Assignment/Problem Set 2

(Group)

Answer each item correctly. Show you solution under each item and box your final answers. You
may directly use word or write in a piece of paper this Problem Set. Make sure to submit a PDF
file.
1. Calculate the Present Value of a 100,000 Pesos discount bond with seven years of
maturity if the yield to maturity is 8%. 58,349.04

2. Consider a bond with a 6% annual coupon and a face value of 50,000 Pesos. Complete
the following table. What relationships do you observe between years to maturity, yield
to maturity, and the current price?

When yield to maturity is above

the coupon rate, the bond’s current
price is below its face value. The
opposite holds true when yield to
maturity is below the coupon rate.
For a given maturity, the bond’s
current price falls as yield to
maturity rises. For a given yield to
maturity, a bond’s value rises as its
maturity increases. When yield to
maturity equals the coupon rate, a
bond’s current price equals its
face value regardless of years to
maturity.
Years to Maturity Yield to Maturity Current Price
2 4% 51,886.09
2 6% 50,000
3 6% 50,000
5 5% 52,164.74
5 8% 46,007.29

3. Suppose you visit with a financial adviser, and you are considering investing some of
your wealth in one of three investment portfolios: stocks, bonds, or commodities. You
financial adviser provides you with the following table, which gives the probabilities of
possible returns from each investment.

Stocks Bonds Commodities

Probability Return Probability Return Probability Return
0.2 15% 0.4 15% 0.2 20%
0.3 8.3% 0.6 5% 0.25 12%
0.2 10% 0.25 6%
0.3 5% 0.2 5%
0.10%

a. Which investment should you choose to maximize your expected return: stocks,
bonds, or commodities?

Commodities
Determine which investment should be chosen to maximize your expected return. To find the
expected return on the portfolio, multiply the expected return on each asset by the appropriate
probability and then sum.
[stock portfolio] 0.2(15%) + 0.3(8.3%) + 0.2(12%) + 0.3(5%) =8.99%
[bond portfolio] 0.4(15%) + 0.6(5%) =9%
[commodities portfolio] 0.2(20%) + 0.25(12%) + 0.25(6%) + 0.2(5%) + 0.1(.10%) =9.51%

b. If you are risk averse and had to choose between stock and the bond investment,
which would you choose? Why?
Bond investment - bonds are generally considered safer than the stock investments. Bonds are a
loan to the company to finance its capital needs. At the end of the term of the bond you are paid
back the principal as well as the agreed upon interest. In short, your capital and its “rent” i.e.
interest is assured as long as the company you chose happens to be a liquid and solvent and
profitable firm. Depending on the terms of the bond, it is obliged to pay the interest and repay the
principal later, termed the maturity.

4. Using both the liquidity preference framework and the supply and demand for bonds
framework, show why interest rates are procyclical (rising when the economy is
expanding and falling during recessions).

Submit within 1 week (Check LMS)