Questions

What is a coupon bond? What is a fixed payment loan? What is the yield to maturity? What is a discount bond? A simple loan of $100 matures in one year and requires a repayment of $115. What is the yield to maturity? Under what conditions will the current yield be a good approximation to the yield to maturity.

If the coupon payment of a $1000 face value (par value) is $100 per year and the bond sells for $1000 what is the yield to maturity? If the price paid for a coupon bond is less than the face price, then the yield to maturity will be less than, equal to, or greater than the coupon rate. What is interest rate risk?

How does interest rate risk depend on the length to maturity?

End of Chapter Question 1. Would a dollar one year from now be worth more or less to you today when the interest rate is 20% or when it is worth 10% Less: Compute the present value PV = . PV = FV 1 = = 0.83 ( 1 + i ) ( 1 + 0.2 ) FV 1 = = 0.91 ( 1 + i ) ( 1 + 0.1)

2. You have just won $20 million in the state lottery that promises to pay you $1 million (tax free) every year for the next 20 years. Would you be better off taking the 20 million now or 1 million per year for 20 years .Have you really won 20 million?

No, because the present discounted value of these payments is necessarily less than $20 million as long as the interest rate is greater than zero.

3. If the interest rate is 10%, what is the present value of a security that pays you $1100 next year, $1210 the year after and $1331 the year after that

PV =

1100 1210 1331 + + = 3000 1 2 (1 + .1) (1 + .1) (1 + .1)3

4)

If the security in problem 3 sold for $4000 is the yield to maturity greater of less than 10%? Why? The yield to maturity is less than 10 percent. Only if the interest rate was less than 10 percent would the present value of the payments add up to $4,000, which is more than the $3,000 present value in the previous problem. (In fact it seems that it would have to be negative)

4. Write down the formula that is used to calculate the yield to maturity on a 20 year 10% coupon bond with a $1000 face value that sells for $2000 2000 = 100 + 100 + 100 +L + 100 + 1000

(1+ i)

( 1+ i)

( 1+ i)

( 1 + 0.1)

20

(1+ i)

20

Solve for i.

5. what is the yield to maturity on a $1000 face value discount bond that sells for $800 1000 800 = (1 + i ) 800 ( 1 + i ) = 1000 1+ i = 1000 = 1.25 800 i = 1.25 1 = 0.25

What is the yield to maturity of a simple loan of $200 that pays $220 in one year?

6. What is the yield to maturity on a simple loan for $1 million that requires a repayment of $2 million in 5 years time 1= 2
5

( 1+ i) 5 ( 1+ i) = 2

1+ i = 5 2

9. Which $1000 bond has the higher yield to maturity? A 20 year bond selling for $800 with a current yield of 15% or a oneyear bond with a current yield of 5% that sells for $800. For the 20 year bond the current yield will be approximately equal to the yield to maturity (current yield will be a good approximation for the yield to maturity for long term bonds). So the yield to maturity for the 20 year bond is approximately 15%. For the 1 year bond 1000 800 = 0.25 = 25% 800 if there was no coupon payment. The existence of the coupon payment makes the yield to maturity greater than 25%, so the yield to maturity on the 1 year bond is greater than for the 20 year bond. i=

11. If there is a decline in interest rates, which would you rather be holding, long term bonds or short term bonds? Why? 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.

14. If mortgage interest rates rise from 5% to 10% but the expected rate of increase if the inflation rate rises from 2% to 9% are people more or less likely to buy houses? Pople 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.)

Know the rules of thumb in text regarding yields and interest rates If the price for a coupon bond is greater than the par value will the yield to maturity be greater or less than the coupon rate? Less than? Equal to? How do you calculate the yield to maturity of a consol? Under what conditions will the current yield be a good approximation to the yield to maturity? Under what conditions will the yield on a discount basis be a good approximation to the yield to maturity. Which will have the highest yield to maturity A a 1% coupon bond with a 20 year maturity and a $1000 face value selling for $1000 B a 2% coupon bond with a 20 year maturity and a $1000 face value selling for $1000 Which will have the highest yield to maturity A a 1% coupon bond with a 20 year maturity and a $1000 face value selling for $1000 B a 1% coupon bond with a 20 year maturity and a $1000 face value selling for $900