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sol5 - FIN300 Managerial Finance Professor H Wang Solutions...

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FIN300 Managerial Finance Professor H. Wang Solutions to Problem Set #5 1. a. The prices of long-term bonds should fall. The price of any bond is the PV of the cash flows associated with the bond. As the interest rate increases, the PV of those cash flows falls. This can be easily seen by looking at a one-year, pure discount bond. P = $1,000 / (1+i) As i increases, the denominator, (1 + i ), rises, thus reducing the value of the numerator ($1,000). The price of the bond decreases. b. The effect on stocks is not as clear-cut as the effect on bonds. The nominal interest rate is a function of both the real interest rate, r , and the inflation rate, i.e., (1+i) = (1+r) (1+Inflation) From this relationship it is easy to conclude that, as inflation rises, the nominal interest rate, i , rises. However, stock prices are a function of dividends and future prices as well as the interest rate. Those dividends and future prices are determined by the earning power of the firm.
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