Tutorial 2 chapter 5

Question 1

Solution

E(r) = [0.28 × 49.0%] + [0.22 × 17.0%] + [0.50 × (–13.5%)] = 0.1071 or 10.71%

σ2 = [0.28 × (49.0 − 10.71)2] + [0.22 × (17.0 − 10.71)2] + [0.50 × (−13.5 − 10.71)2] = 712.281
σ = 0.2669 or 26.69%
 
The mean is unchanged, but the standard deviation has increased, as the probabilities of the high
and low returns have increased. 
References

Question 2

Derive the probability distribution of the 1-year HPR on a 30-year U.S. Treasury bond with a coupon
of 3.0% if it is currently selling at par and the probability distribution of its yield to maturity a year
from now is as shown in the table below. (Assume the entire 3.0% coupon is paid at the end of the
year rather than every 6 months. Assume a par value of $100.) (Leave no cells blank - be certain
to enter "0" wherever required. Negative values should be indicated by a minus sign. Do not
round intermediate calculations. Round your answers to 2 decimal places.)

Solution

Explanation:
The price of the bond will be the present value of all future coupon payments plus the final principal
payment, discounted by the appropriate yield to maturity. Using the present value of an annuity
formula, prices are calculated as follows:
 

PV1= 3∗¿+100/(1.1)^(30-1)=34.41
Or
N=(30-1); FV=100; i/y=10; PMT= 3 cpt PV=34.41

PV2 =44.21
PV3=  50.89
 

 
Capital gains, if any, will be difference between the market value and the par value of the bond,
calculated as follows:

$34.41 − $100 = -$65.59

$44.21 − $100 = -$55.79

$50.89 − $100 = -$49.11

Since coupon interest is paid annually (at the end of the year) and the bond has been held for one
year, one single coupon payment has been distributed: 0.03 × 100 = $3.00

The holding period return will be the rate of return based on any capital gains earned plus the single
coupon received, relative to the par value of the bond:
 
($-65.59⁢+ $3.00)$100=-62.59%
 
($-55.79⁢ +  $3.00)$100= -52.79%
 
($−49.11 +  $3.00)$100= −46.11%

Question 3

During a period of severe inflation, a bond offered a nominal HPR of 83% per year. The inflation rate
was 74% per year.

a. What was the real HPR on the bond over the year? (Round your answer to 2 decimal places.)
b. Find the approximation rreal ≈ rnom − i. Compare your answer in part b to the one in part a.

 
Explanation:
a.
1 + rnominal rnominal − i 0.83 − 0.74
rreal = −1 = = = 0.0517, or 5.17%
1 + i 1 + i 1.74
 
b.
rnominal − i = 83% − 74% = 9% ≈ rreal

Clearly, the approximation gives a real HPR that is too high.

Question 4

  Average Annual Rates   Standard Deviation  

Real T- Inflatio
  T-Bills  Inflation  Bill  T-Bills  n  Real T-Bill 
Full sample  3.38     2.45      0.46     3.12     4.00      3.76   
1927–1951   0.95     1.79    − 0.47     1.24     6.04      6.33   
1952–2018   4.26     3.46      0.81     3.13     2.89      2.12   

 
Small/
Market Big/ Big/ Growt Small/
(1927-2018) Index  Growth  Value   h   Value
Mean excess return (annualized)  8.29    8.07   11.69    8.99   15.38 
18.5
Standard deviation (annualized)       18.35   24.70    26.06   28.21 
2

Suppose that the inflation rate is expected to be 2.45% in the near future using the data provided
above, what would be your predictions for the following? (Round your answers to 2 decimal
places.)

rev: 10_21_2020_QC_CS-236411

 
Explanation:
From the first table, the average real rate on T-bills has been 0.56%.
 
a.
T-bills: 0.46% real rate + 2.45% inflation = 2.91%
 
b.
Expected return on Big/Value:
 
2.91% T-bill rate + 11.69% historical risk premium = 14.60%

c.
The risk premium on stocks remains unchanged. A premium, the difference between two rates, is a
real value, unaffected by inflation.

Question 5

Consider these long-term investment data:

 The price of a 10-year $100 par value zero coupon inflation-indexed bond is $84.36.
 A real-estate property is expected to yield 2% per quarter (nominal) with a SD of the
(effective) quarterly rate of 10%.

Compute the annual rate on the real (i.e., inflation-indexed) bond. (Do not round intermediate
calculations. Round your answer to 2 decimal places.)

 
Explanation:
Total return of the bond is (100/84.36) − 1 = 0.1854. With t = 10, the annual rate on the real bond
is (1 + EAR) = 1.18541/10 = 1.72%

Question 6

Considering the choice between investing $50,000 in a conventional 1-year bank CD offering an
interest rate of 5% and a 1-year “Inflation-Plus” CD offering 1.5% per year plus the rate of inflation.
 
a. Which is the safer investment?
 
Conventional 1-year bank CD
1-year “Inflation-Plus” CD

 
b. Can you tell which offers the higher expected return?
 
Expected rate of inflation
Bank rate
Cannot be determined

 
c. If you expect the rate of inflation to be 3% over the next year, which is the better investment?
 
Conventional CD
“Inflation-Plus” CD

 
d. If we observe a risk-free nominal interest rate of 5% per year and a risk-free real rate of 1.5% on
inflation-indexed bonds, can we infer that the market’s expected rate of inflation is 3.5% per year?
 
