Answers to Tutorial

1. Itwouldbeworth1/(10.20)$0.83whentheinterestrateis20%,ratherthan1/(1
0.10)$0.91whentheinterestrateis10%.Thus,adollartomorrowisworthlesswitha
higherinterestratetoday.
2. $2000$100/(1i)$100/(1i)2...$100/(1i)20$1000/(1i)20.Solvingfori
givestheyieldtomaturity.
3. Whentheyieldtomaturityincreases,thisrepresentsadecreaseinthepriceofthebond.
Ifthebondholder weretosellthebondat alower price, the capitalgainswouldbe
smaller(capitallosseslarger)andthereforethebondholderwouldbeworseoff.
4. No.Ifinterestratesrisesharplyinthefuture,longtermbondsmaysuffersuchasharp
fallinpricethattheirreturnmightbequitelow,possiblyevennegative.
5. Peoplearemorelikelytobuyhousesbecausetherealinterestratewhenpurchasinga
househasfallenfrom3%(5%2%)to1%(10%9%).Therealcostoffinancing
the house is thus lower, even though nominal mortgage rates have risen. (If the tax
deductibilityofinterestpaymentsisallowedfor,thenitbecomesevenmorelikelythat
peoplewillbuyhouses.)
6. (a)Less,becauseyourwealthhasdeclined;(b)more,becauseitsrelativeexpectedreturn
hasrisen;(c)less,becauseithasbecomelessliquidrelativetobonds;(d)less,becauseits
expectedreturnhasfallenrelativetogold;(e)more,becauseithasbecomelessrisky
relativetobonds.
7. True, because for a riskaverse person, more risk, a lower expected return, and less
liquiditymakeasecuritylessdesirable.
8. Interestratesfall.Theincreasedvolatilityofgoldpricesmakesbondsrelativelylessrisky
relativetogoldandcausesthedemandforbondstoincrease.Thedemandcurve, Bd,
shiftstotherightandtheequilibriuminterestratefalls.
9. Interestrateswouldrise.Asuddenincreaseinpeoplesexpectationsoffuturerealestate
pricesraisestheexpectedreturnonrealestaterelativetobonds,sothedemandforbonds
falls.ThedemandcurveBdshiftstotheleft,bondpricesfall,andtheequilibriuminterest
raterises.
10. Thesupplyeffectoflargedeficitsshouldleadtohigherinterest rates.Theeffectsofthe
economiccrisisleadtosignificantlylowerwealthandincome,whichdepressedTreasury
bond demand, but also decreased corporate bond supply by even more because
investmentopportunitiescollapsed.Thelargerleftwardshiftinthebondsupplycurve
thantherightwardshiftinthebondsupplycurvewouldthenresultinariseinbondprices
andafallininterestrates.Inaddition,duetotheseverityoftheglobalcrisis,U.S.treasury
debtbecameasafehaveninvestment,reducing relativeriskandincreasingliquidityfor
U.S.treasurydebt.ThissignificantlyraisedU.S.treasurybonddemand,leadingtohigher
bondpricesandsignificantlyloweryields.Inotherwords,thedecreaseininvestment

opportunitiesandriskfactorssignificantlyoffsetthewealtheffectondemandandthe
deficiteffectonsupply.