Qbank disputes... again beginning, speaking, expected, because, demand

scruge

1.) Generally speaking, an upward sloping yield curve can be expected when:

A.)supply of long-term funds falls short of demand and investors begin to show preference for more liquid/less risky short term securities.

B.) supply of long-term funds falls short of demand

C.) inflationary expectations are beginning to subside and investors begin to show a preference for more liquid/less risky short term securities

I chose C, because if demand exceeds supply, won't that result in PRICE going up in the treasury and yield going down? Answer was A

2.)Last years div is $3.10/share
Growth rate constant at 10%
Return on market is 12%
RFR is 4%
Beta is 1.1

Value is
A.) $34.95
B.) $121.79
C.)$26.64

I used CAPM and got Req rate of ret as 12.8, and made D1 = 3.1(1.1) = 3.41/k-g to get the answer, $121.79, which was correct. However, I thought they missed the discounting of $121.79 / 1.12 (req return) ... no?

3.)Value of an int-rate call option at expiration is zero or the :

A.)market rate minus exercise rate, adj for the period of the rate, times principal amount.

B.)PV of market rate minus excercise rate, adj for period of rate, times principal amount

C.) exercise rate minus market rate, adj for period of rate, times principal amount

I went back and forth with A and B and chose A, because I didn't remember seeing anywhere other than FRA where you discount by the rate at expiration. However they said B and referenced the text, which I read, and had no mention of any discounting, whats up with this one?

siavosh

nicob Wrote:
-------------------------------------------------------
> 1.
> A. the drop in demand for L.t bonds would drop the
> price pushing the yield curve up.
> can't be B - would increase the price. C...given
> they're saying inflation is subsiding, could
> assume a lower inflation premium would be needed.
> also, if inflation is subsiding, is that because
> the CB stepped in and put pressure on ST rates,
> which would invert the yield curve?
>
> 2. I get $121.78
> 3.10(1.10) / 0.128 - 0.10 = $121.785
>
> 3. B
> lower/upper bounds of options?


Supply fell SHORT of demand, indicating increasing DEMAND, are you guys reading?

disiz64

What is the answer to #2? I also got $121.78 -- Po = D1 / (k-g)

dotamasta

markCFAIL Wrote:
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> Didn't you just argue against yourself? You just
> told me that A would cause an inverted yield
> curve.
>
> I do understand that the liquidity preference will
> cause yields to rise in the long term, but they
> are combining an inverting factor "demand >
> supply, price up, yields down", with an upward
> sloping factor, whereas choice B does only the
> first part, so it must invert too. The question
> asks for UPWARD sloping, wtf?



yeh i had to read it a few times myself. its a dumb question. i think your just seeing it differently to me.
It can't be B. that will invert the yield curve as price increases.

when economies boom, you get the inflationary gap, likewise when slowing, inflation falls back. I interpret C as implying that because inflation is backing off, the view is the economy is slowing down. Further this with the flight to quality, by seeking more liquid and less risky bonds, thus creating the inverted yield curve. Thus i don't think C.
That leaves A
If you look at it over the general long term trend, the yield curve will be upward sloping, going on what's above. I did imply inverted initially due to the supply shortage, but over the long term, i think it would be upward sloping.

Its a toss up between A and C, but i think the key part is the slowing inflation. 'A' just implied the price is too high, thus people are shifting to the shorter term securities.
Also, if your paying, say 15% for 10 years, but can borrow 10 lots of 1%, there's an arbitrage opportunity. Thus it would be more costly to 'borrow' at the 10yr 15% then borrow at the 1yr, 1%, 10 times. A 'rational' investor would shift to ST securities, pushing the yields down, LT yields up.

let me know. crap Q but interesting discussion.

also did you figure the options bit out? i was thinking European, but they only discount the put side. for a call, the maximum price is the strike price. Like you say though, its work for FRA's...

Flok

B for #3 seems incorrect...because the question refers to the value of the interest rate call at Expiration so there is no need for discounting for the value of the call...and you are correct that there is no discounting as opposed to FRA because the payoff is not immediate rather at the end of the interest rate period.

So I dont completely agree with the solution..



Edited 1 time(s). Last edit at Tuesday, June 2, 2009 at 01:04PM by sa.86.

Wasteoftime

markCFAIL Wrote:
-------------------------------------------------------
> Nicob, for the option part... they are I think,
> referring to minimum value. In which case, yes,
> it would be 0 or the greater of S-(X/1+RFR^t)
>
> Thats the minimum value for both Euro and American
> Calls, max for both is just stock. It's confusing
> to me because this is true for stock options, and
> i GUESS interest rate options (according to them),
> but in the book under the specific section on
> interest rate options i found them only saying it
> was the strike minus contract adjusted for the
> period, no discounting was shown, anywhere, only
> for FRA's. So im just confused.
>
> Chuck - as discussed below, if they are already
> piling into LT bonds (demand>supply), why do they
> need to entice people with higher yields?

They wouldn't. My brain was fried at that point. I think that was probably the 500th question I had looked at.

ftwcfa

for 3. B is correct, they ask about the value of the option on expiry date. If the option is exercised, the interest equal to difference of the two rates (market and exercise) is paid buy the seller to buyer of the option at the end of interest period. As this cash flow happens at the end of the period and the question is what is the value of that cash flow now, you need to discount it to exercise date.

in case of FRA, it is settled at the beginning and the amount is the discounted interest difference. (just fyi there are also other types of iro (so called interest rate guarantees) which are settled also at the beginning of interest period)