Money Banking and Financial Markets 5th Edition Cecchetti Solutions Manual Download

Chapter 06 - Bonds, Bond Prices, and the Determination of Interest Rates
Money Banking and Financial

Markets 5th Edition Cecchetti
Solutions Manual
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Chapter 6
Bonds, Bond Prices, and the Determination of Interest
Rates
Conceptual and Analytical Problems

1. Consider a U.S. Treasury Bill with 270 days to maturity. If the annual yield is 3.8
percent, what is the price? (LO1)
$100
Answer: P = = $97.24
(1 + 0.038) 9 / 12
2. *You are an officer of a commercial bank and wish to sell one of the bank’s assets—a
car loan—to another bank. Using equation A5 in the Appendix to Chapter 4, compute
the price you expect to receive for the loan if the annual interest rate is 6 percent, the
car payment is $430 per month, and the loan term is five years. (LO1)
Answer: The present value of the payments can be found by using equation A5 in the
appendix to Chapter 4:
6-1
© 2017 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
C 1
PV = i [1 − ]
(1+i)n
The monthly payment, C, is given as $430 per month and there are 60 months in the
five year horizon. The annual interest rate is 6 percent, so the monthly rate in decimal
form is
im = (1.06)1/12 – 1 = .00487
Thus, the value of the car loan is
430 1
PV = .00487 [1 − ] = $22,326
(1.00487)60
3. *Your financial adviser recommends buying a 10-year bond with a face value of
$1,000 and an annual coupon of $80. The current interest rate is 7 percent. What
might you expect to pay for the bond (aside from brokerage fees)? (LO1)
Answer: The value of the bond has two components: the present value of the coupon
payments and the present value of the return of principal at maturity. This is:
C 1 F
P = i [1 − ] + (1+i)n
(1+i)n
In this expression, C is the coupon payment, i is the interest rate, n is the number of
periods the coupon payments are made, and F is the face value. Using the information
in the question, we have
80 1 1000
P = .07 [1 − ] + (1.07)10 = 561.89 + 508.35 = 1,070.24
(1.07)10
4. *Consider a coupon bond with a $1,000 face value and a coupon payment equal to 5
percent of the face value per year. (LO2)
a. If there is one year to maturity, find the yield to maturity if the price of the
bond is $990.
b. Explain why finding the yield to maturity is difficult if there are two years to
maturity and you do not have a financial calculator.
Answer:
a. The yield to maturity can be found by equating the current price of the bond to
the present value of the coupon payment plus the present value of the face
value when both payments are due in one year. Specifically,
50 1000
990 = (1+𝑖) + (1+𝑖)
6-2
Then
1050
(1+i) = = 1.061
990
so that i = .061 or 6.1 percent.
b. If there are two years to maturity, then we would need to solve

50 50 1000
990 = (1+𝑖) + (1+𝑖)2 + (1+𝑖)2
The presence of the quadratic term makes this equation much more time-
consuming to solve without a financial calculator.
5. Which of these $100 face value one-year bonds will have the highest yield to maturity
and why? (LO2)
a. A 6 percent coupon bond selling for $85.
b. A 7 percent coupon bond selling for $100.
c. An 8 percent coupon bond selling for $115.
Answer:
$6 $100
a. $85 = + → i = 24.71%
1+ i 1+ i
$7 $100
b. $100 = + → i = 7%
1+ i 1+ i
$8 $100
c. $115 = + → i = −6.1%
1+ i 1+ i
Option (a) has the highest yield to maturity. The yield to maturity depends both on
the coupon payment and any capital gain or loss arising from the difference between
the selling price and the face value of the bond. While (a) has the lowest coupon rate,
it is selling below face value, and so there is a capital gain. Option (b) is selling at
face value, so there is no capital gain and option (c) is selling above face value and so
there is a capital loss. As the calculations above show, the combination of the coupon
payment and the capital gain on option (a) produces the highest yield to maturity.
6. You are considering purchasing a consol that promises annual payments of $4. (LO2)
a. If the current interest rate is 5 percent, what is the price of the consol?
6-3
b. You are concerned that the interest rate may rise to 6 percent. Compute the
percentage change in the price of the consol and the percentage change in the
interest rate. Compare them.
c. Your investment horizon is one year. You purchase the consol when the interest
rate is 5 percent and sell it a year later, following a rise in the interest rate to 6
percent. What is your holding period return?
Answer:
$4
a. P = = $80
0.05
$4
b. newP = = $66.67
0.06
P falls by 16.7%; i rises by 20%
$4 $66.67 − $80
c. + = −11.7%
$80 $80
7. *Suppose you purchase a 3-year, 5-percent coupon bond at par and hold it for two
years. During that time, the interest rate falls to 4 percent. Calculate your annual
holding period return. (LO2)
Answer: The total holding period return over the two years consists of two coupon
payments of $5 each plus the capital gain from the rise in the price of the bond due to
the interest rate fall.
The price at which you sell the bond after two years will be 5/1.04 +100/1.04 =
$100.96.
Holding period return over two years= 10/100 + (100.96-100)/100 = .1096 or
10.96%.
The total payoff on the bond for which you paid $100 is $110.96.
To calculate the annual rate of return, we refer to the footnote on p. 140. It is

