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Economics 601

Workshop #5 Answer Key


Dustin Chambers

Fall 2014

Instructions: Please show all of your work. Turn-in one assignment per group,
and make sure to list the names of each student in your group. Tip: This
assignment can be solved very quickly using Microsoft Excel.
1.

Consider the following table which contains the current market prices
(as of January 1, 2008) for a series of discount bonds issued by Acme
Biotech, a startup biotechnology firm. The discount bonds all have the
same face value, $10,000, and range in maturity from one (1) to ten
(10) years. Using the Lucas rational expectations-based asset pricing
model, derive market traders expected discount rates for each of the
next ten years (i.e. for 2008 through 2017).
Years
(t)
1
2
3
4
5
6
7
8
9
10

1+iet =
Maturity
January 1, 2009
January 1, 2010
January 1, 2011
January 1, 2012
January 1, 2013
January 1, 2014
January 1, 2015
January 1, 2016
January 1, 2017
January 1, 2018

Price
9,569.38
9,113.69
8,597.82
8,149.60
7,761.52
7,409.57
7,124.58
6,817.78
6,493.13
6,125.59

YTM
4.50%
4.75%
5.16%
5.25%
5.20%
5.12%
4.96%
4.90%
4.92%
5.02%

(1+YTMt )t (1+YTMt )t /(1+YTMt-1)t-1


104.50%
--109.73%
105.00%
116.31%
106.00%
122.71%
105.50%
128.84%
105.00%
134.96%
104.75%
140.36%
104.00%
146.68%
104.50%
154.01%
105.00%
163.25%
106.00%

There are essentially three methods to solve this problem:


Method 1
According to the Lucas Pricing Model, the price of any of these bonds is equal
to the face value ($10,000) divided by the product of the expected discount
factors. For example, consider the current price of the $10,000 discount bond
that matures in year 2 (Jan. 1, 2010):
= 9,113.69 =

10,000
!
!
(1 + !""#
) (1 + !"#"
)

We know that the market thinks that the appropriate discount rate for Acme
Biotech will be 4.5% in 2009 (because the bond expiring Jan. 1, 2009 has a
yield to maturity (YTM) of 4.5%). Plugging this into the price formula for the
two-year discount bond above:

iet
4.50%
5.00%
6.00%
5.50%
5.00%
4.75%
4.00%
4.50%
5.00%
6.00%

= 9,113.69 =

10,000
!
(1 + 0.045) (1 + !"#"
)

Which can be rearranged to solve for the unknown discount rate in 2010:
!
1 + !"#"
=

10,000
= 1.05
1 + 0.045 9,113.69

So the market expects the appropriate discount rate to equal 5% in 2010.


Continuing in this fashion, you can solve for all of the other discount rates.
However, there are two alternative techniques to solve this problem which are
much faster.
Method 2
Consider the pricing formula for bonds maturing in two consecutive years:
!!! =
! =

(1 +

!
!""#
)

10,000
!
!
(1 + !"#"
) (1 + !!!
)

(1 +

!
!"#"
) (1

10,000
(1 +

!
!""#
)

!
+ !!!
) (1 + !! )

So, taking the ratio of the prices:


!!!
!

10,000
!
!
(1 +
(1 + !"#"
) (1 + !!!
)
=
10,000
!
!
!
(1 + !""#
) (1 + !"#"
) (1 + !!!
) (1 + !! )
!
!""#
)

!!!
= (1 + !! )
!
To demonstrate this, consider the example above that solved for the 2010
discount rate. Taking the ratio of the price for 2009 (t-1) and 2010 (t) bonds:
!""# 9,569.38
=
= 1.05
!"#" 9113.69

Method 3
Finally, we can use each bonds average yield (i.e. the YTM) to find the yearspecific discount rates. To see this, we can re-write the pricing equations in a
slightly different fashion:
!!! =

10,000
(1 + !!! )!!!

! =

10,000
(1 + ! )!

So, taking the ratios of the prices gives us the third operational way to solve
the problem:
10,000
!!! (1 + !!! )!!!
(1 + ! )!
=
=
10,000
!
(1 + !!! )!!!
!
(1 + ! )
So, it must be the case that
1 + !! =

(1 + ! )!
(1 + !!! )!!!

Which is the technique used in the table above.

2.

Now, suppose that you have been offered the right to purchase Acme
Biotechs royalties for a new diabetes drug over the next ten years,
with the following expected annual royalty payoffs (see below).
Determine the most you are willing to pay for this non-standard, 10year financial asset.
Years
(t)
1
2
3
4
5
6
7
8
9
10

Payment Date
January 1, 2009
January 1, 2010
January 1, 2011
January 1, 2012
January 1, 2013
January 1, 2014
January 1, 2015
January 1, 2016
January 1, 2017
January 1, 2018

Royalty
(millions)
10.00
15.00
20.00
30.00
40.00
50.00
50.00
40.00
30.00
30.00

Discount
Factor
104.50%
109.73%
116.31%
122.71%
128.84%
134.96%
140.36%
146.68%
154.01%
163.25%
Total >>

PV
(millions)
9.57
13.67
17.20
24.45
31.05
37.05
35.62
27.27
19.48
18.38
233.73

Using the discount factors from the previous table of Acmes bonds:
! = (1 + ! )!
We can appropriately discount the expected income streams from Acmes
new diabetes drug. Adding up these discounted streams gives us a fair
market price for the rights to these royalties ($233.73 million).

