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# hw2 - Ryan Alexander Homework#2 Chapter 6 6 a b If the...

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Ryan Alexander Homework #2 3/11/10 Chapter 6 6. a. b. If the probability that the inflation will rise from 2 percent to 3 percent, the nominal interest rate of the bond will rise. This will also result in a decline in the price of the bond and the demand of the bond will decrease and the supply will increase. 8. When the prices of bonds increase, it gives the company a higher return. This explains the 13 ½ percent return. However, when bond prices increase, the interest rates tend to decrease which explains the low rates of around 5 percent. Chapter 7 6. In this case, I would expect the one-year yield in one year’s time to be higher than the two year bond because due to the liquidity premium theory, the short term bond has less inflation risk and less interest rate risk. Because of this, the one year’s yield should be higher. 7. a) The rate of return would be 3.5%+4%+5% / 3 =4.17%. Therefore, the return on three one year bonds would be 1,130.24 b) The rate of return on a three year bond at 5% would be (1.05)(1.05)=1.1025. Therefore at a rate of 10.25% over 3 years would return 1,340.10 c) A two year bond followed by a one year bond would have a return of (1.04)(1.04)=1.0816 or 8.16%. Therefore at a rate of 8.16% for 2 years, the return would be 1,169.86 and for the third year at 5% would be 1,228.35.

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