Quantitative Problem Chapter 3

1.

Calculatethepresentvalueof$1,000zerocouponbondwith5yearstomaturityiftherequired
annualinterestrateis6%.
Solution: PVFV/(1i)n,whereFV1000,i0.06,n5
PV747.25grandprizeis

2.

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

3.

Considerabondwitha7%annualcouponandafacevalueof$1,000.Completethefollowingtable:
YearstoMaturity
3
3
6
9
9

DiscountRate
5
7
7
7
9

CurrentPrice

Whatrelationshipdoyouobservebetweenyieldtomaturityandthecurrentmarketvalue?
Solution:
YearstoMaturity
3
3
6
9
9

YieldtoMaturity
5
7
7
5
9

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

Whenyieldtomaturityisabovethecouponrate,thebandscurrentpriceisbelowitsface
value.Theoppositeholdstruewhenyieldtomaturityisbelowthecouponrate.Fora
givenmaturity,thebondscurrentpricefallsasyieldtomaturityrises.Foragivenyieldto
maturity,abondsvaluerisesasitsmaturityincreases.Whenyieldtomaturityequalsthe
couponrate,abondscurrentpriceequalsitsfacevalueregardlessofyearstomaturity.
4.

Consideracouponbondthathasa$1,000pervalueandacouponrateof10%.Thebondiscurrently
sellingfor$1,150andhas8yearstomaturity.Whatisthebondsyieldtomaturity?
Solution: Tocalculatethebondsyieldtomaturityusingafinancialcalculator:
N8;PMT10000.10100;FV1000;PV1150
ComputeI:I7.44

5.

Youarewillingtopay$15,625nowtopurchaseaperpetuitywhichwillpayyouandyourheirs
$1,250eachyear,forever,startingattheendofthisyear.Ifyourrequiredrateofreturndoesnot
change,howmuchwouldyoubewillingtopayifthiswerea20year,annualpayment,ordinary
annuityinsteadofaperpetuity?
Solution: Tofindyouryieldtomaturity,PerpetuityvaluePMT/I.
So,156251250/I.I0.08
Theanswertothefinalpart,usingafinancialcalculator:
N20;I8;PMT1250;FV0
ComputePV:PV12,272.69

7.

PropertytaxesinDeKalbCountyareroughly2.66%ofthepurchasepriceeveryyear.Ifyoujust
boughta$100,000home,whatisthePVofallthefuturepropertytaxpayments?Assumethatthe
houseremainsworth$100,000forever,propertytaxratesneverchange,andthata9%discountrateis
usedfordiscounting.
Solution: Thetaxesona$100,000homeareroughly100,0000.02662,660.
ThePVofallfuturepayments2,660/0.09$29,555.55(aperpetuity).

8.

Assumeyoujustdeposited$1,000intoabankaccount.Thecurrentrealinterestrateis2%and
inflationisexpectedtobe6%overthenextyear.Whatnominalinterestratewouldyourequirefrom
thebankoverthenextyear?Howmuchmoneywillyouhaveattheendofoneyear?Ifyouare
savingtobuyastereothatcurrentlysellsfor$1,050,willyouhaveenoughtobuyit?
Solution: Therequirednominalratewouldbe:
iire
2%6%8%.
Atthisrate,youwouldexpecttohave$1,0001.08,or$1,080attheendoftheyear.Can
youaffordthestereo?Intheory,thepriceofthestereowillincreasewiththerateof
inflation.So,oneyearlater,thestereowillcost$1,0501.06,or$1,113.Youwillbe
shortby$33.

9.

A10year,7%couponbondwithafacevalueof$1,000iscurrentlysellingfor$871.65.Compute
yourrateofreturnifyousellthebondnextyearfor$880.10.
Solution: R

C Pt 1 Pt 70 880.10 871.65

0.09, or 9%.
Pt
871.65

10. Youhavepaid$980.30foran8%couponbondwithafacevalueof$1,000thatmatureinfiveyears.
Youplanonholdingthebondforoneyear.Ifyouwanttoearna9%rateofreturnonthisinvestment,
whatpricemustyousellthebondfor?Isthisrealistic?
Solution: Tofindtheprice,solve

80 Pt 1 980.30
0.09 for
980.30

Pt 1 . Pt 1 988.53.

