Explain why an increase in the inflation rate will cause the yield to maturity on a bond to increase.

Explain why an increase in the inflation rate will cause the yield to maturity on a bond to increase.

Answer:  When the inflation rate increases, it means that the risk free rate of return will increase. This happens because investors need to make some real return, even on a risk free investment. This means that in order to keep the real rate of return constant, when the inflation rate goes up, the nominal interest rate goes up as well. Consequently, to maintain the same real rate of return, the nominal rate must go up, which in turn raises the required return, or yield to maturity.

What elements determine what the yield to maturity will be for a bond?

Answer:  The starting point is the risk free rate, a rate for a bond with no risks. A short term treasury bill reflects the risk free rate. The risk free rate comprises the real rate of return plus an inflation premium, so that the investor can earn the real return. If one knows the nominal risk free rate and the inflation rate, one can determine the real rate through the Fisher effect. When there is a possibility of default, the investor must receive a default premium to reflect that risk. Finally, there is the risk that the yield to maturity of the bond may change over the life of the bond, possibly lowering its value. This risk is reflected by the investor adding a maturity premium to the required return. In summary, the yield to maturity will be the real return, plus premiums for inflation, default, and maturity.

Given the anticipated rate of inflation (i) of 6.3% and the real rate of interest (R) of 4.7%, find the nominal rate of interest (r).

Answer: 

r = R + i + iR

r = .047 + 0.63 + (.063)(.047)

r = 11.3%

If provided the nominal rate of interest (r) of 14.2% and the anticipated rate of inflation (i) of 5.5%, what is the real rate of interest (R)?

Answer: 

r = R + i + iR

.142 = R + .055 + (.055)(R)

.142 - .055 = 1.055R + .055 - .055

.087 = 1.055R

R = 8.2%

Given the anticipated rate of inflation (i) of 6.13% and the real rate of interest (R) of 7.56%, what is the true inflation premium?

Answer:  We know the inflation premium to equal i + iR or = 0.0613 + (.0613)(.0756) = 6.59%

You buy a race horse, which has a winning streak for four years, bringing in $500,000 per year, and then it dies of a heart attack

You buy a race horse, which has a winning streak for four years, bringing in $500,000 per year, and then it dies of a heart attack. If you paid $1,518,675 for the horse four years ago, what was your annual return over this four-year period?

A) 8%

B) 33%

C) 18%

D) 12%

You are considering a home loan with monthly payments at an annual percentage yield of 5.116%. What is the quoted rate of interest on the loan?

A) 4.5%

B) 4.75%

C) 5%

D) 6%

You deposited $2,000 in a bank account paying 6% on January 1, 2004, and then you made $2,000 deposits on January 1 in 2005 and 2006. Which of the following expressions will calculate your bank balance just after the last payment was deposited?

A) FV = $2,000[1.06]-1 + $2,000[1.06]-2 + $2,000[1.06]-3 

B) FV = $2,000[1.06]1 + $2,000[1.06]2 + $2,000[1.06]3 

C) FV = $2,000[1.06]0 + $2,000[1.06]1 + $2,000[1.06]2 

D) FV = $2,000[1.06]-0 + $2,000[1.06]-1 + $2,000[1.06]-2 + $1,000[1.06]-3 

Harry just bought a new four-wheel-drive Jeep Cherokee for his lumber business. The price of the vehicle was $35,000, of which he made a $5,000 down payment and took out an amortized loan for the rest. His local bank made the loan at 12% interest for five years. He is to pay back the principal and interest in five equal annual installments beginning one year from now. Determine the amount of Harry's annual payment.

A) $8,322

B) $9,600

C) $9,709

D) $6,720

Your investment goal is to have $3,000,000 in 40 years for retirement. You decide to invest in a mutual fund today that pays 12% per year compounded monthly. How much must you invest at the end of each month to meet your investment goal? Round to the nearest $1.

A) $245

B) $255

C) $285

D) $305

E) $315

You have borrowed $70,000 to buy a sports car. You plan to make monthly payments over a 15-year period. The bank has offered you a 9% interest rate compounded monthly. Calculate the total amount of interest dollars you will pay the bank over the life of the loan. Round to the nearest dollar and assume end-of-month payments.

A) $47,451

B) $51,644

C) $54,776

D) $57,798

If you put $700 in a savings account with a 10% nominal rate of interest compounded monthly, what will the investment

If you put $700 in a savings account with a 10% nominal rate of interest compounded monthly, what will the investment be worth in 21 months (round to the nearest dollar)?

A) $827

B) $833

C) $828

D) $1,176

Which of the following is the formula for compound value?

A) FVn = P(1 + i)n 

B) FVn = (1 + i)/P

C) FVn = P/(1 + i)n 

D) FVn = P(1 + i)-n 

At 8% compounded annually, how long will it take $750 to double?

A) 6.5 years

B) 48 months

C) 9 years

D) 12 years

At what rate must $400 be compounded annually for it to grow to $716.40 in 10 years?

A) 6%

B) 5%

C) 7%

D) 8%

An increase in future value can be caused by an increase in the

A) annual interest rate.

B) number of compounding periods.

C) original amount invested.

D) both A and B.

A friend plans to buy a big-screen TV/entertainment system and can afford to set aside $1,320 toward the purchase today. If your friend can earn 5.0%, compounded yearly, how much can your friend spend in four years on the purchase? Round off to the nearest $1.

A) $1,444

B) $1,604

C) $1,764

D) $1,283

You just purchased a parcel of land for $10,000. If you expect a 12% annual rate of return on your investment, how much will you sell the land for in 10 years?

A) $25,000

B) $31,060

C) $38,720

D) $34,310

If you place $50 in a savings account with an interest rate of 7% compounded weekly, what will the investment be worth at the end of five years (round to the nearest dollar)?

A) $72

B) $70

C) $71

D) $57

A bond issue with a face amount of $500,000 bears interest at the rate of 10%. The current market rate of interest is also 10%

A bond issue with a face amount of $500,000 bears interest at the rate of 10%. The current market rate of interest is also 10%. These bonds will sell at a price that is:

A) Equal to $500,000.

B) More than $500,000.

C) Less than $500,000.

D) The answer cannot be determined from the information provided.

Answer: A

Convertible bonds:

A) Provide potential benefits only to the issuer.

B) Provide potential benefits only to the investor.

C) Provide potential benefits to both the issuer and the investor.

D) Provide no potential benefits.

Answer: C

For a bond issue that sells for more than the bond face amount, the stated interest rate is:

A) The actual yield rates.

B) The prime rate.

C) More than the market rate.

D) Less than the market rate.

Answer: C