assumed, for simplicity, that the first-year coupon is not reinvested for the second
year. The annual rate of return is [(110.96/100)1/2 –1] = .0534 or 5.34 percent.
Because the interest rate fell during the holding period and you made a capital gain,
the annual holding period return is higher than the coupon rate.
6-4
8. In a recent issue of the Wall Street Journal (or on www.wsj.com or an equivalent

financial website), locate the prices and yields on U.S. Treasury issues. For one bond
selling above par and one selling below par (assuming they both exist), compute the
current yield and compare it to the coupon rate and the ask yield printed in the paper.
(LO2)
Answer:
a. For the Treasury bond due August 15, 2025 with a coupon of 6.875%, on
November 25, 2016, the bond price was 136.4141 and the asked yield 2.25%.
That means the current yield was 6.875/136.4141 × 100 = 5.04%, so the coupon
rate > current yield > asked yield, in line with Table 6.1 when the bond price is
above the face value of 100.
b. For the Treasury bond due August 15, 2025 with a coupon of 2.000%, on
November 25, 2016, the bond price was 97.3516 and the asked yield 2.338%.
That means the current yield was 2.000/97.3516 × 100 = 2.05%, so the coupon
rate < current yield < asked yield, in line with Table 6.1 when the bond price is
below the face value of 100.
9. In a recent issue of the Wall Street Journal (or on www.wsj.com), locate the yields on
government bonds for various countries. Find a country whose 10-year government
bond yield was above that on the U.S. 10-year Treasury bond and one whose 10-year
yield was below the Treasury yield. What might account for these differences in
yields? (LO4)
Answer: As of Thursday, December 1, 2016, the 10-year U.S. Treasury yield was
2.441%, while the 10-year government bond yields in Germany and Australia were
0.373% and 2.790%, respectively. Because the default risk of all three governments
is very low, the yield differentials most likely reflect differences in long-run inflation
expectations, with inflation in Germany expected to be lower than in the United
States, while inflation in Australia is expected to be a bit higher.
10. A 10-year zero-coupon bond has a yield of 6 percent. Through a series of unfortunate
circumstances, expected inflation rises from 2 percent to 3 percent. (LO2, LO4)
a. Assuming the nominal yield rises in an amount equal to the rise in expected
inflation, compute the change in the price of the bond.
b. Suppose that expected inflation is still 2 percent, but the probability that it will
move to 3 percent has risen. Describe the consequences for the price of the bond.
Answer:
a. Price (with 2% expected inflation) = 100/(1.06)10 = $55.84
Price (with 3% expected inflation) = 100/(1.07)10 = $50.83
The price has fallen by $5.01
6-5
b. There is increased inflation risk. Investors will require compensation for taking
on additional risk, so the price will fall and the yield will rise.
11. As you read the business news, you come across an advertisement for a bond
mutual fund – a fund that pools the investments from a large number of people and
then purchases bonds, giving the individuals “shares” in the fund. The company
claims their fund has had a return of 13½ percent over the last year. But you
remember that interest rates have been pretty low – 5 percent at most. A quick
check of the numbers in the business section you’re holding tells you that your
recollection is correct. Explain the logic behind the mutual fund’s claim in the
advertisement. (LO2)
Answer: There are two possible explanations for the high return. The first is that
the mutual fund is investing in relatively risky bonds and is being compensated for
taking on this risk with higher returns. The second is that the fund was holding
bonds during a period when interest rates were falling, so the holding period return
far exceeded the interest rate.
Remember that when interest rates fall, the prices of bonds rise, giving the owner a
capital gain. If interest rates are now low, then the likelihood is that they will rise,
causing a capital loss to the owners. Chances are that if the high return is a
consequence of the interest rate decline, not only will it not be repeated, it is likely
to be followed by a low or even negative return when interest rates rise.
12. You are sitting at the dinner table and your father is extolling the benefits of
investing in bonds. He insists that as a conservative investor he will only make
investments that are safe, and what could be safer than a bond, especially a U.S.
Treasury bond? What accounts for his view of bonds? Explain why you think it is
right or wrong. (LO4)
Answer: Like most people, your father believes that the government guarantee
means that he will get his investment back. He’s right that the U.S. Treasury is
extremely unlikely to default. But he’s wrong about interest-rate and inflation
risk. The value of the bond will fluctuate when the interest rate changes (moving
inversely) and the purchasing power of the coupon and principal repayment will
fluctuate with inflation. So, the bond is not risk free.
13. *Consider a one-year, 10-percent coupon bond with a face value of $1,000 issued
by a private corporation. The one-year risk-free rate is 10 percent. The
corporation has hit on hard times, and the consensus is that there is a 20 percent
probability that it will default on its bonds. If an investor were willing to pay at
most $775 for the bond, is that investor risk-neutral or risk averse? (LO4)
6-6
Answer: If the bond were risk free, it would pay off $1,100 in one year’s time - $100
coupon payment and $1,000 face value of the bond.
If there is a 20% risk of default, then the expected value of these payment flows
