Deck 7: Inflation and Deflation, Yield Curves, and Duration: Impact on Interest Rates and Asset Prices

Question 1

According to the Harrod-Keynes effect a rise in the expected rate of inflation will increase an investor's real return from holding bonds.

Answer 1

False

Question 2

A rise in expected inflation lowers the real rate of return on common stock and real estate according to the Harrod-Keynes effect.

Answer 2

False

Question 3

According to the money-substitutes hypothesis, if interest rates rise above "normal"
levels, investors will come to expect an eventual decline in the level of interest rates and capital gains on the bonds they hold and, therefore, will settle for lower liquidity premiums.

Answer 3

False

Question 4

According to the Harrod-Keynes Effect, the real rate will be unaffected by inflation.

Question 5

For the bond described in question #60, the price elasticity when interest rates move above the bond's coupon rate must be (to the nearest thousandth place):

A) -0.781
B) -0.510
C) -0.632
D) -0.753
E) None of the above

Question 6

Considering the government bond described in question #63, if the investor in the question has a desired holding period of 7 years, this investor should:

A) Buy the bond because his or her interest rate risk will then be zero
B) Look for another security if he or she desires to force interest-rate risk to zero
C) Wait until the bond's yield to maturity falls to 10 percent for then the bond will sell at par and the investor will be free of interest-rate risk
D) Look for a security with a higher coupon rate but the same maturity because the investor will then have a better chance of minimizing interest-rate risk
E) None of the above are advisable moves for the investor given the bond's characteristics and the investor's desired holding period

Question 7

The view that the nominal interest-rate need not be affected by inflation, but the real rate will be affected by inflation is known as the:

A) Fisher Effect
B) Harrod-Keynes Effect
C) Darby Effect
D) Inflation-caused Wealth Effect
E) None of the above

Question 8

The Harrod-Keynes effect argues that :

A) There is a direct positive relationship between the nominal rate of interest on bonds and the expected rate of inflation
B) Since the coupon rate on bonds is fixed, an investor's real rate of return on bonds is lowered if inflation increases
C) Inflation lowers the return on common stocks and real assets
D) The real rate of return on bonds is determined by the total demand for and the supply of money
E) None of the above

Question 9

What is inflation? Why is it important?

Question 10

Explain how inflation affects interest rates. What is the Fisher effect? What does it assume?

Question 11

Explain how the following connect inflation to changes in interest rates:

Question 12

What is meant by deflation? How does deflation appear to impact interest rates and the economy? Which nation has experienced deflation on a significant scale in recent years?

Question 13

What are TIPS? What advantages do they offer investors? Any disadvantages?

Question 14

Explain the meaning of the phrase term structure of interest rates. What is a yield curve? What assumptions are necessary to construct a yield curve?

Question 15

What uses does the yield curve have? Why is each possible use of potential value to borrowers and lenders of funds?

Question 16

What conclusions can you draw from recent research regarding the determinants of the yield curve? Which theory of the yield curve discussed in this chapter appears to be most supported by recent research studies?

Question 17

Explain the meaning and importance of the concept of duration.

Question 18

What are the limitations of duration and the portfolio immunization technique?

Question 19

According to the Fisher effect if the real interest rate is currently 3 percent and the nominal rate is 8 percent, what rate of inflation is the financial marketplace predicting? Explain the reasoning behind your answer. If the nominal rate rises to 11 percent and following the assumptions of the Fisher effect, what would you conclude about the expected inflation rate? The real rate?

Question 20

An investor buys a U.S. Treasury bond whose current yield to maturity as reported in the daily newspaper is 10 percent. The investor is subject to a 33 percent federal income tax rate on any new income received. His real after-tax return from this bond is 2 percent. What is the expected inflation rate in the financial marketplace?

Question 21

Price of the bond at a14% yield to maturity = 941.73 So the percentage change in the price of the bond is: ($941.73 - $914.35)/$914.35 = 2.99%
Duration = $3083.98/$914.35 = 3.37 years.
Present value of the bond at a 14% yield to maturity:
$\begin{array}{|c|r|c|}\hline\text { Period }& \begin{array}{c} \text {Expected} \\\text {Cash Flows }\\\text {from Security}\end{array} & \begin{array}{c} \text {Present} \\\text {value }\\\text {of expected} \\\text {Cash Flows} \\\text {(at 15 \% } \\\text {Rate} \\\text {of Discount)}\end{array} \\\hline 1 & 120 & 105.26 \\\hline 2 & 120 & 92.34 \\\hline 3 & 120 & 81.00 \\\hline 4 & 120 & 71.05 \\\hline 4 & 1,000 & 592.08 \\\hline\end{array}$

Calculate the value of duration for a 4-year, $1,000 par value U.S. Government bond purchased today at a yield to maturity of 15%. The bond's coupon rate is 12 percent and it pays interest once a year at year's end. Now suppose the market interest rate on comparable securities falls to 14 percent. What percentage change in this bond's price will result?

Question 22

For the bond described in Problem 7, calculate the percentage change in this bond's price if interest rates on comparable securities in the market decline to 9 percent. What percentage change will occur if interest rates jump to 11 percent?

Question 23

The 10 - year Treasury bond rate is currently trading at 6.08 percent, while the one-year bond rate carries a yield to maturity of 5.35 percent. What is the current yield spread between these instruments? What is this yield spread forecasting for the economy in the period ahead? Please explain.

Question 24

Synchron Corporation borrows long term-capital at an interest rate of 8.5 percent under the expectation that the annual inflation rate over the life of this borrowing was likely to be 5 percent. However, shortly after the loan contract was signed, the actual inflation rate climbed to 5.5 percent and is expected to remain at that level until Synchron's loan reaches maturity. Other factors held constant, what is likely to happen to the market value per share of Synchron's common stock? Please explain your reasoning.

Question 25

A 4-year TIPS government bond promises a real annual coupon return to investors of 4 percent and its face value is $1,000. While the annual inflation rate was approximately zero when the bond was first issued, the inflation rate suddenly accelerated to 3 percent and is expected to remain at that level for the 4-year term of the bond. What will be the approximate amount of interest paid in nominal dollars each year of the bond's life? What will be the face (nominal) value of the bond at the end of each year of its life?