Name:_________________________

ECO 340 820 Money & Banking

1.

Homework #4, due Wednesday, 10/19

[7, #18] Below is some data for a 5 month period in the U.S. economy. Given the data in the table below, would you
say that this economy is heading for a boom or for a recession? Explain your choice using all 3 columns of data and
your understanding of the risk and term structure.
January
February
March
April
May

3 mo. Tbill
1%
1.05%
1.1%
1.2%
1.25%

10-yr. Tnote
3%
3.5%
4%
4.6%
5%

10-yr. Baa corp

7%
7.2%
7.6%
8%
8.2%

2.

Suppose the interest rate on one-year bond is 4% today, is expected to be 6% one year from now, and 8% two years
from now. Using the expectations hypothesis, plot the yield curve over the next three years in the space below:

3.

[7, #6] Suppose the yield on both one-year bonds and two-year bonds are the same. Under the liquidity premium
theory, would you expect the future yield on the one-year bond, one year from today, to be higher, lower of the same
that todays one-year bond yield? Explain your answer.

4.

Describe 2 reasons why stock ownership is considered more risky than bond ownership.

5.

[8: #11,17,18] Consider the dividend-discount model:

a. The stock of XYZ company paid a $10 dividend this year and these dividends are expected to grow at 4% per
year. The risk free rate is 3% and you require a risk premium of 5%. If the price of the stock in the market is
$200 a share, should you buy it? (Be sure to show/explain how you arrive at your answer.)

b. Based on the dividend discount model, explain what would happen to stock prices if there were an increase in
the perceived riskiness of bonds?

c. Use the dividend-discount model to explain why an increase in stock prices is often a good indication that the
economy is expected to do well.