associated with the bond are ($1,100 × 0.8) + ($0 × 0.2) = $880
The present value of $880 in one year’s time is $880/1.1 = $800. This would be the
price a risk-neutral investor would be willing to pay.
If the investor is willing to pay at most $775 for the bond, he or she requires
compensation for bearing the risk associated with the bond and so is risk averse.
14. If, after one year, the yield to maturity on a multi-year coupon bond that was
issued at par is higher than the coupon rate, what happened to the price of the bond
during that first year? (LO2)
Answer: The price of the bond fell below par. When a bond is at par, the yield to
maturity equals the coupon rate. If the yield to maturity rises, the price of the
bond falls. If you buy the bond below par, the capital gain you receive by holding
it to maturity is included along with the coupon payments, so the yield to maturity
is higher than the coupon rate alone.
15. Use your knowledge of bond pricing to explain under what circumstances you
would be willing to pay the same price for a consol that pays $5 a year forever and
a 5-percent, 10-year coupon bond with a face value of $100 that only makes
annual coupon payments for 10 years. (LO1, LO2)
Answer: The price you are willing to pay for a bond reflects the present value of
the payment flows from the bond. In this case, if i = 5%, the present value of the
payment flows for both these bonds would be $100. Intuitively, while the consol
makes coupon payments forever, the 10-year coupon bond pays back the principal
at maturity, which then can be reinvested. Assuming you have no reason to believe
that rates will rise or fall over the 10-year period, you would be indifferent
between these bonds. If you are certain that rates will be higher in ten years, you
would prefer the 10-year coupon bond, whose proceeds can then be reinvested at
the higher rate while the value of the consol would have fallen. Similarly, if you
are certain that rates will be lower in ten years, you would prefer the consol.
16. *You are about to purchase your first home and receive an advertisement
regarding adjustable-rate mortgages (ARMs). The interest rate on the ARM is
lower than that on a fixed rate mortgage. The advertisement mentions that there
would be a payment cap on your monthly payments and you would have the
option to convert to a fixed-rate mortgage. You are tempted. Interest rates are
currently low by historical standards and you are anxious to buy a house and stay
6-7
in it for the long term. Why might an ARM not be the right mortgage for you?
(LO4)
Answer: There are several factors to consider. First, with a fixed rate mortgage, your
payments are fixed over the life of the loan. The interest rate on this mortgage is
higher because the lender is assuming the interest rate risk. The ARM has a lower
interest rate in part because you will assume risk associated with interest rate
movements over the life of the loan (your payments will rise if rates rise). Given that
interest rates are currently relatively low, it is more likely that they will rise, pushing
up your payments. This problem is more likely to be an issue the longer you plan to
stay in the house. Second, converting later to a fixed-rate mortgage from an
adjustable rate loan often involves restrictions and fees. Third, payment caps may
limit how much your monthly payments can rise, but may be associated with negative
amortization if your payments don’t cover the interest costs of your loan. Shortages
are added to the principal of your loan, pushing up your costs.
17. Use the model of supply and demand for bonds to illustrate and explain the impact
of each of the following on the equilibrium quantity of bonds outstanding and on
equilibrium bond prices and yields: (LO3)
a. A new website is launched facilitating the trading of corporate bonds
with much more ease than before.
b. Inflationary expectations in the economy fall evoking a much stronger response
from issuers of bonds than investors in bonds.
c. The government removes tax incentives for investment and spends additional
funds on a new education program. Overall, the changes have no effect on the
government’s financing requirements.
d. All leading indicators point to stronger economic growth in the near future. The
response of bond issuers dominates that of bond purchasers.
Answer:
a. The new website would increase the relative liquidity of bonds, shifting the bond
demand curve to the right, increasing the equilibrium price of bonds and reducing
yields. The equilibrium quantity of bonds outstanding rises.
S
Price of Bonds
P1
P0
D1
D0
6-8
© 2017 by McGraw-Hill Education. This is proprietary material solely forQauthorized
0 Q1 instructor use. Not authorized for sale or distribution in
Quantity of Bonds
b. For a given nominal interest rate, a fall in inflationary expectations increases the
real interest rate, shifting the bond supply curve to the left and the bond demand
curve to the right. If the response of the bond issuers is relatively stronger, the
supply curve shift will dominate and the quantity of bonds outstanding will fall.
Regardless of the relative size of the shifts, the equilibrium price of bonds will
rise and yields will fall.
S1
Price of Bonds S0
P1
P0
D0 D1
Q1 Q0
Quantity of Bonds
c. The removal of tax incentives on investment would make investment more costly,
reducing the supply of bonds by corporations, shifting the supply curve to the left.
As there is no change in the financing requirements of the government, the supply
of government bonds doesn’t change. Equilibrium quantity falls. Equilibrium
bond prices rise and yields fall.
S1
S0
Price of Bonds
P1
P0
D0
Q1 Q0
Quantity of Bonds
6-9
d. A business cycle upturn increases business investment opportunities, shifting the

