Chapter3

AnswerstoEndofChapterQuestions
1. $2000$100/(1i)$100/(1i)2$100/(1i)20$1000/(1i)20.
2.

Youwouldratherbeholdinglongtermbondsbecausetheirpricewouldincreasemorethanthepriceofthe
shorttermbonds,givingthemahigherreturn.

3.

No.Ifinterestratesrisesharplyinthefuture,longtermbondsmaysuffersuchasharpfallinpricethat
theirreturnmightbequitelow,possiblyevennegative.

4.

Peoplearemorelikelytobuyhousesbecausetherealinterestratewhenpurchasingahousehasfallenfrom
3percent(5percent2percent)to1percent(10percent9percent).Therealcostoffinancingthehouseis
thuslower,eventhoughmortgagerateshaverisen.(Ifthetaxdeductibilityofinterestpaymentsisallowed
for,thenitbecomesevenmorelikelythatpeoplewillbuyhouses.)

Quantitative Problem
1.
Calculatethepresentvalueof$1,000zerocouponbondwith5yearstomaturityiftherequired
annualinterestrateis6%.
Solution: PVFV/(1i)n,
where

FV1000,i0.06,n5
PV747.25grandprizeis

2.
Alotteryclaimsitsgrandprizeis$10million,payableover20yearsat$500,000peryear.If
thefirstpaymentismadeimmediately,whatisthisgrandprizereallyworth?Useadiscountrateof6%.
Solution: Thisisasimplepresentvalueproblem.Usingafinancialcalculator:
N20;PMT500,000;FV0;I6%;PmtsinBEGINmode.
ComputePV:PV$6,079,058.25
3.
table:

Considerabondwitha7%annualcouponandafacevalueof$1,000.Completethefollowing

YearstoMaturity

DiscountRate

3
3
6
9
9

CurrentPrice

5
7
7
7
9

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

YieldtoMaturity

CurrentPrice

5
7
7
5
9

$1,054.46
$1,000.00
$1,000.00
$1,142.16
$880.10

Whenyieldtomaturityisabovethecouponrate,thebandscurrentpriceisbelowitsface
value.Theoppositeholdstruewhenyieldtomaturityisbelowthecouponrate.Foragiven
maturity,thebondscurrentpricefallsasyieldtomaturityrises.Foragivenyieldtomaturity,a
bondsvaluerisesasitsmaturityincreases.Whenyieldtomaturityequalsthecouponrate,a
bondscurrentpriceequalsitsfacevalueregardlessofyearstomaturity.

4.
Consideracouponbondthathasa$1,000pervalueandacouponrateof10%.Thebondis
currentlysellingfor$1,150andhas8yearstomaturity.Whatisthebondsyieldtomaturity?
Solution: Tocalculatethebondsyieldtomaturityusingafinancialcalculator:
N8;PMT10000.10100;FV1000;PV1150
ComputeI:I7.44
5.
Youarewillingtopay$15,625nowtopurchaseaperpetuitywhichwillpayyouandyourheirs
$1,250eachyear,forever,startingattheendofthisyear.Ifyourrequiredrateofreturndoesnotchange,
howmuchwouldyoubewillingtopayifthiswerea20year,annualpayment,ordinaryannuityinsteadof
aperpetuity?
Solution: Tofindyouryieldtomaturity,PerpetuityvaluePMT/I.
So,156251250/I.I0.08
Theanswertothefinalpart,usingafinancialcalculator:
N20;I8;PMT1250;FV0
ComputePV:PV12,272.69
6.
PropertytaxesinDeKalbCountyareroughly2.66%ofthepurchasepriceeveryyear.Ifyou
justboughta$100,000home,whatisthePVofallthefuturepropertytaxpayments?Assumethatthe
houseremainsworth$100,000forever,propertytaxratesneverchange,andthata9%discountrate
isusedfordiscounting.
Solution: Thetaxesona$100,000homeareroughly100,0000.02662,660.
ThePVofallfuturepayments2,660/0.09$29,555.55(aperpetuity).
7.

Assumeyoujustdeposited$1,000intoabankaccount.Thecurrentrealinterestrateis2%and
inflationisexpectedtobe6%overthenextyear.Whatnominalinterestratewouldyourequire
fromthebankoverthenextyear?Howmuchmoneywillyouhaveattheendofoneyear?Ifyou
aresavingtobuyastereothatcurrentlysellsfor$1,050,willyouhaveenoughtobuyit?

