 Answers to End-of-Chapter Questions

1. $2000 = $100/(1 + i) + $100/(1 + i)2 +    + $100/(1 + i)20 + $1000/(1 + i)20.

2. You would rather be holding long-term bonds because their price would increase more than the price
of the short-term bonds, giving them a higher return.

3. No. If interest rates rise sharply in the future, long-term bonds may suffer such a sharp fall in price
that their return might be quite low, possibly even negative.

4. People are more likely to buy houses because the real interest rate when purchasing a house has
fallen from 3 percent (=5 percent –2 percent) to 1 percent (=10 percent - 9 percent). The real cost of
financing the house is thus lower, even though mortgage rates have risen. (If the tax deductibility of
interest payments is allowed for, then it becomes even more likely that people will buy houses.)

 Quantitative Problems
1. Calculate the present value of a $1,000 zero-coupon bond with 5 years to maturity if the required
annual interest rate is 6%.
Solution: PV = FV/(1 + i)n
where FV = 1000, i = 0.06, n = 5
PV = 747.25

2. A lottery claims its grand prize is $10 million, payable over 20 years at $500,000 per year. If the first
payment is made immediately, what is this grand prize really worth? Use a discount rate of 6%.
Solution: This is a simple present value problem. Using a financial calculator,
N = 20; PMT = 500,000; FV = 0; I = 6%; Pmts in BEGIN mode.
Compute PV: PV = $6,079,058.25

3. Consider a bond with a 7% annual coupon and a face value of $1,000. Complete the following table:

Years to Maturity Discount Rate Current Price

3 5
3 7
6 7
9 7
9 9
 What relationship do you observe between yield to maturity and the current market value?
Solution:

Years to Maturity Yield to Maturity Current Price

3 5 $1,054.46
3 7 $1,000.00
6 7 $1,000.00
9 5 $1,142.16
9 9 $ 880.10

When yield to maturity is above the coupon rate, the band’s current price is below its face
value. The opposite holds true when yield to maturity is below the coupon rate. For a given
maturity, the bond’s current price falls as yield to maturity rises. For a given yield to
maturity, a bond’s value rises as its maturity increases. When yield to maturity equals the
coupon rate, a bond’s current price equals its face value regardless of years to maturity.

4. Consider a coupon bond that has a $1,000 par value and a coupon rate of 10%. The bond is currently
selling for $1,150 and has 8 years to maturity. What is the bond’s yield to maturity?
Solution: To calculate the bond’s yield to maturity using a financial calculator,
N  8; PMT  1000  0.10  100; FV  1000; PV  1150
Compute I: I  7.44

5. You are willing to pay $15,625 now to purchase a perpetuity which will pay you and your heirs
$1,250 each year, forever, starting at the end of this year. If your required rate of return does not
change, how much would you be willing to pay if this were a 20-year, annual payment, ordinary
annuity instead of a perpetuity?
Solution: To find your yield to maturity, Perpetuity value  PMT/I.
So, 15,625  1,250/I; I  0.08
The answer to the final part using a financial calculator:
N  20; I  8; PMT  1,250; FV  0
Compute PV: PV  12,272.69

6. The price would be $50/.025 = $2000. If the yield to maturity doubles to 5%, the price would fall to
half its previous value, to $1000 = $50/.05.

7. Property taxes in DeKalb County are roughly 2.66% of the purchase price every year. If you just
bought a $100,000 home, what is the PV of all the future property tax payments? Assume that the
house remains worth $100,000 forever, property tax rates never change, and that a 9% discount rate
is used for discounting.
Solution: The taxes on a $100,000 home are roughly 100,000  0.0266  2,660.
The PV of all future payments  2,660/0.09  $29,555.55 (a perpetuity).

8. Assume you just deposited $1,000 into a bank account. The current real interest rate is 2% and
inflation is expected to be 6% over the next year. What nominal interest rate would you require from
the bank over the next year? How much money will you have at the end of one year? If you are
saving to buy a stereo that currently sells for $1,050, will you have enough to buy it?
 Solution: The required nominal rate would be:

At this rate, you would expect to have $1,000  1.08, or $1,080 at the end of the year.
Can you afford the stereo? In theory, the price of the stereo will increase with the rate of
inflation. So, one year later, the stereo will cost $1,050  1.06, or $1,113. You will be
short by $33.

9. A 10-year, 7% coupon bond with a face value of $1,000 is currently selling for $871.65. Compute
your rate of return if you sell the bond next year for $880.10.
Solution:

10. You have paid $980.30 for an 8% coupon bond with a face value of $1,000 that mature in five years.
You plan on holding the bond for one year. If you want to earn a 9% rate of return on this
investment, what price must you sell the bond for? Is this realistic?
Solution: To find the price, solve:

Although this appears possible, the yield to maturity when you purchased the bond was
8.5%. At that yield, you only expect the price to be $983.62 next year. In fact, the yield
would have to drop to 8.35% for the price to be $988.53.