TUTORIAL 2

MONEY AND INTEREST RATES

Part 1: Review questions

1. Definition of money, measuring money
2. Distinguish major credit types, provide examples
3. Relationship between YTM and bond prices
4. Yield and returns

Part 2: Multiple choice questions

1. Fiat money is:

A. credit card charges
B. not convertible into precious metals.
C. coins
D. checks

2. Which of these is not a function of money in an economy?

A. Unit of account
B. Source of income
C. Store of value
D. Medium of exchange

3. Which of the following is not part of M1?

A. traveler's checks
B. savings accounts
C. checking accounts
D. currency

4. If Mary deposits $100 of her currency in her checking account, then:

A. M2 will fall by $100.
B. M1 will increase by $100.
C. M1 and M2 will not change.
D. M2 will increase by $100.

5. If Mary moves $100 from her savings account to her checking account, then:
increase M1, M2 not change
A. M2 will not change.
B. M2 will fall by $100.
C. M1 will not change.
D. M1 will fall by $100

6. Inefficiencies that are created when using checks as money include:

A. Checks can transfer funds slowly and require paper shuffling.
B. Checks can be written for any amount.
C. Checkbooks can be stolen.
 D. There are too many bad checks written

7. The liquidity of an asset is:

A. the amount of an asset sold at discount or premium.
B. the ability of an asset to earn interest income.
C. the relative ease with which an asset can be converted into a medium of
exchange.
D. the relative ease with which an asset can be converted into a common
stock.

8. Which of the following is true regarding money's store of value function?

A. money is superior to all other stores of value during periods of inflation.
B. money is the most liquid store of value available.
C. money is the only store of value available.
D. money does not allow a person to hold purchasing power from the time
income is earned until it is spent.

9. Which of the following is not a disadvantage of electronic money?

A. The cost of setting up a system for processing e-money payments is high.
B. People are concerned about the privacy and security of e-money
transactions.
C. E-money does not allow people to take advantage of float.
D. E-money transactions cost more than paper check transactions.

10. You receive a check for $100 two years from today. The discounted present value
of this $100 is:
A. $100*(1+i)
B. $100/(1+i)2
C. $100*(1+i)2
D. $100/(1+i)

11. Why do current prices on previously issued bonds offered for resale change
when the market interest rate changes?
A. Because old bonds cannot sell at face value today.
B. Because no buyer of bonds today will accept a lower yield to maturity than
the market rate, and no buyer will be able to get a higher yield.
C. Because the marketplace does not provide enough information to price
bonds accurately.
D. Because new bonds are always preferred to old bonds.

12. If a bond sells at a premium, where price exceeds face value, then we would
expect to see: Coupon>YTM
A. market interest rates could be the same, higher, or lower than the coupon
rate.
B. market interest rate the same as the coupon rate.
 C. market interest rates below the coupon rate.
D. market interest rates above the coupon rate.

13. As bond prices increase:

A. yields to maturity decrease.
B. yields to maturity increase.
C. yields to maturity can rise, fall, or not change.
D. yields to maturity do not change.

14. For a $1000 one year discount bond with a price of $975, the yield to maturity is
A. ($1000 – $975)/($1000)
B. $975/$1000
C. ($1000 – $975)/$975 (F-P)/P
D. $1000/$975

15. The return on a bond is

A. current yield + rate of capital gain.
B. coupon rate – rate of capital gain.
C. coupon rate + rate of capital gain.
D. current yield – rate of capital gain

16. Interest rate risk is:

A. the risk the coupon rate on the bond will fall.
B. the risk the government or firm will not make interest payments.
C. the risk associated with change in return with changes in interest rates.
D. the risk the coupon payment will rise.

17. The real interest rate is:

A. the nominal rate plus the expected inflation rate.
B. the nominal interest rate/the CPI.
C. the product of the nominal rate and the CPI.
D. the nominal rate minus the expected inflation rate

18. For a coupon bond, the yield to maturity is the:

A. difference between the bond's price and its face value.
B. annual interest payment divided by the bond's face value.
C. interest rate that equates the bond's present value with its price.
D. interest rate that equates the bond's present value with its face value.

19. When interest rates fluctuate, which bonds will experience the least price
volatility?
A. 20-year bonds
B. 1-year bonds
C. 5-year bonds
D. 10-year bonds
20. Why is the Rate of Return often the most relevant measure of a bond's benefit to
the buyer?
A. Because the Rate of Return uses the current yield.
B. Because the Rate of Return includes the return of the face value at maturity.
C. Because the Rate of Return uses the difference between the face value and
the purchase price to compute a capital gain on the bond.
D. Because the Rate of Return recognizes that many bond buyers do not plan
to hold to maturity, but will sell the bond before maturity.

21. If a $5,000 coupon bond has a coupon rate of 13 percent, then the coupon
payment every year is
A) $650.
B) $1,300.
C) $130.
D) $13.

22. Examples of discount bonds include
A) U.S. Treasury bills.
B) corporate bonds.
C) U.S. Treasury notes.
D) municipal bonds.

23.Economists consider the ________ to be the most accurate measure of interest
rates
A) simple interest rate.
B) current yield.
C) yield to maturity.
D) real interest rate.