Solution: Therequirednominalratewouldbe:

iir e
2%6%

8%.
Atthisrate,youwouldexpecttohave$1,0001.08,or$1,080attheendoftheyear.
Canyouaffordthestereo?Intheory,thepriceofthestereowillincreasewiththerateof
inflation.So,oneyearlater,thestereowillcost$1,0501.06,or$1,113.Youwillbeshortby
$33.
8.
A10year,7%couponbondwithafacevalueof$1,000iscurrentlysellingfor$871.65.
Computeyourrateofreturnifyousellthebondnextyearfor$880.10.
Solution:

C Pt 1 Pt 70 880.10 871.65

0.09, or 9%.
Pt
871.65

9.
Youhavepaid$980.30foran8%couponbondwithafacevalueof$1,000thatmatureinfive
years.Youplanonholdingthebondforoneyear.Ifyouwanttoearna9%rateofreturnonthis
investment,whatpricemustyousellthebondfor?Isthisrealistic?
Solution: Tofindtheprice,solve

80 Pt 1 980.30
0.09 for Pt 1. Pt 1 988.53.
980.30
Althoughthisappearspossible,theyieldtomaturitywhenyoupurchasedthebondwas8.5%.
Atthatyield,youonlyexpectthepricetobe$983.62nextyear.Infact,theyieldwouldhaveto
dropto8.35%forthepricetobe$988.53.

10. Calculatethedurationofa$1,0006%couponbondwiththreeyearstomaturity.Assumethatallmarket
interestratesare7%.
Solution:
Year

Sum

Payments

60.00

60.00

1060.00

PV of Payments

56.07

52.41

865.28

Time Weighted PV of Payments

56.07

104.81

2595.83

Time Weighted PV of Payments

Divided by Price

0.06

0.11

2.67

973.76
2.83

This bond has a duration of 2.83 years. Note that the current price of the bond is $973.76, which is the sum of the
individual PV of payments.
11.
Consider the bond in the previous question. Calculate the expected price change if interest rates
drop to 6.75% using the duration approximation. Calculate the actual price change using discounted cash flow.
Solution:

P DUR

Using the duration approximation, the price change would be:

i
0.0025
P 2.83
973.76 6.44.
1 i
1.07

The new price would be $980.20. Using a discounted cash flow approach, the price is 980.23
only $.03 different.
Year

Payments

60.00

60.00

1060.00

PV of payments

56.21

52.65

871.3

Sum
980.23

12.
The duration of a $100 million portfolio is 10 years. $40 million in new securities are added to
the portfolio, increasing the duration of the portfolio to 12.5 years. What is the duration of the
$40 million in new securities?
Solution:
First, note that the portfolio now has $140 million in it. The duration of a portfolio is the
weighted average duration of its individual securities. Let D equal the duration of the
$40 million in new securities. Then, this implies:
12.5 (100/140 10) (40/140 D)
12.5 7.1425 0.2857 D
18.75 D
The new securities have a duration of 18.75 years.
13.
A bank has two, 3-year commercial loans with a present value of $70 million. The first is a $30 million
loan that requires a single payment of $37.8 million in 3 years, with no other payments until then. The second is
for $40 million. It requires an annual interest payment of $3.6 million. The principal of
$40 million is due in 3 years.
a.

What is the duration of the banks commercial loan portfolio?

b.
8.5%?

What will happen to the value of its portfolio if the general level of interest rates increased from 8% to

Solution: Thedurationofthefirstloanis3yearssinceitisazerocouponloan.Thedurationofthe
secondloanisasfollows:
Year
Payment
PVofPayments
TimeWeightedPVofPayments
TimeWeightedPVofPayments
DividedbyPrice

3.60
3.33
3.33
0.08

3.60
3.09
6.18
0.15

43.60
34.61
103.83
2.53

Sum
41.03
2.76

Thedurationofaportfolioistheweightedaveragedurationofitsindividualsecurities.
So,theportfoliosduration3/7(3)4/7(2.76)2.86
Ifratesincreased, P DUR

14.

i
0.005
P 2.86
70,000,000 926,852.
1 i
1.08

Consider a bond that promises the following cash flows. The required discount rate is 12%.
Year

Promised Payments

160

170

180

230

You plan to buy this bond, hold it for 2 years, and then sell the bond.
a.
What total cash will you receive from the bond after the 2 years? Assume that periodic cash flows are
reinvested at 12%.
b.
If immediately after buying this bond, all market interest rates drop to 11% (including your reinvestment
rate), what will be the impact on your total cash flow after 2 years? How does
this compare to part (a)?
c.

Assuming all market interest rates are 12%, what is the duration of this bond?

Solution:
a.
You will receive 160, reinvested that for 1.5 years, and 170 reinvested for 0.5 years. Then you will sell
the remaining cash flows, discounted at 12%. This gives you:

160 (1.12)1.5 170 (1.12)0.5

b.

180
230

$733.69.
0.5
1.12
1.121.5

This is the same as part (a), but the rate is now 11%.

160 (1.11)1.5 170 (1.11)0.5

180
230

$733.74.
0.5
1.11
1.111.5

Notice that this is only $0.05 different from part (a).

c.

The duration is calculated as follows:

Year

Payments

160.00

170.00

180.00

230.00

PV of Payments

142.86

135.52

128.12

146.17

Time Weighted PV of Payments

142.86

271.05

384.36

584.68

Time Weighted PV of Payments

Divided by Price

0.26

0.49

0.70

1.06

Sum
552.67
2.50

Since the duration and the holding period are the same, you are insulated from immediate changes in
interest rates! It doesnt always work out this perfectly, but the idea is important.