3330%20PS3%20solution - Cornell University Fall 2009...

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Cornell University Fall 2009 Economics 3330: Problem Set 3 Solutions 1. True/False/Explain State whether each of the following is true or false and explain your answer. Please limit your explanations to no more than two sentences. a. According to the expectations theory, if the yield curve is flat, the market must expect a decrease in short-term rates. False. The expectations theory holds that nothing affects the shape of the yield curve but expectations of future rates, so it must be that the market expects no change in short-term rates. b. According to the liquidity preference theory, if the yield curve is flat, the market must expect a decrease in short-term rates. True. The liquidity preference theory says that there may be a liquidity premium on longer term bonds that results in the yield curve being flat even if the market expects short term rates to decline. c. Passive bond management does not involve buying and selling bonds but rather holding them to maturity. False. Passive bond management does not involve identifying mispricings, but does involve buying and selling in order to rebalance positions. d. A risk-averse consumer will not buy insurance when the price of insurance is not actuarially fair. False. Even when prices are not actuarially fair, a consumer may purchase some insurance. The consumer will generally not fully insure unless the price is actuarially fair. 2. Coupon Renegotiation (Question 20 of Chapter 14 of the text) A 10-year bond of a firm in severe financial distress has a coupon rate of 14% and sells for $900. The firm is currently renegotiating the debt, and it appears that the lenders will allow the firm to reduce coupon payments on the bond to one-half the originally contracted amount. The firm can handle these lower payments. What is the stated and expected yield to maturity of the bond? The bond makes its coupon payments annually. The stated yield to maturity, based on promised payments, equals 16.075%. Based on expected coupon payments of $70 annually, the expected yield to maturity is 8.526%. 3. Immunization You will be paying $40,000 a year in tuition expenses at the end of each of the next two years. Bonds currently yield 4%. a. What is the present value and duration of your obligation? The present value of the obligation is $75,443.79. and the duration is 1.4902 years, as shown in the following table: Computation of duration, interest rate = 4% (1) (2) (3) (4) (5) Time Payment Disc. 4% Weight t*weight 1 40,000 38,461.54 0.5098 0.5098 2 40,000 36,982.25 0.4902 0.9804 Column Sum: 75,443.79 1.0000 1.4902 b. What maturity zero-coupon bond would immunize your obligation? What would it pay at that time?
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The zero coupon bond that would immunize your obligation would mature in 1.4902 years. Since
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This note was uploaded on 12/22/2009 for the course ECON 3330 taught by Professor Mbiekop during the Fall '08 term at Cornell University (Engineering School).

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3330%20PS3%20solution - Cornell University Fall 2009...

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