest rates on a 3-year bond, 6-year bond, and 9-year bond?