Question

Interest rates affect corporate profits and security prices. Based on your understanding of the relationship between interest rates and corporate profits and security prices,identify which of the following statements is true and which is false. Statements 1. Interest rates affect the level of economic activity, which in turn affects the profits earned by a business organization, all other considerations remaining constant. 2. Interest rates will affect the preference of investors to own stocks versus owning bonds. 3. A sharp decrease in interest rates will increase the price of bonds, which can significantly decrease the potential for capital gains and the yield earned by a bondholder. This should decrease the demand for bonds compared to the demand for stocks, all other considerations remaining constant. 4. An increase in market interest rates will increase the opportunity cost of investors' funds and increase the price of financial assets.

Answer 1

Answer:

1. Interest rates affect the level of economic activity, which in turn affects the profits earned by a business organization, all other considerations remaining constant.

TRUE, higher interest rates "cool down" the economy, reducing economic activity, disposable income and the profits earned by companies. Lower interests rates due the opposite.

2. Interest rates will affect the preference of investors to own stocks versus owning bonds.

TRUE, e.g. if interest rates increase, the price of bonds decrease, which can result in higher yields for bondholders. Since money is limited, if more people invest in bonds, less people will invest in stocks. A decrease in interest rates results in the opposite.

3. A sharp decrease in interest rates will increase the price of bonds, which can significantly decrease the potential for capital gains and the yield earned by a bondholder. This should decrease the demand for bonds compared to the demand for stocks, all other considerations remaining constant.

TRUE, for the same reasons as question 2.

4. An increase in market interest rates will increase the opportunity cost of investors' funds and increase the price of financial assets.

FALSE, as the interest rates increase, the price of financial assets decrease. They basically go on the opposite way. If the interest rates decrease, then the price of financial assets increases.