1.Suppose you have an offer of $200,000 to sell your house this year. The market
ID: 1194099 • Letter: 1
Question
1.Suppose you have an offer of $200,000 to sell your house this year. The market rate of interest is 10%. You expect to be able to sell your house next year for $230,000.
In particular, what does it tell you about how prices must behave in a market for nonrenewable resources?
a. Prices in the market for nonrenewable resources follow hotelling's rule, meaning prices should rise at the rate of interest
b.As stated in the previous question, these examples are not related
c.We should preserve natural resources at all cost
d.We should use the nonrenewable resources since we will leave more capital goods for future generations
2.Suppose you have an offer of $200,000 to sell your house this year. The market rate of interest is 10%. You expect to be able to sell your house next year for $230,000.
How does this relate to the theory of nonrenewable resource allocation over time as discussed in class?
a.It does not relate because the housing market is not natural
b.To make a selling decision we take into account the discounted present value and the expected selling price
c.Because houses are set in land it is expected that they behave like a natural resource
d.Houses can be renewed so this example does not relate
Explanation / Answer
Reinvestment risk is the uncertainty of the earning rate on the redeployment of assets that have matured. This risk occurs when an FI holds assets with maturities that are less than the maturities of its liabilities. For example, if a bank has a two-year loan funded by a ten-year fixed-rate time deposit, the bank faces the risk that it might be forced to lend or reinvest the money at lower rates after two years, perhaps even below the deposit rates. Also, if the bank receives periodic cash flows, such as coupon payments from a bond or monthly payments on a loan, these periodic cash flows will also be reinvested at the new lower (or higher) interest rates. Besides the effect on the income statement, this reinvestment risk may cause the realized yields on the assets to differ from the a priori expected yields.
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