Althoughthisappearspossible,theyieldtomaturitywhenyoupurchasedthebondwas
8.5%.Atthatyield,youonlyexpectthepricetobe$983.62nextyear.Infact,theyield
wouldhavetodropto8.35%forthepricetobe$988.53.
11. Calculatethedurationofa$1,0006%couponbondwiththreeyearstomaturity.Assumethatall
marketinterestratesare7%.
Solution:
Year
Payments
PVofPayments
TimeWeightedPVofPayments
TimeWeightedPVofPayments
DividedbyPrice

1
60.00
56.07
56.07
0.06

2
60.00
52.41
104.81
0.11

3
1060.00
865.28
2595.83
2.67

Sum
973.76
2.83

Thisbondhasadurationof2.83years.Notethatthecurrentpriceofthebondis$973.76,
whichisthesumoftheindividualPVofpayments.
12. Considerthebondinthepreviousquestion.Calculatetheexpectedpricechangeifinterestratesdrop
to6.75%usingthedurationapproximation.Calculatetheactualpricechangeusingdiscountedcash
flow.
Solution: Usingthedurationapproximation,thepricechangewouldbe:
P DUR

i
0.0025
P 2.83
973.76 6.44.
1 i
1.07

Thenewpricewouldbe$980.20.Usingadiscountedcashflowapproach,thepriceis
980.23only$.03different.
Year
Payments
PVofpayments

1
60.00
56.21

2
60.00
52.65

3
1060.00
871.37

Sum
980.23

13. Thedurationofa$100millionportfoliois10years.$40millioninnewsecuritiesareaddedto
theportfolio,increasingthedurationoftheportfolioto12.5years.Whatisthedurationofthe
$40millioninnewsecurities?
Solution: First,notethattheportfolionowhas$140millioninit.Thedurationofaportfolioisthe
weightedaveragedurationofitsindividualsecurities.LetDequalthedurationofthe
$40millioninnewsecurities.Then,thisimplies:
12.5(100/14010)(40/140D)
12.57.14250.2857D
18.75D
Thenewsecuritieshaveadurationof18.75years.
14. Abankhastwo,3yearcommercialloanswithapresentvalueof$70million.Thefirstis
a$30millionloanthatrequiresasinglepaymentof$37.8millionin3years,withnoother
paymentstillthen.Thesecondisfor$40million.Itrequiresanannualinterestpaymentof$3.6
million.Theprincipalof$40millionisduein3years.
(a) Whatisthedurationofthebankscommercialloanportfolio?
(b) Whatwillhappentothevalueofitsportfolioifthegenerallevelofinterestratesincreasedfrom
8%to8.5%?
Solution: Thedurationofthefirstloanis3yearssinceitisazerocouponloan.Thedurationofthe
secondloanisasfollows:
Year
Payment
PVofPayments
TimeWeightedPVofPayments
TimeWeightedPVofPayments
DividedbyPrice

1
3.60
3.33
3.33
0.08

2
3.60
3.09
6.18
0.15

3
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

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

15. Considerabondthatpromisesthefollowingcashflows.Therequireddiscountrateis12%.
Year
PromisedPayments

1
160

2
170

3
180

4
230

Youplantobuythisbond,holditfor2years,andthensellthebond.
(a) Whattotalcashwillyoureceivefromthebondafterthe2years?Assumethatperiodiccash
flowsarereinvestedat12%.
(b) Ifimmediatelyafterbuyingthisbond,allmarketinterestratesdropto11%(includingyour
reinvestmentrate),whatwillbetheimpactonyourtotalcashflowafter2years?Howdoesthis
comparetopart(a)?
(c) Assumingallmarketinterestratesare12%,whatisthedurationofthisbond?
Solution:
(a) Youwillreceive160,reinvestedthatfor1.5years,and170reinvestedfor0.5years.Thenyou
willselltheremainingcashflows,discountedat12%.Thisgivesyou:
180
230
160 (1.12)1.5 170 (1.12)0.5

$733.69
0.5
1.12
1.121.5
(b) Thisisthesameaspart(a),buttherateisnow11%.
180
230
160 (1.11)1.5 170 (1.11)0.5

$733.74.
0.5
1.11
1.111.5
Noticethatthisisonly$0.05differentfrompart(a).
(c) Thedurationiscalculatedasfollows:
Year
Payments
PVofPayments
TimeWeightedPVofPayments
TimeWeightedPVofPayments
DividedbyPrice

1
160.00
142.86
142.86
0.26

2
170.00
135.52
271.05
0.49

3
180.00
128.12
384.36
0.70

4
230.00
146.17
584.68
1.06

Sincethedurationandtheholdingperiodarethesame,youareinsulatedfromimmediate
changesininterestrates!Itdoesntalwaysworkoutthisperfectly,buttheideaisimportant.

Sum
552.67
2.50