Chapter 4: Textbook Practice Questions

1. Would a dollar tomorrow be worth more to you today when the interest rate is 20% or
when it is 10%? 10%

2. Explain which information you would need to take into consideration when deciding to
receive $5000 today or $5500 one year from today.
From the above formula, it can be said that the present value is inversely related to the
opportunity cost of capital. To decide whether to receive $5,000 today or $5,500 one year
from today, the opportunity cost of capital and hence the present value of $5,500 will
be considered.

3. To help pay for university, you have just taken out a $1000 government loan that makes
you pay $126 per year for 25 years. However, you don’t have to start making these
payments until you graduate from college two years from now. Why is the yield to maturity
necessarily less than 12%? (This is the yield to maturity on a normal $1000 fixed-payment
loan on which you pay $126 per year for 25 years.)
When the interest rate was 12%, the current discounted value of the payments for
government loans would be less than the $1,000 loan amount; however, the payments
would not begin for another two years. The yield to maturity will be less than 12% because
the payment will start later.
As a result, the yield to maturity for the current discounted value will be less than 12%

4. Do bondholders fare better when the yield to maturity increases or when it decreases?
Why?
The bondholders fare better when yield to maturity decreases because price increases
when yield to maturity decreases. Similarly, it states that there is negative relationship
between yield to maturity and bond prices.

5. Suppose today you buy a coupon bond that you plan to sell one year later. Which part of
the rate of return formula incorporates future changes into the bond’s price? Note: Check
Equations 7 and 8 in this chapter.
The rate of capital gain is a component of the rate of return formula that takes into account
future changes in the bond's price.

6. If mortgage rates rise from 5% to 10%, but the expected rate of increase in housing prices
rises from 2% to 9%, are people more or less likely to buy houses?
People are more likely to purchase homes now that the real interest rate they must pay
has dropped from 3% to 1%. People are repaying more in dollars, but their property prices
have increased at such a rate that the true cost of financing their homes has decreased.

7. When is the current yield a good approximation of the yield to maturity?

8. Why would a government choose to issue a perpetuity, which requires payments forever,
instead of a terminal loan, such as a fixed-payment loan, discount bond, or coupon bond?
Governments choose to give perpetuities instead of fixed payments or terminal loans with
the focus of cash flows in the future because the future cash flows would have lower
discounted values than the current value.

9. Under what conditions will a discount bond have a negative nominal interest rate? Is it
possible for a coupon bond or a perpetuity to have a negative nominal interest rate?
The yield to maturity of a discount bond is negative whenever the current price P exceeds
the face value F. A coupon bond can have a negative nominal interest rate if the coupon
payment and face value are both low in comparison to the current price.

10. True or False: With a discount bond, the return on the bond is equal to the rate of capital
gain.
The statement is true. Discount bonds do not have coupon payments; therefore, their returns
are equal to the capital gain rate. Discount bonds do not have coupon installments, and
therefore their current yield is always zero.

11. If interest rates decline, which would you rather be holding, long-term bonds or short-term
bonds? Why? Which type of bond has the greater interest-rate risk?
Long-term bonds would be a better investment since their price would rise faster than short-
term bonds, offering you a bigger return. Longer-term bonds are more vulnerable to price
swings than shorter-term bonds, posing a higher risk of interest rate fluctuations.

12. Interest rates were lower in the mid-1980s than in the late 1970s, yet many economists
have commented that real interest rates were actually much higher in the mid-1980s than
in the late 1970s. Does this make sense? Do you think that these economists are right?
Economists are correct in their assessments. They claim that nominal interest rates were lower
than expected inflation rates in the late 1970s, resulting in negative real interest rates.
Predicted inflation, on the other hand, fell significantly faster than nominal interest rates in the
mid-1980s, resulting in nominal interest rates being higher than expected inflation and real
rates being positive.

13. Retired persons often have much of their wealth placed in savings accounts and other
interest-bearing investments and complain whenever interest rates are low. Do they have
a valid complaint?
The commitment of an asset to increase in value over time is referred to as investment.
Investment necessitates the loss of a current item, such as time, money, or effort. The goal of
investing in finance is to make a profit from the asset you've put money into.
While it may appear that their wealth is eroding as nominal interest rates decrease, their real
return on savings accounts will be unaffected as long as projected inflation declines at the
same rate as nominal interest rates. In actuality, however, projected inflation as measured by
 the cost of living for seniors and retirees is frequently substantially greater than typical inflation
metrics.

APPLIED PROBLEMS
14. 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?
15. Calculate the present value of a $1000 discount bond with five years to maturity if the yield
to maturity is 6%.
16. A lottery claims its grand prize is $10 million, payable over five years at $2 000 000 per
year. If the first payment is made immediately, what is this grand prize really worth? Use
an interest rate of 6%.
17. Suppose that a commercial bank wants to buy Treasury bills. These instruments pay
$5000 in one year and are currently selling for $5012. What is the yield to maturity of these
bonds? Is this a typical situation? Why?
18. What is the yield to maturity on a simple loan for $1 million that requires a repayment of
$2 million in five years’ time?
19. Which $1000 bond has the higher yield to maturity, a 20-year bond selling for $800 with a
current yield of 15% or a 1-year bond selling for $800 with a current yield of 5%?
20. Consider a bond with a 4% annual coupon and a face value of $1000. Complete the
following table. What relationships do you observe between years to maturity, yield to
maturity, and the current price?
The column headings from left to right are years to maturity, yield to maturity, and current
price. The column for current price is blank. The data in the five rows for the first two
columns is as follows.
Row 1. 2 and 2%.
Row 2. 2 and 4%.
Row 3. 3 and 4%.
Row 4. 5 and 2%.
Row 5. 5 and 6%.
21. Consider a coupon bond that has a $1000 par value and a coupon rate of 10%. The bond
is currently selling for $1044.89 and has two years to maturity. What is the bond’s yield to
maturity?
22. What is the price of a perpetuity that has a coupon of $50 per year and a yield to maturity
of 2.5%? If the yield to maturity doubles, what will happen to the perpetuity’s price?