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Chapter 17: Q10. (page 369)

If the Fed increases interest rates, the SML will shift _______ and asset prices will _______.

  1. down; rise

  2. down; fall

  3. up; rise

  4. up; fall

Short Answer

Expert verified

The correct option is (d): up; fall

Step by step solution

01

Step 1. Explanation

SML vertical intercept shifts upward with the increase in the rate of interest by the Fed. The rate of return on a risky asset will increase, leading to a decrease in price as the price is inversely related to its return. Thus, the asset price will fall. Hence, the SML will shift up, and asset prices will fall.

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Most popular questions from this chapter

Identify each of the following investments as either an economic investment or a financial investment.

a. A company builds a new factory.

b. A pension plan buys some Google stock.

c. A mining company sets up a new gold mine.

d. A woman buys a 100-year-old farmhouse in the countryside.

e. A man buys a newly built home in the city.

f. A company buys an old factory.

Consider an asset that costs \(120 today. You are going to hold it for 1 year and then sell it. Suppose that there is a 25 percent chance that it will be worth \)100 in a year, a 25 percent chance that it will be worth \(115 in a year, and a 50 percent chance that it will be worth \)140 in a year. What is its average expected rate of return? Next, figure out what the investment’s average expected rate of return would be if its current price were $130 today. Does the increase in the current price increase or decrease the asset’s average expected rate of return? At what price would the asset have a zero average expected rate of return?

Sammy buys stock in a suntan-lotion maker and also stock in an umbrella maker. One stock does well when the weather is good; the other does well when the weather is bad. Sammy’s portfolio indicates that “weather risk” is a _______ risk.

  1. diversifiable

  2. nondiversifiable

  3. automatic

Suppose initially that two assets, A and B, will each make a single guaranteed payment of \(100 in 1 year. But asset A has a current price of \)80 while asset B has a current price of $90.

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  2. Assume that arbitrage continues until A and B have the same expected rate of return. When arbitrage ends, will A and B have the same price?

Suppose that the Federal Reserve thinks that a stock market bubble is occurring and wants to reduce stock prices. What should it do to interest rates?
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