Name:______________________________

ECO 342 810    Banking & Financial Markets            Homework #4, due Monday, 3/29

1. Consider the overall level of interest rates today.  What are the implications for the price volatility of bonds in response to a change in interest rates?

2. Consider a municipal and corporate bond with the same rating, liquidity and maturity.  Suppose you are in a 30% marginal tax bracket, and the municipal bond yield is 3.5%.

a) What yield on a corporate bond would make you indifferent between a taxable bond and the tax-free municipal?

b) If the corporate bond in part has a yield of 5.5%, which bond would the investor choose?  At what tax rate would an investor be indifferent between the corporate and municipal bond?

3. Consider the market for loanable funds.   Explain what would happen to this market (supply/demand, interest rates) if

a) tax laws are changed to make interest payments are car loans and credit cards tax deductible.

b) the federal government issues more Treasury debt to finance the deficit.

c) the FOMC votes to raise the federal funds rate target

4. Consider the following statement: “Risk averse investors will not hold bonds with low credit rating or a high duration.”  Is this statement true or false?  Explain your answer.

5. Consider the three bonds below.  Which one has the greatest interest rate risk (price volatility)?  Explain your answer.

• a zero-coupon bond with 10 years to maturity

• a 4% coupon bond with 8 years to maturity

• a 4% coupon bond with 10 years to maturity