2: Money And The Payments System

4: Interest Rates and Rates of Return

Multiple-Choice Questions 4-1 When you place your funds in a savings account at a bank, those funds are Answer: a a. an asset to you and a liability to the bank. Difficulty: E b. a liability to you and an asset to the bank. c. an asset both to you and the bank. d. a liability both to you and bank.

4-2 Debt instruments are also called Answer: b a. equities. Difficulty: E b. credit market instruments. c. prospectuses. d. units of account

4-3 A debt instrument represents Answer: b a. an ownership claim by the purchaser on the issuer. Difficulty: E b. a promise by a borrower to repay principal plus interest to a lender. c. an attempt by a borrower in default to restore his or her credit. d. a nontaxable asset, owned primarily by large corporations.

4-4 Simple loans and discount bonds differ from coupon bonds and fixed-payment loans in Answer: d that Difficulty: M a. interest on simple loans and discount bonds is taxable, while interest on coupon bonds and fixed-payment loans is not. b. interest on coupon bonds and fixed-payment loans is taxable, while interest on simple loans and discount bonds is not. c. interest rates on simple loans and discount bonds are generally higher than interest rates on comparable coupon bonds and fixed-payment loans. d. Interest on simple loans and discount bonds is paid in a single payment, while issuers of coupon bonds and fixed-payment loans make multiple payments of interest and principle.

4-5 Issuers of coupon bonds Answer: a 1. make multiple payments of interest and principal. Difficulty: M 2. make a single payment of interest and principal. 3. make multiple payments of principal, but a single payment of interest. 4. make a single payment of principal at the time the bond is issued and multiple payments of interest over the life of the bond. 4-6 Answer: c A simple loan involves Difficulty: E a. interest payments from the borrower to the lender periodically during the life of the loan. b. no payment of interest by the borrower to the lender. c. payment of interest by the borrower to the lender only at the time the loan 4-7 matures. Answer: a d. no repayment of principal by the borrower to the lender. Difficulty: E The amount of funds the borrower receives from the lender with a simple loan is called the a. principal. 4-8 b. equity. Answer: d c. maturity. Difficulty: E d. collateral.

The total payment to a lender for a simple loan is 1. P. Essay Questions

1. Suppose that the inflation rate is currently 8% and that most investors believe that inflation will remain at this level indefinitely. You are convinced, however, that the inflation will decline to 5% or less. Should you buy a 10-year Treasury bond or a 10-year TIPS?

2. Suppose you are considering buying one of two coupon bonds. Bond A has a current market price of $975 and a face value of $1000. Bond B has a current market price of $1025 and a face value of $1000. Is Bond A the better investment?

3. Winners of state lotteries are often given the choice of receiving their winnings either as one lump sum or as annual payments spread out over a period of 20 or more years. For example, a state lottery winner may be given the choice of receiving $1.2 million at once, or $125,000 per year for 20 years. In states where it is allowed, investors will sometimes approach lottery winners and offer to pay them a lump sum greater than the state is offering them (in this case, say, $1.4 million) in exchange for the lottery winner signing over to the investor the right to receive the annual payments. Under what circumstances might this be a good deal for both the lottery winner and the investor?

4. During the late nineteenth century many farmers in the American Midwest complained that the real interest rates they were paying on their mortgages were higher than the nominal rates. Is this possible? Aren’t real rates always lower than nominal rates?

Answers

1. You should buy the 10-year Treasury bond. If the inflation rate does decline, the coupon rate on newly issued bonds will decline. This will increase the market price of existing 10-year bonds, raising your total return above what you would receive if you held a 10-year TIPS.

2. Assuming all other characteristics of the bonds are same, the bonds should have the same yields to maturity and the same expected returns, even though they have different market prices. Presumably, the bond with the higher price has a higher coupon rate.

3. There are three discounts rates involved here: the discount rate used by the state to convert the annual lottery payments into a lump sum payment, the discount rate used by the lottery winner to convert the lottery payments into a lump sum payment, and the discount rate used by the investor. If the lottery winner’s discount rate is lower than the state’s discount rate, but higher than the investor’s discount rate, then both the lottery winner and the investor will be made better off by the deal. In the example, the state is discounting the 20 annual payments at a rate of about 10% to arrive at the lump sum. Suppose the lottery winner’s discount rate is 8%. Then the present value to him of the annual payments is about $1.325 million and he will choose to take the annual payments rather than the lump sum offered by the state. If the investor has a discount rate of 6%, the annual payments will have a present value to her of about $1.52 million. She is able to offer a payment of $1.4 million to the lottery winner – which the lottery winner will accept because it is greater than the lump sum offered by the state and greater than the lottery winner’s own evaluation of the present value of the annual payments – and will receive in exchange the right to receive a series of annual payments whose present value she evaluates as being greater than payment she makes to the lottery winner.

4. If there is inflation, real interest rates will be lower than nominal interest rates. In the late nineteenth century, the United States experienced deflation. So, the real interest rate on farm mortgages was in fact higher than the nominal rate.