Money markets

1. What would be the underestimation of your earnings as an investor if you use the discount rate
instead of the investment rate to measure the return on your investment if you buy a $5,000 T-bill
that matures in 91 days for $4,999.55?
Solution:

Annualized discount rate = [(5,000 – 4,999.55)/5,000] × (360/91) = 0.035604%.

Annualized investment rate = [(5,000 – 4,999.55)/4,999.55] × (365/91) = 0.036102%.

0.036102% – 0.035604% = 0.000498%

Therefore, you would underestimate your return by 0.000498% if you use the discount rate.

2. What is the annualized discount rate % and your annualized investment rate % on a Treasury bill
that you purchase for $9,940 that will mature in 91 days for $10,000?

Solution: Discount Rate 

Investment Rate 

3. If you want to earn an annualized discount rate of 3.5%, what is the most you can pay for a 91-
day Treasury bill that pays $5,000 at maturity?

Solution:

4. What is the minimum discount rate you will accept if you want to earn at least a 0.25%
annualized investment rate on a 182 day $1,000 T-bill?
Solution: In order to obtain at least a 0.25% annualized investment rate, you will have to pay at
most 998.754975 for the $1.000 T-bill maturing in 182 days. This price comes from
solving the following equation, where P is the price of the T-bill:

0.0025 < [($1,000 ‒ P) / P] × 365/182 → P < 998.754975

Thereby, you should bid a minimum discount rate of 0.246269% (the minimum
discount rate that guarantees a price of 998.754975). This discount rate satisfies the
following equation:

(($1,000 – 998.754975) / $1,000) × 360/182 = 0.00246269

5. The price of 182-day commercial paper is $7,840. If the annualized investment rate is 4.093%,
what will the paper pay at maturity?
Solution: Let B  what will be paid at maturity

6. Your minimum discount rate bid of 0.35% for a $10,000 T-bill that matures in 91 days has been
accepted. Calculate your annualized investment rate.
Solution: Since your bid was accepted, you will pay for this T-bill $9,991.16. We can calculate
this price using the formula for the discount rate:

0.0035 = [($10,000 – P) / P] × 360/91 → P = $9,991.16

Therefore, your annualized investment rate will be 0.3548611%

[($10,000 - $9,991.160) / $9,991.16] × 365/91 = 0.003548611

Bond markets
1. A bond pays $80 per year in interest (8% coupon). The bond has 5 years before it matures at
which time it will pay $1,000. Assuming a discount rate of 10%, what should be the price of the
bond (Review Chapter 3)?
Solution: $924.18
2. Calculate the price of a bond that matures in 8 years, has a face value of $5.000, a coupon rate of
2% (paid semiannually) if the market interest rate is 1%. What is the price of the bond if the
market interest rate drops to 0.5%?
Solution: In this case the semiannual coupon payment is (5,000 x 0.02)/2 = $50.
The price of the bond when market interest rate is 1% solves the following equation:

Using a financial calculator (or an excel spreadsheet), P = $5,383.50

The price of the bond when market interest rate is 0.5% solves the following equation:

Using a financial calculator (or an excel spreadsheet), P = $5,587.44

3. Consider the two bonds described below:
Bond A Bond B

Maturity 15 yrs 20 yrs

Coupon Rate 10% 6%
(Paid semiannually)
Par Value $1,000 $1,000

a. If both bonds had a required return of 8%, what would the bonds’ prices be?
b. Describe what it means if a bond sells at a discount, a premium, and at its face amount
(par value). Are these two bonds selling at a discount, premium, or par?
c. If the required return on the two bonds rose to 10%, what would the bonds’ prices be?
Solution:
a. Bond A = $1,172.92
Bond B = $802.07
b. Bond A is selling at a premium
Bond B is selling at a discount
c. Bond A = $1,000
Bond B = $656.82

4. A 2-year $1,000 par zero-coupon bond is currently priced at $819.00. A 2-year $1,000 annuity is
currently priced at $1,712.52. If you want to invest $10,000 in one of the two securities, which is
a better buy? You can assume
a. the pure expectations theory of interest rates holds,
b. neither bond has any default risk, maturity premium, or liquidity premium, and
c. you can purchase partial bonds.
Solution: With PV = $819; FV = $1,000; PMT = 0; and N = 2, the yield to maturity on the
two-year zero-coupon bonds is 10.5%. For the two-year annuity, PV = $1,712.52;
PMT = $1000;
FV = 0; and N = 2 gives a yield to maturity of 11.00%. The two year annuities are
the better buy.
5. Consider the following cash flows. All market interest rates are 12%.

Year 0 1 2 3 4
Cash Flow 160 170 180 230

a. What price would you pay for these cash flows? What total wealth do you expect after 2½
years if you sell the rights to the remaining cash flows? Assume interest rates remain
constant.
b. Immediately after buying these cash flows, all market interest rates drop to 11%. What is the
impact on your total wealth after 2½ years?
Solution:

a.

b. Expected Wealth =
Since you are holding the cash flows for their duration, you are essentially immunized from
interest rate changes (in this simplistic example).
6. The yield on a corporate bond is 10% and it is currently selling at par. The marginal tax rate is
20%. A par value municipal bond with a coupon rate of 8.50% is available. Which security is a
better buy?
Solution: The equivalent tax-free rate = taxable interest rate  (1 - marginal tax rate). In this
case, 0.10  (1 - 0.20) = 8%. The corporate bond offers a lower after-tax yield given
the marginal tax rate, so the municipal bond is a better buy.