Chapter 14, Problem 1QAP

a)

To determine

The validity of the statement that both real and nominal terms could be used in calculating the present discounted value applicable for a stream of returns.

Answer to Problem 1QAP

True

Explanation of Solution

Inflation could be accounted for in two ways when present discounted value and net present value is being calculated. Real cash flows could be converted into nominal cash flows and be discounted at the applicable nominal rate. Further, estimating real cash flows and then discounting them at the applicable real rate could also be done. As there are indices that could be used in converting real rates into nominal rates and vice versa, the statement could be considered as true.

Economics Concept Introduction

Introduction:The nominal value of something is the actual monetary value involved. It goes hand in hand with the real value which is the value that has been adjusted for inflation. These two concepts are being widely used in economics.

b)

To determine

The validity of the statement that the present discount value pertaining to a payment a year later would lower as the one year interest rate increases.

Answer to Problem 1QAP

True

Explanation of Solution

The statement could be considered as true. A discount rate is the sum of the time value and the relevant rate of interest. It enhances the future value of cash flows that are being held currently. Similarly, provided that the rates of interest are higher, the required present value would be lesser.

Economics Concept Introduction

Introduction:A discount rate could be defined as the sum of time values and an applicable interest rate that would increase the future value of an amount held at present. These concepts are being widely discussed in economics.

c)

To determine

The validity of the statement that interest rates pertaining to a single year is anticipated to be persistent over time.

Answer to Problem 1QAP

False

Explanation of Solution

The statement could be considered as false. One cannot say that an interest rate would be persistent over time. In reality, interest rates change frequently in line with market conditions.

Economics Concept Introduction

Introduction:Interest rates are being widely used in analyzing and explaining a number of economic and financial concepts. They are subject to changes in accordance with many parameters within an economy.

d)

To determine

The validity of the statement that bonds could be considered as a claim to a sequence of payments that are constant over a specific number of years.

Answer to Problem 1QAP

True

Explanation of Solution

The statement could be considered as true. A bond earns its buyer a fixed income. In fact the buyer loans the issuing entity and the entity has to honor the agreed amount at the applicable time period. Bonds are in general referred to as fixed income financial securities. They would pay a constant rate over the life time being in line with the face value of the bond.

Economics Concept Introduction

Introduction:A bond is a financial instrument that would earn the buyer a pre-agreed fixed income rate at the time of maturity. There could be bonds with varying maturity periods. Bonds could also be called as fixed income financial instruments.

e)

To determine

The validity of the statement that stocks could be considered as a claim to a sequence of dividend payments over a specific number of years.

Answer to Problem 1QAP

True

Explanation of Solution

The statement could be considered as true. When a person buys stocks from a particular organization, he would be entitled in receiving dividend payments, based on the profits made by the company. Such dividend amounts would be paid every year. However, the amount or the value of the dividend payment could differ with the profit figure.

Economics Concept Introduction

Introduction:Stocks can also be called as equity. It is a financial security that makes its buyer an owner of the issuing company. In other words, a fraction of the company’s ownership would be held by the buyer. Individual units of a stock would be called as shares.

f)

To determine

The validity of the statement that house prices could be considered as a claim to a sequence of expected rents in future over a specific number of years.

Answer to Problem 1QAP

True

Explanation of Solution

The statement could be considered as true. The price of a house would be decided upon the present value figures of the rent amounts that could be charged in future. For a high rent to be charged in the future, the price of the house at present must also be high. On the other hand, provided that the house price is low at present, the present value of future rent amounts will also be low.

Economics Concept Introduction

Introduction:House prices and rent amounts are concepts that go hand in hand. The rent that could be earned by a house owner would be heavily reliant on the price of the house at present. It is important that house owners as well as parties that rent out houses understand the underlying connection between the two.

g)

To determine

The validity of the statement that the curve showing the yield is upward sloping.

Answer to Problem 1QAP

True

Explanation of Solution

The statement could be considered as true. The yield curve would be used in presenting the relationship between the maturity period and the applicable interest rate of an investment. If the maturity period is longer, the interest rate would also be higher. This is due to the fact that investors wanting to cover themselves from uncertainty of future risks that may have to be faced in investing in the long run.

Economics Concept Introduction

Introduction:The yield curve is a much common economic concept that is being widely discussed. It puts forward the relationship that exists between the maturity period and the interest rate applicable for a particular investment.

h)

To determine

The validity of the statement that a same expected return rate would be applicable for all assets that are being held for one year.

Answer to Problem 1QAP

False

Explanation of Solution

The statement could be considered as false. Every assets becomes unique with the applicable features such as its risk level, the expectations, uncertainties that may be relevant in future and the market conditions. These features pertaining to each asset in different magnitudes cause them in providing different returns. For example, an asset that carries a higher risk would ideally provide a higher return.

Economics Concept Introduction

Introduction:The return of an asset is reliant upon a number of aspects. Expectations, the risk level involved, future uncertainties and market conditions are some of such aspects. The return of each asset would thus depend on the applicable aspects such as these.

i)

To determine

The validity of the statement that an asset’s value in a bubble is equal to the expected present value of the applicable future returns.

Answer to Problem 1QAP

False

Explanation of Solution

The statement could be considered as false. At a time of an asset bubble, speculative trading makes the asset prices high. This is being called as inflating asset prices. At such a time the asset price is far from its real value. In other words, during a bubble, the prices that are being reflected as asset prices cannot be considered as fairly valued.

Economics Concept Introduction

Introduction:Economic bubbles have been a common topic especially after the dawn of the new millennium. During a bubble prices of assets change drastically. However, it is not the reality of asset prices as well as it would not last very long. It is not prudent in making important decisions on assets at such times.

j)

To determine

The validity of the statement that in general the real value of a stock market would not be much volatile within a year.

Answer to Problem 1QAP

False

Explanation of Solution

The statement could be considered as false. By nature, stock markets are much volatile. It is unable to match the value of a stock market to a real value as there are constant changes. Thus, it cannot be fixed or solid over a year. Even at a time period that is much less than a year, a stock market could change drastically. For example, negative incidents that impact upon the economy could bring down the value of a stock market overnight.

Economics Concept Introduction

Introduction:Stock market is where stocks and shares of listed organizations are being traded to investors willing to buy them. The term volatility is much in line with stock markets. The reason for this is the fact that stock prices being subject to constant change.

k)

To determine

The validity of the statement that indexed bond holders would be protected against inflation that is unexpected.

Answer to Problem 1QAP

True

Explanation of Solution

The statement could be considered as true. As the returns to an indexed bond is being linked to a specific price index, the returns would be protected against inflation. Price variations would not adversely affect the returns a particular investor would earn by investing in an indexed bond.

Economics Concept Introduction

Introduction:An indexed bond is similar to a normal bond. The key difference is that its interest amounts are being paid in relation to a price index that is specified. The normally used price index in this regard is the consumer price index.