Yes
No

 
Explanation:
a.
The “Inflation-Plus” CD is the safer investment because it guarantees the purchasing power of the
investment. Using the approximation that the real rate equals the nominal rate minus the inflation
rate, the CD provides a real rate of 1.5% regardless of the inflation rate.
 
b.
The expected return depends on the expected rate of inflation over the next year. If the expected
rate of inflation is less than 3.5% then the conventional CD offers a higher real return than the
inflation-plus CD; if the expected rate of inflation is greater than 3.5%, then the opposite is true.
 
c.
If you expect the rate of inflation to be 3% over the next year, then the conventional CD offers you an
expected real rate of return of 2%, which is 0.5% higher than the real rate on the inflation-protected
CD. But unless you know that inflation will be 3% with certainty, the conventional CD is also riskier.
The question of which is the better investment then depends on your attitude towards risk versus
return. You might choose to diversify and invest part of your funds in each.
 
d.
No. We cannot assume that the entire difference between the risk-free nominal rate (on conventional
CDs) of 5% and the real risk-free rate (on inflation-protected CDs) of 1.5% is the expected rate of
inflation. Part of the difference is probably a risk premium associated with the uncertainty
surrounding the real rate of return on the conventional CDs. This implies that the expected rate of
inflation is less than 3.5% per year.

Question 7
EAR = (1+0.09/12)^(12) -1 =0.0938

MCQ

1. Over the past year, you earned a nominal rate of interest of 12% on your money. The inflation rate
was 3% over the same period. The exact actual growth rate of your purchasing power was
a. 15.5%.
b. 10.0%.
c. 5.0%.
d. 8.7%.
e. 15.0%.
r = (1 + R)/(1 + I) − 1; 1.12/1.03 − 1 = 8.7%.
2. A year ago, you invested $1,000 in a savings account that pays an annual interest rate of 9%.
What is your approximate annual real rate of return if the rate of inflation was 2% over the year?
a. 5%
b. 10%
c. 7%
d. 3%
9% − 2% = 7%.
3. You purchased a share of stock for $25. One year later, you received $1 as a dividend and sold
the share for $29. What was your holding-period return?
a. 45%
b. 20%
c. 5%
d. 40%
e. None of the options are correct.
($1 + $29 − $25)/$25 = 0.20, or 20%.
4. Which of the following determine(s) the level of real interest rates?

1.I) The supply of savings by households and business firms

2. II) The demand for investment funds
3. III) The government's net supply and/or demand for funds

a. I only
b. II only
c. I and II only
d. I, II, and III
The value of savings by households is the major supply of funds; the demand for investment funds is
a portion of the total demand for funds; the government's position can be one of either net supplier or
net demander of funds. The above factors constitute the total supply and demand for funds, which
determine real interest rates.
5. Which of the following statement(s) is(are) true?

I) The real rate of interest is determined by the supply and demand for funds.

II) The real rate of interest is determined by the expected rate of inflation.

III) The real rate of interest can be affected by actions of the Fed.

IV) The real rate of interest is equal to the nominal interest rate plus the expected rate of
inflation.

a. I and II only
b. I and III only
c. III and IV only
d. II and III only
e. I, II, III, and IV only
The expected rate of inflation is a determinant of nominal, not real, interest rates. Real rates are
determined by the supply and demand for funds, which can be affected by the Fed.
6. Other things equal, an increase in the government budget deficit
a. drives the interest rate down.
b. drives the interest rate up.
c. might not have any effect on interest rates.
d. increases business prospects.
An increase in the government budget deficit, other things equal, causes the government to increase
its borrowing, which increases the demand for funds and drives interest rates up.
7.
You have been given this probability distribution for the holding-period return for KMP stock:
 
Stock of the Economy Probability HPR
Boom   0.30     18%
Normal growth   0.50     12%
Recession   0.20   – 5%

What is the expected holding-period return for KMP stock?

a. 10.40%
b. 9.32%
c. 11.63%
d. 11.54%
e. 10.88%
HPR = 0.30 (18%) + 0.50 (12%) + 0.20 (−5%) = 10.4%.
8. If a portfolio had a return of 18%, the risk-free asset return was 5%, and the standard deviation of
the portfolio's excess returns was 34%, the risk premium would be
a. 13%.
b. 18%.
c. 49%.
d. 12%.
e. 29%.
18% − 5% = 13%.

8. Given the following returns and return relatives over the past four years,
compute the arithmetic mean (AM) and geometric mean (GM) rates of
return.
Period Returns Return Relative
t1 0.05 1.05
t2 -0.10 0.90
t3 0.11 1.11
t4 -0.02 0.98
a) AM = 4.000%, GM = 1.010%
b) AM = 1.000%, GM = 0.692%
c) AM = 0.692%, GM = 4.000%
d) AM = 1.000%, GM = 1.0692%
e) AM = 4.000%, GM = 0.0692%
Answer:B

9. Your portfolio currently has an asset allocation that is 15% cash, 35% bonds, and
50% stocks. The returns over the past years for cash was 3.5%, bonds
5.75%, and stocks –8.5%. The return on your portfolio for the past year was
a) -5.04%
b) 5.47%
c) 0.25%
d) 5.91%
e) -1.71%
Answer :e