24.If the amount payable in two years is $2420 for a simple loan at 10 percent
interest, the loan amount is
A) $1000.
B) $1210.
C) $2000.
D) $2200. 2420/(1+10%)

25.If $22,050 is the amount payable in two years for a $20,000 simple loan made tod
ay, the interest rate is
A) 5 percent. 22050/20000=(1+i)^2
B) 10 percent.
C) 22 percent.
D) 25 percent

26.If a security pays $110 next year and $121 the year after that, what is its yield to 
maturity if it sells for $200?
A) 9 percent
B) 10 percent 200 = 110/(1+i) + 121/(1+i)^2
C) 11 percent
D) 12 percent

27.The price of a coupon bond and the yield to maturity are ________ related; that i
s, as the yield to maturity ________, the price of the bond ________.
A) positively; rises; rises
B) negatively; falls; falls
C) positively; rises; falls
D) negatively; rises; falls
.
28. Which of the following $5,000 face-value securities has the highest to maturity?
A) A 6 percent coupon bond selling for $5,000 6% YTM=coupon rate
B) A 6 percent coupon bond selling for $5,500
C) A 10 percent coupon bond selling for $5,000 10% YTM=coupon rate
D) A 12 percent coupon bond selling for $4,500
Coupon rate = YTM -> bond price = face value
Coupon rate < YTM -> bond price < face value
Coupon rate > YTM -> bond price > face value
The higher YTM, the lower bond price

29. In which of the following situations would you prefer to be the lender?
A) The interest rate is 9 percent and the expected inflation rate is 7 percent.
B) The interest rate is 4 percent and the expected inflation rate is 1 percent.
C) The interest rate is 13 percent and the expected inflation rate is 15 percent.
D) The interest rate is 25 percent and the expected inflation rate is 50 percent.

30. In which of the following situations would you prefer to be the borrower?
A) The interest rate is 9 percent and the expected inflation rate is 7 percent.
B) The interest rate is 4 percent and the expected inflation rate is 1 percent.
C) The interest rate is 13 percent and the expected inflation rate is 15 percent.
D) The interest rate is 25 percent and the expected inflation rate is 50 percent.

Part 3: End-of-chapter questions

Chapter 3: Questions 12, 13, 15
Question 12: Explain the concept of liquidity. Rank the following assets from most liquid
to least liquid: c-d-f-b-e-a
a. Land
b. The inventory of a merchandiser
c. Cash in hand
d. A savings account at a local bank
e. A one-year bond
f. Ordinary shares

Question 13: Which of the Federal Reserve’s measures of the monetary aggregates—M1
or M2—is composed of the most liquid assets? M1
Which is the larger measure? M2

Question 15: For each of the following assets, indicate which of the monetary aggregates
(M1 and M2) includes them:
a. Currency M1
b. Money market mutual funds M2
c. Small-denomination time deposits M2
d. Checkable deposits M1

Chapter 4: Questions 2, 6, 7, 10, 11

Question 2: What is the formula used to calculate the yield to maturity on a 20-year
coupon bond with a current yield of 12% and $1,000 face value that sells for $2,500.
Coupon payment = 1000 * 12% = 120
2500 = 120/(1+i)+120/(1+i)^2+…+120/(1+i)^20+1000/(1+i)^20

Question 6: If mortgage rates rise from 5% to 10% but the expected rate of increase in
housing prices rises from 2% to 9%, are people more or less likely to buy houses?
People are more likely to buy houses because the real interest rate when purchasing a
house has fallen from 3% (5-2%) to 1% (10-9%) and is thus lower, even though nominal
mortgage rates have risen. (If the tax deductibility of interest payments is allowed for,
then it becomes even more likely that people will buy houses.)

Question 7: When is the current yield a good approximation of the yield to maturity?
The current yield will be a good approximation to the yield to maturity whenever the
bond price is very close to par or when the maturity of the bond is over about ten years.
This is because cash flows farther in the future have such small present discounted values
that the value of a long-term coupon bond is close to a perpetuity with the same coupon
rate.

Question 10: True or False: With a discount bond, the return on the bond is equal to the
rate of capital gain.
True. The return on a bond is the current yield iC plus the rate of capital gain, g. A
discount bond, by definition, has no coupon payments, thus the current yield is always
zero (the coupon payment of zero divided by current price) for a discount bond.

Question 11: If interest rates decline, which would you rather be holding, long-term
bonds or short-term bonds? Why? Which type of bond has the greater interest-rate risk?
You would rather be holding long-term bonds because their price would increase more
than the price of the short-term bonds, giving them a higher return. Longer-term bonds
are more susceptible to higher price fluctuations than shorter-term bonds, and hence have
greater interest-rate risk.

Part 4: Additional problems

1. You have just purchased a 10-year, $1,000 par value bond. The coupon rate on
this bond is 8 percent annually, with interest being paid each 6 months. If you
expect to earn a 10 percent yield on this bond, how much did you pay for it?

V= +
V: Bond price
I : Coupon payment (Coupon rate x par value)
FV: Face value
YTM: Required return rate (Yield to maturity)
n : Number of periods

V= +
V= $875.37
2. Callaghan Motors ‘bonds have 10 years remaining to maturity. Interest is paid
annually, they have a $1,000 par value, the coupon interest rate is 8%, and the
yield to maturity is 9%. What is the bond’s current market price?

V= +
V= $935.83
3. A bond has a $1,000 par value, 10 years to maturity, and a 7% annual coupon and
sells for $985.

a. What is its yield to maturity (YTM)?

C: Coupon payment
FV: Face value
PV: Prensent value
t: numbers of periods

YTM = 7.215%
b. Assume that the yield to maturity remains constant for the next 3 years. What
will the price be 3 years from today?
=> Remaining 7 years

V= +
V= $988.46