(a) Consider a two-year discount bond called X with today’s interest rate equal to 10% (the face value is 121). Suppose all bonds (with all terms) earn the same equilibrium interest rate. There is only one change in equilibrium interest rates over the next two years, and this change occurs a few days before time t+1 when equilibrium interest rates fall to 0%. If an investor sells X at time t+1, his one-year holding period return will equal ______%.

(b) Consider the dividend discount model based on earnings. Assume that, starting from today, company X’s earnings are expected to have a zero growth rate, forever into the future (g equals 0%). The fair P/E will equal 20 if ____________. Suppose, for this company, return on equity is positive and dividends in the past year were 5. Retained earnings in the upcoming year are expected to equal _______.

(c) Suppose the yield curve is horizontal and the preferred habitat theory holds. With a horizontal yield curve, the market expects the interest rate on one-year bonds to __________ over the next year. Today’s interest rate on a two-year bond _____________ today’s interest rate on a one-year bond. 

(d) Use the Dividend Discount Model. Use a calculator. The dividend in the past year was 10. Suppose that, for the next year, the dividend is expected to grow by 100%. After that, dividends are expected to grow by 10% per year forever. The fair rate of return is 20%. The fair stock price equals ________. 

(e) Consider a domestic investor that buys foreign currency today, buys a foreign bond today, and agrees to sell foreign currency in a forward exchange contract signed today (let taxes equal 0). The percentage return on this investment will equal __________.

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