bond supply curve to the right. Wealth also increases, shifting the bond demand
curve to the right. If the supply shift dominates, equilibrium bond prices fall and
yields rise. The equilibrium quantity of bonds outstanding increases.
S0
S1
Price of Bonds
P0
P1
D0 D1
Q0 Q1
Quantity of Bonds
18. Suppose that a sustainable peace is reached around the world, reducing military
spending by the U.S. Government. How would you expect this development to
affect the U.S. bond market? (LO3)
Answer: As the government’s need to issue bonds to finance military spending is

reduced, the supply of government bonds will fall, shifting the supply curve to the
left. Bond prices will increase and yields will fall.
6-10
19. Use the model of supply and demand for bonds to determine the impact on bond
prices and yields of expectations that the real estate market is going to weaken. (LO3)
Answer: If we think of real estate as an alternative investment to bonds, expected

weakness in the real estate market implies an increase in the relative return on bonds.
Bond demand shifts to the right, increasing the equilibrium bond prices and lowering
yields.
20. *Suppose there is an increase in investors’ willingness to hold bonds at a given price.
Use the model of the demand for and supply of bonds to show that the impact on the
equilibrium bond price depends on how sensitive the quantity supplied of bonds is to
the bond price. (LO3)
Answer: The sensitivity of bond supply to changes in the price of bonds is reflected in
the slope of the supply curve. The more sensitive quantity supplied is to a movement
in the price, the flatter the supply curve and the smaller the impact on the equilibrium
price for any given shift in the demand curve.
S
Price of Bonds
Price of Bonds
S
P1
P1
P0 P0
D1 D1
D0 D0
Quantity of Bonds Quantity of Bonds
6-11
21. Under what circumstances would purchase of a Treasury Inflation Protected Security
(TIPS) from the U.S. government be virtually risk free? (LO4)
Answer: Purchasing a Treasury Inflation Protected Security (TIPS) would be virtually

