EXERCISES FOR REVISION

Following are some types of exercises you need to be able to solve in order to answer the multiple choice
and long-answer questions in the final exam. I mean these are just several typical exercises, not all the
types of questions that will appear in the exam ^^.

1. Property taxes in a particular district are 4% of the purchase price of a home every year. If you
just purchased a $250,000 home, what is the present value of all the future property tax
payments? Assume that the house remains worth $250,000 forever, property tax rates never
change, and a 6% interest rate is used for discounting.
Answer:
Annual property tax payment = 250,000 x 4% = $10,000
As the house is assumed to remain forever, the future property tax payments also occur
perpetually.
Present value of all the future property tax payments is the present value of a perpetuity with
CF = $10,000 at i = 6%
= CF/i = 10,000/0.06 = $166,666.67
2. A £1,000-face-value UK Gilt has a 2% coupon rate, its current price is £1,100, and its price is
expected to increase to £1,150 next year. Calculate the current yield, the expected rate of
capital gain, and the expected rate of return.
Answer:
current yield = C/Pt = (2%x1000)/1100=0.0182 or 1.82%
expected rate of capital gain = (Pt+1 – Pt)/Pt = (1150-1100)/1100 = 0.0454 or 4.54%
the expected rate of return = current yield + expected rate of capital gain = 1.82 + 4.54 = 6.36%
3. Consider a coupon bond that has a $1,000 par value and a coupon rate of 10%. The bond is
currently selling for $1,044.89 and has two years to maturity. What is the bond’s yield to
maturity?
Answer:
C = 1000 x 10% = 100
YTM is the interest rate (i) that equals the current price and present value of all cash flows of the
bond:
100 100 1000
1,044.89= + +
( 1+i ) ( 1+i )2 ( 1+i )2
Using the calculator we have i = 7.5%
4. If the interest rate is 10%, what is the present value of a security that pays you $1,100 next year,
$1,210 the year after, and $1,331 the year after that?
(Answer yourself as we had done this several times in class)
5. Calculate the present value of a $1,000 discount bond with five years to maturity if the yield to
maturity is 6%.
(Answer yourself as we had done this several times in class)
6. Explain why you would be more or less willing to buy a share of Microsoft stock in the following
situations.

a. Your wealth falls.

W falls, demand falls => less willing

b. You expect the stock to appreciate in value.

This increases the expected rate of return of stock => more willing

c. The bond market becomes more liquid.

Bond is the alternative investment to stock. As bond liquidity increases, demand for bond
increases. I will be more willing to invest in bond and I will be less willing to invest in stock

d. You expect gold to appreciate in value.

Gold is the alternative investment to stock. As expected return for gold increases, demand for
gold increases. I will be more willing to invest in gold and I will be less willing to invest in stock

e. Prices in the bond market become more volatile.

This means higher risk for bond => less willing to invest in bond and more willing to invest in
stock

7. Explain how the demand for bonds change and how the demand curve for bonds move if the
expected rate of return for stocks increase.
expected rate of return for stocks increase => more willing to invest in stock, demand for bond
falls and demand curves for bond shift to the left
8. Suppose that the required reserve ratio is 9%, currency in circulation is $620 billion, the amount
of checkable deposits is $950 billion, and excess reserves are $15 billion.
a. Calculate the money supply, the currency deposit ratio, the excess reserve ratio, and the
money multiplier.
b. Suppose the central bank conducts an unusually large open market purchase of bonds held by
banks of $1,300 billion due to a sharp contraction in the economy. Assuming the ratios you
calculated in part (a) remain the same, predict the effect on the money supply.
c. Suppose the central bank conducts the same open market purchase as in part (b), except that
banks choose to hold all of these proceeds as excess reserves rather than loan them out, due to
fear of a financial crisis. Assuming that currency and deposits remain the same, what happens to
the amount of excess reserves, the excess reserve ratio, the money supply, and the money
multiplier?
(Answer yourself as we had done this several times in class)
9. If the Fed sells $2 million of bonds to the First National Bank, what happens to reserves and the
monetary base? Use T-accounts of balance sheets of the central bank and the commercial
banking system to explain your answer.
(Answer yourself as we had done this several times in class)

10. What happens to reserves at the First National Bank if one person withdraws $1,100 of cash and
another person deposits $200 of cash? Use T-accounts to explain your answer. (besides, you
need to be able to write the new balance sheets after other transactions such as a commercial
bank sell off its securities, etc.)
(Answer yourself as we had done this several times in class)

11. If the currency appreciates, how the value of domestic goods change? How will the country’s
import/export change?
A: currency appreciates, the value or prices of domestic goods increase. This will increase the
country import and decrease its export.

12. “The Fed can perfectly control the amount of reserves in the system.” Is this statement true,
false, or uncertain? Explain.
A: False as the central bank cannot control the amount of borrowings from the commercial
banks, which affect the amount of reserves in the system.

13. The Fed buys $100 million of bonds from the public and also lowers the required reserve ratio.
What will happen to the money supply?
A: The Fed buys $100 million of bonds from the public => increase MB
lowers the required reserve ratio => increase money multiplier
 Both increase the money supply
14. If the public changes their behavior and chooses to hold more cash, what will be the effect on
the money supply?
A: This means the currency ratio increase and thus increase money multiplier
 increase the money supply

15. Suppose you have just had $1,000. Which of the following options would you choose for
investing the money to maximize your return?
In this question, no information on risk is given so we only consider our investment based on
rate of return.

Option 1: Hold the money in cash and earn zero return. => Rate of return 1 (R1) = 0%

Option 2: Loan the money to one of your friend’s roommates, Mike, at an agreed-upon interest
rate of 8% in two years. => Rate of return 2 (R2) = 8%

Option 3: Invest the money in a two-year coupon bond bought at $950 and coupon rate of 7%.
 950 = 70/(1+YTM) + (1000+70)/(1+YTM)2

=> Rate of return 3 (R3) = YTM of the bond = 9.88% (equation same as exercise 3 above)

Thus we choose option 3 with the highest rate of return.

16. A lottery claims its grand prize is $15 million, payable over 5 years at $3,000,000 per year. If the
first payment is made immediately, what is this grand prize really worth? Use an interest rate of
7%.
Answer:
The grand price worth = $3m + $3m/(1+0.07) + $3m/(1+0.07)^2 + $3m/(1+0.07)^3 +
$3m/(1+0.07)^4
17. If the Canadian dollar to U.S. dollar exchange rate is 1.24 and the British pound to U.S. dollar
exchange rate is 0.68, what must be the Canadian dollar to British pound exchange rate?
CAD/USD = 1.24 => 1USD = 1.24 CAD
GBP/USD = 0.68 => 1USD = 0.68 GBP
CAD/GBP = 1.24/0.68 = 1.823
18. If the price level recently increased by 19% in England compared to that in the United States, by
how much must the exchange rate change if Purchasing power parity (PPP) holds? Assume that
the current exchange rate is 0.58 pound per dollar.
Answer:
Inflation of England compared to US = 19%
According to PPP, the currency of England will depreciate by 19% compared to the currency of
the US
The new exchange rate = 0.58 x (1+0.19) = 0.6902 GBP/USD