L3 Review SOLUTIONS

Expected inflation Year 2003 4.01% 2.06% 1.95% 1.91% 2004 4.27% 1.83% 2.44% 2.40% 2005 4.29% 1.81% 2.48% 2.44% 2006 4.80% 2.31% 2.49% 2.43% Fisher equation 10-year Nominal Treasury Rates 10-year Inflation Adjusted Rates As a difference By Fisher equation

Q2 a) Year CPI Inflation 1970 38.8 1971 40.5 4.2% 1972 41.8 3.3% 1973 44.4 6.3% 1974 49.3 11.0% 1975 53.8 9.1% 1976 56.9 5.8% 1977 60.6 6.5% 1978 65.2 7.6% 1979 72.6 11.3% 1980 82.4 13.5% 1981 90.9 10.4% 1982 96.5 6.2% 1983 99.6 3.2% 1984 103.9 4.4% 1985 107.6 3.5% 1986 109.7 1.9% 1987 113.6 3.6% 1988 118.3 4.1% 1989 123.9 4.8% 1990 130.7 5.4% b) arithmetic 6.30% c) geometric 6.25% d) The Federal Reserve Bank increased the short term interest rates (see next tab for Fed Funds Rates), "creating" a deep recession in 1980-82; during recession the prices of goods and wages stopped growing at a high rate and inflation rate declined 197 1 197 2 197 3 1 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

a) Real rate 0.75% Inflation 2.15% Nominal rate 2.92% b) Investment $ 10,000.00 Time 5 years Future value $ 11,545.62 Original wage $ 70,000 Nominal increase 3.00% Nominal wage $ 72,100 Inflation rate 3.50% Real rate -0.48% Real wage $ 69,662 If the inflation adjusted (real) rate is currently 0.75% and the expected inflation is 2.15% annually a) What is the nominal rate? b) If you invest $10,000 right now at this nominal rate, what will be the amount of your savings in 5 years? Your salary after graduation was $70,000. After a year at work, you received a raise of 3.0% while during that year the inflation rate was 3.5%. What is your new salary in real terms? 𝑟𝑒𝑎𝑙 𝑟𝑎𝑡𝑒 =((1+𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒))/((1+𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛

𝑛 𝑟𝑎𝑡𝑒))−1

1/01/1978 01/01/1982 01/01/1986 01/01/1990 Federal Funds Rate Federal Reserve System (US)/FRED

#1 House price $ 700,000.00 Downpayment $ 140,000.00 20.00% Loan amount $ 560,000.00 Treasury 2.96% Risk premium 1.25% Interest rate 4.21% PV $ 560,000.00 FV 0 PMT ($4,201.43) Rate 0.35% N 180 You decided to pursue a graduate degree and since this might take 4-5 years, you are considering buying a house; you approach a real estate agent, who tells you that there is currently a house for sale in a desired location for $700,000; you know that you need to pay a 20% down payment and the interest rate on 15-year mortgages is equal to 10-yr Treasury rate + 1.25%. What is your expected monthly payment? Note: Treasury rates are presented on the right

u pay in interest and

PV ($965.78) Coupon rate 3.30% FV $1,000 Annual payment $33.00 PMT $16.50 Semiannual payment $16.50 Rate 1.93% semiannual N 14 7.00 a) 3.863% Annual (YTM) b) PV ($912.81) FV $1,000 PMT $16.50 Rate 2.50% N 12 6 YTM 5.000% The Ford Motor Company issued a bond with a coupon of 3.30% with semiannual payments, which matures in 7 years; the bond is trading at $965.78. a) What is the YTM on this bond? b) If the YTM on this bond moves to 5.0% one year later , what would be the price of the bond?

$ 1,000.00 5.00% 10 years $ 613.91 ($613.91) $ 1,000.00 0 5.00% 10 -13.40% e price of the