risk free if you purchased a bond whose maturity exactly matched your investment
horizon. The default risk of holding a U.S. government-issued bond is very low
while inflation risk is eliminated by the inflation-indexed nature of the TIPS. If you
know your investment horizon with certainty and purchase a bond whose maturity
matches that horizon, you eliminate interest rate risk, as you are confident that the
bond will be redeemed at par when it matures. Interest rate movements that cause the
price of the bond to change before it matures will not affect you.
22. In the wake of the financial crisis of 2007-2009, negative connotations often
surrounded the term mortgage-backed security. What arguments could you make to
convince someone that they may have benefitted from the growth in securitization
over the past 30 years? (LO4)
Answer: If the person you are trying to convince is a borrower, they may have
received a lower mortgage interest rate due to the increased liquidity provided by
securitization. If they are from a small town, they may have found it easier to get a
mortgage as securitization broadened the potential sources of funds for their loan. If
they are an investor, you might point to the opportunities for diversification provided
by securitization.
23. During the euro-area sovereign debt crisis, the spread between the yields on bonds
issued by the governments of geographically peripheral European countries (such as
Greece, Ireland, Italy, Portugal, and Spain) and those on bonds issued by Germany
widened considerably. Use the model of supply and demand for bonds to illustrate
how this could be explained by a change in investors’ perceptions of the relative
riskiness of peripheral sovereign versus German bonds. (LO3, LO4).
Answer: Investor worries about the possibility of default on bonds issued by

relatively indebted peripheral euro-area governments increased during the crisis. This
can be illustrated with a leftward shift of the bond demand curve, lowering the price
and raising the yield. For a given German bond yield, this would increase the spread
of peripheral government bond yields above those on German bonds, reflecting the
need for a larger risk premium to compensate investors.
6-12
S
Price of Bonds
P0
P1
D1 D0
Q1 Q0
Quantity of Bonds
24. Not long after the United Kingdom’s vote to leave the European Union, the yields on
some British Government bonds (called gilts) turned negative. Assuming that these
bonds were issued with a positive coupon rate, would you expect their market prices
to be above, below or equal to their face value? Explain your choice. (LO2)
Answer: If the yield on a bond with a positive coupon rate is negative, the price must
be above the face value. Thinking about maturity, if the yield is negative, the investor
must suffer a capital loss to offset the positive coupon payments. Therefore, the
market price of the bond must be above the face value.
Data Exploration
1. Graph investors’ long-term expected inflation rate since 2003 by subtracting from the
10-year U.S. Treasury bond yield (FRED code: GS10) the yield on 10-year Treasury
Inflation Protected Securities (FRED code: FII10). Do these market-based inflation
expectations appear stable? Did the financial crisis of 2007-2009 affect these
expectations? (LO4)
Answer: The indicated data plot is:
6-13
With the exception of the downward spike in late 2008, inflation expectations by this
measure appeared stable through 2014, fluctuating mostly in the range of 2.0 percent
to 2.5 percent. The temporary plunge in expectations at the end of 2008 followed the
Lehman bankruptcy, which ushered in the most intense episode of the 2007-2009
financial crisis. More recently, this measure of expected inflation has drifted lower,
perhaps due to the persistent undershoot of the Fed’s 2 percent inflation target and to
the modest growth of real GDP.
S0
S1
Price of Bonds
P0
P1
6-14
D0for authorized
© 2017 by McGraw-Hill Education. This is proprietary material solely D1 instructor use. Not authorized for sale or distribution in
Q0 Q1
Quantity of Bonds
2. Compare long-run market expectations of inflation with a consumer survey measure

