FOFM-Tut 4

FOFM - Tutorial 4
Q1. Describe what is likely to happen to the

average price of a share of stock if the stock
markets decide to close every Friday andCompute the present value of each payment
Monday to provide workers at theoption, assuming the interest rate is 12%.
Now, compute the present values based on
exchanges with longer weekends.
an interest rate of 5%. Compare your
Q2. Standard & Poor's sells information toanswers.
investors; this is their primary business. Is
this an example of a financial intermediary?
FOFM - Tutorial 4
Explain.
Q1. Describe what is likely to happen to the
Q3. Consider a typical individual who owns
average price of a share of stock if the stock
the following financial instruments: A life
markets decide to close every Friday and
insurance policy for $250,000; a certificate
Monday to provide workers at the
of deposit for $10,000; homeowner's and
exchanges with longer weekends.
auto insurance policies; $50,000 in a mutual
Q2. Standard & Poor's sells information to
fund, and $150,000 in her pension fund at
investors; this is their primary business. Is
work. Which of these are instruments used
this an example of a financial intermediary?
primarily as stores of value & which are
Explain.
being used to transfer risk?
Q3. Consider a typical individual who owns
Q4. A lender expects to earn a real interest
the following financial instruments: A life
rate of 4.5% over the next 12 months. She
insurance policy for $250,000; a certificate
charges a 9.25% (annual) nominal rate for a
of deposit for $10,000; homeowner's and
12-month loan. What inflation rate is she
auto insurance policies; $50,000 in a mutual
expecting? If the lender is in a 30% marginal
fund, and $150,000 in her pension fund at
tax bracket, the borrower in a 25% marginal
work. Which of these are instruments used
tax bracket, and they both have the same
primarily as stores of value & which are
inflation expectations, what are the real
being used to transfer risk?
after-tax rates each expects?
Q4. A lender expects to earn a real interest
Q5. What is the monthly interest rate if you
rate of 4.5% over the next 12 months. She
are asked to convert a 12 percent annual
charges a 9.25% (annual) nominal rate for a
rate to a monthly rate (calculate to 4
12-month loan. What inflation rate is she
decimal places)?
expecting? If the lender is in a 30% marginal
Q6. Which investment plan will provide the
tax bracket, the borrower in a 25% marginal
highest future value: $500 invested at 5
tax bracket, and they both have the same
percent annually for four years and then
inflation expectations, what are the real
that balance invested at 7 percent annually
after-tax rates each expects?
for an additional three years, or $500
Q5. What is the monthly interest rate if you
invested at 6 percent annually for seven
are asked to convert a 12 percent annual
years?
rate to a monthly rate (calculate to 4
Q7. Suppose that you have a winning
decimal places)?
lottery ticket for $100,000. The State of
Q6. Which investment plan will provide the
Kerala doesn't pay this amount up front highest future value: $500 invested at 5
this is the amount you will receive over
percent annually for four years and then
time. The State offers you two options. The
that balance invested at 7 percent annually
first pays you $80,000 up front and that will
for an additional three years, or $500
be the entire amount. The second pays you
invested at 6 percent annually for seven
winnings over a three year period. The last
years?
option pays you a large payment today with
Q7. Suppose that you have a winning
small payments in the future. The payment
lottery ticket for $100,000. The State of
options are detailed in the table below:
Kerala doesn't pay this amount up front this is the amount you will receive over
time. The State offers you two options. The
first pays you $80,000 up front and that willCompute the present value of each payment
be the entire amount. The second pays youoption, assuming the interest rate is 12%.
winnings over a three year period. The lastNow, compute the present values based on
option pays you a large payment today withan interest rate of 5%. Compare your
small payments in the future. The paymentanswers.
options are detailed in the table below:
Solution
Q1. The average price of stocks would decrease. The fact that the markets are open
less decreases the liquidity of stocks and, as a result, their prices would have to be
lower in order to entice savers to hold these instruments.
Q2. No. A financial intermediary is involved indirectly in a financial transaction. It
matches up the ultimate lenders (savers) with the ultimate spenders (borrowers). The
funds flow through the intermediary which is acting as a "middleman." That is not the
case with Standard & Poor's.
Q3. The life insurance policy, the homeowner and auto insurance policies are
instruments being used to primarily transfer risk. The cost of an untimely death or loss
resulting from an auto accident or damage to her house is a risk the individual prefers
to transfer to someone else. The certificate of deposit, the balances in her mutual fund
and pension are instruments that are serving primarily as stores of value. In these
instruments wealth is being accumulated and stored for use at a later time.
Q4. The first part she expected an inflation rate of 4.75%. We obtain this answer using
the Fisher equation where i = r + e. For the second part we need to use a variation of
the Fisher equation. The lender receives an after-tax nominal rate of 6.475% from
which we subtract the inflation rate of 4.75% and the lender expects a real after-tax
rate of 1.725%. The borrower expects to pay an after-tax real rate of 2.188%.
Q5. It is not as simple as dividing 12 percent by 12 and thus obtaining an answer of
1.000 percent. The monthly rate, im, can be determined by using the following
formula: (1 + im)12 = (1.12) which we can manipulate to (1 + im) = (1.12)1/12 which
equals 1.0095. Therefore the monthly interest rate is 0.95%.
Q6. $500 invested for four years at 5 percent interest and then that balance invested
at 7% for three additional years will produce a balance of $744.52 at the end of seven
years. The future value of $500 invested for seven years at 6 percent interest is
$751.82.
Q7. When the interest rate is 5%, the present values are as follows:
When the interest rate is 12%, the present values are as follows:
From the computations above, when the interest rate is 5%, Option #3 has the
highest present value. When the interest rate is 12%, Option #1 has the highest
present value. When the interest rate increases from 5% to 12%, the opportunity
cost of foregoing future payments is higher. That is, while the winner is waiting to
receive his/her future payments, he/she is forgoing interest that could be earned
on a bank deposit or other investment. When the interest rate is low, this
opportunity cost is relatively low, making Option #3 (with larger fixed payments
similar to coupon payments on a bond) more attractive. When the interest rate is
relatively high, these future fixed payments have less value, making Option #1
more attractive.

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FOFM - Tutorial 4

Q1. Describe what is likely to happen to the

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