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An investor currently has $100 in cash and intends to use this money 5 years from now to start a business. The

more he has to invest in his business the better for him. His options are: (a) 5-year treasury bills/bonds to be issued at a price equal to face value and with a coupon rate of 2 percent; (b) stocks that pay annual dividends of $1; (c) 5-year US inflation-indexed government bonds, with an annual interest coupon of 0.5 percent; and (d) 5-year zero-coupon treasuries with an annual yield of 2 percent. The investor's expectation is that the stock market will be 20 percent higher in 5 years.

(1)   On day "0", what would be a discount risk factor that would make this investor indifferent between holding treasuries (hint: this is related to RE)? Justify your answers with a chart showing how your calculation changes depending on the riskiness of stocks.

(2)   On day "0", assuming that the discount risk factor makes stocks and treasuries equivalent, what be the expected inflation rate that would make the indexed bonds preferable over the other two options? Show your answer with a chart with different inflation rates to justify your answer.

(3)   On day zero, what would be the expected payment from a zero-coupon after 5 years?

(4)   Suppose at the end of year 3 the stock market is 5 percent higher, the annual inflation so far turned out to be 4 percent, and the yield on zero-coupon 2-year treasuries is now 3 percent. Assuming the risk associated with stocks remained unchanged from (2). Which investment has so far turned out to be better and why? Justify your answer with figures for the three options.

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