of one-year-ahead inflation expectations. Starting with the graph from Data
Exploration Problem 1, add as a second line the University of Michigan survey
measure of inflation expectations (FRED code: MICH) Why might these measures
differ systematically? (LO4)
Answer: The indicated data plot is:
We should not expect that one-year ahead consumer inflation expectations match 10-
year-ahead investor inflation expectations, but they are broadly correlated.
Interestingly, consumer short-term inflation expectations exceed investor long-term
expectations virtually throughout this period. One reason may be that consumers
focus more on the prices of goods that they buy frequently,such as food and gasoline
where price changes are visible and frequent, and less on infrequent purchases (like
electronics) for which inflation may be lower. In contrast, TIPS compensate investors
for changes in the CPI that includes all these prices.
6-15
3. How does the variability of annual inflation – an indicator of inflation risk – change
over time? Graph the percent change from a year ago of the consumer price index
(FRED code: CPIAUCSL) since1990 and visually compare the decades of the 1990s,
the 2000s, and the period that began in 2010. (LO4)
Answer: The data plot is:
After inflation declines to around 3 percent in the early 1990s, it appears less variable
than in the 2000s, which includes the relatively large downward spike to negative
inflation occurs during 2009. By visual inspection, if variability of inflation
represents inflation risk, then this risk appears to change through time, and picked up
temporarily during the financial crisis of 2007-2009. Even ignoring the Great
Recession, inflation variability since 2000 appears higher than in the 1990s.
4. Download the data from the graph you produced in Data Exploration Problem 3.
Calculate the standard deviation of the annual inflation rate for the three time periods
and compare these results against your visual assessment from Data Exploration
Problem 3. (LO4)
6-16
Answer: The standard deviation from 1990 through 1999 is 1.13. From 2000 through
2009, it is 1.42, but this masks a lower standard deviation of 0.84 from 2000 through
2007:12 (the onset of the Great Recession). From 2010 through mid-2016, the
standard deviation is 0.98. (Computations after this date will include additional
observations and incorporate any data revisions.) These results appear consistent with
the visual assessment in Data Exploration Problem 3.
5. Economists sometimes exclude food and energy prices from the “headline” consumer
price index and use the resulting “core” price measure to assess inflation prospects.
For the period since 1990, plot on one graph the percent change from a year ago of
the consumer price index (FRED code: CPIAUCSL) and the percent change from a
year ago of the consumer price index excluding food and energy (FRED code:
CPILFESL). Visually compare the variability of these two measures of inflation.
Why might inflation, excluding food and energy, be a better predictor of future
inflation than headline inflation? (LO4)
Answer: The data plot is:
Because food and energy prices are relatively volatile, the “core” measure of inflation
is less variable than the “headline” measure. Volatility tends to mask the trend of an
economic indicator by adding statistical “noise” to the trend. Consequently,
6-17
examining core inflation can reveal to economists the underlying trend of inflation. If
that trend is stable, it can be useful in anticipating inflation prospects.
* indicates more difficult problems
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Chapter 06 - Bonds, Bond Prices, and the Determination of Interest Rates

Money Banking and Financial

Solution Manual: https://testbankpack.com/p/solution-manual-

Test Bank: https://testbankpack.com/p/test-bank-for-money-

Conceptual and Analytical Problems

Thus, the value of the car loan is

so that i = .061 or 6.1 percent.

b. If there are two years to maturity, then we would need to solve

b. A 7 percent coupon bond selling for $100.

c. An 8 percent coupon bond selling for $115.

P falls by 16.7%; i rises by 20%

To calculate the annual rate of return, we refer to the footnote on p. 140. It is

8. In a recent issue of the Wall Street Journal (or on www.wsj.com or an equivalent

d. A business cycle upturn increases business investment opportunities, shifting the

Answer: As the government’s need to issue bonds to finance military spending is

Answer: If we think of real estate as an alternative investment to bonds, expected

Quantity of Bonds Quantity of Bonds

Answer: Purchasing a Treasury Inflation Protected Security (TIPS) would be virtually

Answer: Investor worries about the possibility of default on bonds issued by

Answer: The indicated data plot is:

2. Compare long-run market expectations of inflation with a consumer survey measure

Answer: The data plot is:

* indicates more difficult problems

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