ELS Chapter 9: Graphing Exercise 2 Answers

ELS Chapter 9: Graphing Exercise 2 Answers
Financial Asset Prices
1.	You expect a share of a company to be worth $58 in one year and pay a $1 dividend at that time. What should you be willing to pay for the stock today if the prevailing interest rate in the market (equal to your required rate of return) is 5%? How would your answer change if the prevailing interest rate was instead 2%? What do you conclude about the relationship between stock prices and interest rates?
	answer: If you expect a share of a company to be worth $58 in one year and pay a $1 dividend at that time, you would be willing to pay up to $56.19 for the stock today, if the prevailing interest rate in the market is 5%. If the prevailing interest rate instead was 2%, you would be willing to pay $57.84. There is an inverse relationship between interest rates and stock prices, holding all other factors constant.
2.	You expect a share of a company to be worth $99 in one year and pay no dividend. What should you be willing to pay for the stock today if the prevailing interest rate in the market (equal to your required rate of return) is 4%? How would your answer change if economic news was released indicating a likely slowing of the economy over the next year? How does "bad" economic news about the future affect stock prices today?
	answer: If you expect a share of a company to be worth $99 in one year and pay no dividend, you would be willing to pay up to $95.19 for the stock today. If economic news was released indicating a likely slowing of the economy over the next year, the expected future value of the stock will fall, reducing the current value of the stock. Alternately, this news may increase the riskiness of the stock, requiring a higher interest rate premium to induce you to buy the stock. In either case, the current value of the stock is reduced by the negative news about the economy; changes in future economic conditions affect stock values today.
3.	During the late 1990s, stocks of Internet-related companies often rose dramatically, helping to fuel a dramatic broad increase in the stock market. Use the relationship above to help explain why this might occur, despite the fact that these companies often had negative profits at the time that their stock prices were rising. Explain how this dramatic rise in stock prices could also reverse quickly, leading to a significant drop in stock prices.
	answer: While current profits may be negative for start-up companies, if expected future returns are high, the stock's current value may be high (try it, using the applet above). Similarly, if expected future returns drop dramatically, as was the case for many internet-based companies in the late 1990s, the company's current stock value can also drop dramatically.
4.	If you expect the Federal Reserve to increase interest rates in the near future, would it be a good time to buy bonds? Why or why not?
	answer: If interest rates rise (try it, using the applet above), current bond prices fall, so you wouldn't want to purchase bonds at the present time. The best time to purchase bonds is just before interest rates start to fall, because then you can sell the bonds at a higher price after the interest rate decline.
5.	Assume that you are currently holding a three-year government bond that was issued at a face value of $1000 and a coupon rate of 8%, payable at the end of each year. One year prior to the bond's maturation, the Federal Reserve cuts interest rates from 10% to 4%. What would you expect to happen to the current price of the bond?
	answer: Holding the bond until it matures in a year will generate an interest payment of $80, plus the face value of the bond, $1000, at the end of that year. The current value of the bond, with an interest rate of 10%, is about $982. However, if the interest rate falls to 4%, the value of the bond rises to over $1038. Thus, the price of the bond will rise. Bond prices and interest rates move in opposite directions, holding all other factors constant.
6.	Assume that you are currently holding a three-year government bond that was issued at a face value of $10,000 and a coupon rate of 4%, payable at the end of each year. One year prior to the bond's maturation, bond prices begin to fall dramatically. What has happened to interest rates? How do you know?
	answer: Since interest rates and bond prices move in opposite directions, holding all other factors constant, if bond prices fell dramatically, this signals that interest rates have increased.