3.

Consider the following table of annual data on core inflation, 10-year


Treasury yields, and investment grade (BAA) bond yields. Determine
the real risk-free rate of return, and the real risk premium on
investment grade bonds.
Year
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013

10-year Bond Yields Core


Real Returns (%)
BAA
US
Inflation Risk-Free
Risk
Corp.
Treasury
Premium
8.36
6.03
2.4
3.63
2.33
7.95
5.02
2.7
2.32
2.93
7.80
4.61
2.3
2.31
3.19
6.77
4.02
1.5
2.52
2.75
6.39
4.27
1.8
2.47
2.12
6.06
4.29
2.1
2.19
1.77
6.48
4.79
2.5
2.29
1.69
6.48
4.63
2.3
2.33
1.85
7.45
3.67
2.3
1.37
3.78
7.30
3.26
1.7
1.56
4.04
6.04
3.21
1.0
2.21
2.83
5.66
2.79
1.7
1.09
2.87
4.94
1.80
2.1
-0.30
3.14
5.10
2.35
1.8
0.55
2.75

The risk free real return (!" ) is equal to the difference between the risk
free nominal return (!" ) and the current rate of inflation ():
!" = !"
We use Treasury bond yields as a measure of the nominal, risk-free
return. So, for 2000, the risk-free real return is 3.63% (6.03% - 2.4%).
To calculate the risk premium, just subtract the nominal return on the
risk free asset (Treasuries) from the return of a risky asset (Corp.
Bonds). Therefore, in 2000, the risk premium is 2.33% (8.36% 6.03%).

4.

Suppose that Wall Street analysts anticipate that Coca-Cola will pay a
$5 annual dividend for the foreseeable future (i.e., forever). Assuming
that Wall Street analysts posses rational expectations, what should be
the price of a share of Coca-Cola if we assume that interest rates are
fixed at 5% (also assume that you will receive your first dividend
payment next year)? Hint: The value of a geometric series (
1
.
S = a 0 + a1 + a 2 + a 3 +L ) is equal to: S =
1 a
According to rational expectations theory:
5
5
5
P=
+
+
+!
2
1.05 1.05 1.053

5
from the above infinite sum:
1.05
0
1
2
"
%
%
5 "
1
1
5 $( 1 + ( 1 + ( 1 +
'
P=
$1+
+
+!
=

+
+
+!
*
*
*
'
$
'&
1.05 # 1.05 1.052
1.05
1.05
1.05
1.05
&
, )
, )
,
#)
"
%
"
%
"
%
$
'
$
'
$
'
5 $
1
1
' = 5 $
' = 5 $ 1 ' = 5 " 1.05 %
P=

$
'
1.05 $ ( 1 + ' 1.05 $ 1.05 ( 1 + ' 1.05 $ 0.05 ' 1.05 # 0.05 &
*
-'
-'
$1 *
$
$# 1.05 '&
# ) 1.05 , &
# 1.05 ) 1.05 , &
P = 100

Factoring out

5. Suppose that Wall Street analysts have a one-year consensus price target
(forecast) for Intel of $100 per share (i.e. they forecast that the price of
a share of stock will be $100 next year). Further, suppose that the
current price of Intel is $95.45 per share and that interest rates are
assumed to remain fixed at 10% for one year. What is next years
expected dividend amount?

Pt =

Dte+1 + Pt e+1
Dte+1 = Pt (1 + i ) Pt e+1 = 95.45 (1.1) 100
(1 + i )

Dte+1 = 5

6. Suppose that interest rates are fixed forever at the rate of 4%, and shares
of Acme Inc. are selling for $37.50. Assume Acmes dividend
payments are also fixed forever, and that the next dividend payment is
one year away.
a. Determine the annual dividend amount.
D
From question #1, we know that P = . Therefore,
i
D = P i = 37.50 0.04 = 1.50
b. Suppose that interest rates jump to 6%, determine Acmes new
stock price.
D 1.50
P= =
= 25
i 0.06
7. What is the lemons problem? What are its consequences? How can the
market and the government respond to this problem?
The lemons problem refers to the fact that asymmetric information in a
market leads to adverse selection. The lemons problem raises lending
costs because lenders are not able to distinguish between credit-worthy
and un-credit-worthy borrowers. Consequently, the average credit risk of
borrowers increase, which in-turn, causes lenders to issue fewer loans at
any given interest rate.
One market response to the problem is to engage in credit rationing,
whereby lenders force borrowers to aggressively compete for a small pool
of loanable funds (thus limiting credit to only the most qualified borrowers).
Moreover, lenders may impose more stringent collateral requirements.
Governments can help combat the lemons problem by requiring more
financial transparency (i.e. firms are required to disclose important
financial data to the general public).