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Chapter 3 pratise Quantitative Problems (2)

The document contains various quantitative problems related to bond valuation, including calculations for present value, yield to maturity, and rate of return on investments. It provides solutions for zero-coupon bonds, coupon bonds, and scenarios involving changes in interest rates. Additionally, it discusses the implications of interest rate fluctuations on investment returns and reinvestment risk.

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2 views4 pages

Chapter 3 pratise Quantitative Problems (2)

The document contains various quantitative problems related to bond valuation, including calculations for present value, yield to maturity, and rate of return on investments. It provides solutions for zero-coupon bonds, coupon bonds, and scenarios involving changes in interest rates. Additionally, it discusses the implications of interest rate fluctuations on investment returns and reinvestment risk.

Uploaded by

ammarafaheem79
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Quantitative Problems

1. Calculate the present value of a $1,000 zero-coupon bond with six years to maturity if the yield to
maturity is 7%.

Solution: Bond price present value


Since there are no coupon payments as this is a zero-coupon bond, the first term in the equation
above is zero.

Bond price present value

3. Consider a bond with an 8% annual coupon and a face value of $1,000. Complete the following table:

Years to Maturity Discount Rate Current Price


4 6
5 8
7 9
10 11
11 12

Solution:

Years to Maturity Yield to Maturity Current Price


4 6 $1,069.30
5 8 $1,000.00
7 9 $949.67
10 11 $823.32
11 12 $762.49

Copyright © 2019 Pearson Education Ltd.


Chapter 3: What Do Interest Rates Mean and What Is Their Role in Valuation? 12

4. Consider a coupon bond which has a $1,000 par value and a coupon rate of 20%. The bond is currently
selling for $2,300 and has 16 years to maturity. Calculate the bond’s yield to maturity.

Solution: To calculate the bond’s yield to maturity using a financial calculator,


N = 16; PV = 2300; PMT = 200; FV = 1000;
Compute I: I = 6.6%

6. Calculate the yield to maturity on the bond that has a price of $1,000 and pays $50 dividend for the
life of the bond. What will happen if the dividend is $25 instead of $50?

Solution: Since the bond pays dividends forever, I = C/P, where I is the yield to maturity, C is the
yearly payment of $50 in this case, and P is the price of a bond, which is $1,000 in this case; I =
50/1000 = 0.05 or 5%;
If the payment is $25, I = 25/1000 = 0.025 or 2.5%.

Copyright © 2019 Pearson Education Ltd.


Chapter 3: What Do Interest Rates Mean and What Is Their Role in Valuation? 13

7. Suppose you bought land that costs $500,000 today. You will need to continue to pay tax on the
land, and the rate is 3% of your purchase. Calculate the PV of your payment, using a 10% discount rate.
Assume that there are no changes in the land’s price and tax rate.

Solution: Yearly payment will be 500,000  3% = 15,000.


Present value of future payments is 15,000/0.10 = 150,000 (a perpetuity).

8. Suppose that you want to take out a loan at a bank that wants to charge you an annual real interest
rate equal to 5%. Assuming that the expected rate of inflation during the life of the loan is 2%, what
will be the nominal interest rate that the bank will charge you? If the real inflation was 3% instead of
the expected 2%, what was the actual real interest rate on the loan?

Solution: Since the bank wants to charge an annual real interest rate of 5%, and the expected rate of
inflation is 2%, according to the Fisher formula, the nominal interest rate will be 5% + 2% = 7%; If
the real inflation was 3%, and the nominal interest rate on the loans was 7%, using the same formula,
the real interest rate is 7% - 3% = 4%. Therefore, the bank received 4% rather than 5% on your loan.

Copyright © 2019 Pearson Education Ltd.


Chapter 3: What Do Interest Rates Mean and What Is Their Role in Valuation? 14

9. Anna bought a bond with a par value of $10,000 and a coupon rate of 8% at par. After a year, she was
able to sell her bond for $11,000. Calculate the rate of return on Anna’s investment. What is the
current yield and capital gain on her investment?

Solution: Return on investment = (coupon payment + price in the following year - the current
price)/current price;
Return on investment = (800 + 11,000 – 10,000)/10,000 = 0.18 or 18%;
The current yield will be 800/10,000 = which is 8%, and the capital gain will be (11,000
-10,000)/10,000 = 0.1 or 10%.

10. Suppose that you have a bond with a face value of $1,000 and a coupon rate of 8% for one year and
that you buy another one after one year. What will be your gain if the interest rate increases up to
10%? How will your answer change if the interest rate falls to 6%? What conclusion can you draw
from these cases?

Solution: After one year, you will have 1,000 + (1,000  8%) = 1,080.
If the interest rates rise up to 10%, for the $1,080 that you have invested, you will get back $1,080 +
$108 = $1,188. The total interest earned is (1,188 – 1,000)/1,000 = 0.1880 or 18.80%.
Compute the annual return: 1,000 x (1 + i)2 = 1,188 which gives us i = 8,99%
If the interest rate falls to 6%, for the $1,080 that you have invested, you will get back 1,080 + 64.80
= 1,144.80; the total interest earned is (1,144.80 - 1,000)/1,000 = 0.1448 or 14.48%.
Compute the annual return: 1,000  (1 + i)2 = 1,144.80; i = 6.99%.
From the above cases, you can draw the conclusion that when the holding period is greater than the
term to maturity, return is uncertain. This is, therefore, about reinvestment risk. You may be better off
if interest rates increase and vice versa.

Copyright © 2019 Pearson Education Ltd.

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