Consider a bond and a stock. The bond will pay out 100,000 at the end of year five. It will pay nothing at the end of years 1, 2, 3, or 4. The stock is for a corporation that makes profits off a patent. It will pay dividends for the next 25 years, 5,000 dollars at the end of each year. After that, the patent expires and the dividends go to zero. a) Suppose the interest rate is zero. What is the present value of each of these two assets? In other words, if you had to pay now, which is worth more? [Note: This requires calculating “present values”; you can use excel and if needed] b) The Fed’s monetary policy raises the interest rate to 2.5%. Which is worth more? c) The Fed’s monetary policy raises the interest rate to 5%. Which is worth more?
Consider a bond and a stock. The bond will pay out 100,000 at the end of year five. It
will pay nothing at the end of years 1, 2, 3, or 4. The stock is for a corporation that
makes profits off a patent. It will pay dividends for the next 25 years, 5,000 dollars at
the end of each year. After that, the patent expires and the dividends go to zero.
a) Suppose the interest rate is zero. What is the present value of each of these two
assets? In other words, if you had to pay now, which is worth more? [Note: This
requires calculating “present values”; you can use excel and if needed]
b) The Fed’s
c) The Fed’s monetary policy raises the interest rate to 5%. Which is worth more?
d) What is the intuition for the different results in a), b) and c)?
e) Do the above results suggest that, by raising the interest rate, the Fed can powerfully
affect the price of assets like stocks?
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