Report

Investments

(Assignment 2)

Due: November 6 (Tue) 1:30 pm

Problem 1

You are considering the choice between investing $50,000 in a conventional 1 -year bank CD

offering an interest rate of 5% and a 1-year “Inflation-Plus” CD offering 1.5% per year plus the

rate of inflation.

a. Which is the safer investment?

b. Which offers the higher expected return?

c. If you expect the rate of inflation to be 3% over the next year, which is the better

investment? Why?

d. If we observe a risk-free nominal interest rate of 5% per year an d a risk-free real rate of

1.5% on inflation-indexed bonds, can we infer that the market’s expected rate of

inflation is 3.5% per year?

Problem 2

Assume the annualized interest rate is 12% compounded monthly and that rent is paid at the

beginning of each month. A young couple has made a nonrefundable deposit of the first month ’s

rent (equal to $1,000) on a 6-month apartment lease. The next day they find a different

apartment that they like just as well, but its monthly rent is only $900.

a.

They plan to be in the apartment only 6 months. Should they switch to the new

apartment?

b. What if they plan to stay 1 year?

Problem 3

Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be either

$70,000 or $200,000 with equal probabilities of 0.5. The alternative risk-free investment in T-bills

pays 6% per year.

a. If you require a risk premium of 8%, how much will you be willing to pay for the

portfolio?

b. Suppose that the portfolio can be purchased for the amount you found in part a.

What will be the expected rate of return on the portfolio?

c. Now suppose that you require a risk premium of 12%. What is the price that you will

be willing to pay?

d. Comparing your answers to part a and c, what do you conclude about the relationship

between the required risk premium on a portfolio and the price at which the portfolio

will sell?

Problem 4

Consider the following information about a...