1.) Assume that the following two events occur at the same time . -Individuals u
ID: 2383916 • Letter: 1
Question
1.) Assume that the following two events occur at the same time.
-Individuals unexpectedly increase their retirement savings (made possible by higher income levels).
-New economic data suggests that inflation over the next year might be higher than previously expected.
A.) Will nominal interest rates increase, decrease, or remain unchanged? Your answer should identify the impact of each event individually as well as the combined effect of the two events on interest rates.
B.) Will real interest rates increase, decrease, or remain unchanged? Your answer should identify the impact of each event individually as well as the combined effect of the two events on interest rates.
2.) Shankalot Investment Company plans to purchase either (1) zero-coupon bonds that have ten years to maturity, a par value of $100 million, and a purchase price of $40 million, or (2) bonds with five years to maturity, a 9 percent coupon rate (paid annually), a par value of $40 million, and a purchase price of $40 million.
A.) What is the yield to maturity on each bond?
B.) What is the duration of each bond?
C.) If the bonds have the same level of default risk, explain how it is possible for the bonds to have different yield to maturities.
D.) Assume that Shankalot believes the yield to maturity on the zero-coupon bond will be 11 percent five years from today. What annual return does Shankalot expect to earn on each bond over a five-year holding period?
Explanation / Answer
Nominal interest rate =(1+Real interest rate)×(1+Inflation rate)-1
A)
Increase in retirement savings decreases the nominal interest rates. As, when savings are increased, companies will offer lower interests rate to gain the benefit of increased flow of investments.
When inflation is increased nominal interest rates will remain unchanged. Nominal interests are affected only by the changes in investments flows. If investment flow is decreased, companies will offer higher nominal interest rates to increase the flow of investments.
B)
Since, inflation is a constant factor in the economy, and increase in investment flow decreases the nominal interest rates as discussed in Part (A), real interest rates will decrease.
Real interest rate is a function of nominal interest rate and inflation rate, increase in inflation rate decreases the real return to the investor. i.e. real interest rate.
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