2. An interest-rate increase by the central bank sometimes triggers the crash of a financial bubble...

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2. An interest-rate increase by the central bank sometimes triggers the crash of a financial bubble by causing a decrease in stock prices. a) Explain why an increase in the risk-free rate decreases the fundamental value of stocks using the corresponding mathematical formula. b) An increase in the risk-free rate causes the fundamental value of some firms to drop more than that of other firms. Which are those firms, and why? Specifically, consider two firms. One pays dividends k > 1 each year until infinity. The other pays dividends It in each period t until infinity, with l > 1 and lồ < 1 where 8 = 1/(1 + r) and r is the risk-free rate. Assume I and k are such that at initial risk-free rate roboth firms have the same fundamental value. Which firm's fundamental value is more strongly affected by an increase in the risk-free rate? What is the general lesson about which firms' valuations will be more affected by changes in the risk-free rate? c) Explain in words why an increase in the risk-free rate can cause a decrease in the price of stocks even if fundamental value remains constant d) In terms of the CAPM, which firms are more affected by an increase in the risk-free rate, and which are less affected? 2. An interest-rate increase by the central bank sometimes triggers the crash of a financial bubble by causing a decrease in stock prices. a) Explain why an increase in the risk-free rate decreases the fundamental value of stocks using the corresponding mathematical formula. b) An increase in the risk-free rate causes the fundamental value of some firms to drop more than that of other firms. Which are those firms, and why? Specifically, consider two firms. One pays dividends k > 1 each year until infinity. The other pays dividends It in each period t until infinity, with l > 1 and lồ < 1 where 8 = 1/(1 + r) and r is the risk-free rate. Assume I and k are such that at initial risk-free rate roboth firms have the same fundamental value. Which firm's fundamental value is more strongly affected by an increase in the risk-free rate? What is the general lesson about which firms' valuations will be more affected by changes in the risk-free rate? c) Explain in words why an increase in the risk-free rate can cause a decrease in the price of stocks even if fundamental value remains constant d) In terms of the CAPM, which firms are more affected by an increase in the risk-free rate, and which are less affected?

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a Explain why an increase in the riskfree rate decreases the fundamental value of stocks using the corresponding mathematical formula The fundamental value of a stock is the present value of all of it... View the full answer