Chapter 5: ANSWERS TO "DO YOU UNDERSTAND" TEXT QUESTIONS DO YOU UNDERSTAND? 1.

Why is a dollar today worth more to most people than a dollar received at a future date? Solution: There are two ways to view this issue. First, people generally have a positive time preference for consumption; that is, holding the amount of money constant, they prefer to consume today to consuming in the future. Second, the dollar today is worth more ecause if one has it, it can e invested to earn interest. !. "f you were to invest #1$$ in a savings account offering % percent interest compounded &uarterly, how much money would e in the account after three years? Solution: 'se F( ) *(+1 , i-n ) #1$$+1.$%-. ) #1$$+1.1/1- ) #11/.1$. .. 0ou have 1ust won #%$ million in the *ower all lottery2 The lottery promises to pay you #!$ million at the end of each year for the ne3t three years. "f the mar4et rate of interest is 5 percent, how much money would you accept today in e3change for the three #!$ million payments? Solution: The an4 will only lend you the present value of the lottery winnings. 6alculate the present value of each cash flow and then sum the present values:
PV = $20,000,000 $20,000,000 $20,000,000 + + =$52,486,321. 1.07 1.07 2 1.07 3

DO YOU UNDERSTAND? 1. When a ond7s coupon rate is less than the prevailing mar4et rate on interest on similar onds, will the ond sell at par, a discount, or a premium? 83plain. Solution: The ond will sell at a discount. "f, for e3ample, it were priced at par, the yield to maturity of the ond would e less than the prevailing mar4et rate of interest on similar onds and no one would purchase it. They will only purchase the ond if the price is discounted to provide a yield to maturity e&ual to that offered y similar alternatives in the mar4et. !. 'nder what conditions will the reali9ed yield on a ond e&ual the promised yield? Solution: "f the investor receives all cash flows as promised y the issuer and reinvests them at the ond7s promised yield +the yield to maturity at the time of its purchase-, the reali9ed yield will e&ual the promised yield. "f the issuer defaults on payments of coupon interest or principal, if the investor consumes the coupon payments rather than reinvesting

them, or if the mar4et interest rate at which the coupon payments can e reinvested deviates from the promised yield, the reali9ed yield will not necessarily e&ual the promised yield. .. 'sing the trial:and:error method, find the yield to maturity of a ond with five years to maturity, par value of #1,$$$, and a coupon rate of ; percent +annual payments-. The ond currently sells at /;.< percent of par value. Solution: The price of the ond is #/;< ) $./;<+#1,$$$-. Set up the 4nown information in the ond pricing formula and try different interest rates until the right hand side e&uals the left hand side:
5 $80 $1,000 $985 = + t ( 1 + i ) (1 + i )5 t =1

The yield to maturity is ;..; percent. =. >n investor purchases a #1,$$$ par value ond with five years to maturity at #/;<. The ond pays #;$ of interest annually. The investor plans to hold the ond for two years and e3pects to sell it at the end of the holding period for /= percent of its face value. What is this investor7s e3pected yield? 'se the trial:and:error method. Solution: The current price is #/;<. The investor e3pects to sell it after two years for #/=$ ) $./=+#1,$$$-. Set up the 4nown information in the ond pricing formula, and try different interest rates until the right hand side e&uals the left hand side:

985 =
t =1

$80 $940 + t (1 + i ) (1 + i ) 2

The e3pected yield is <./$ percent. DO YOU UNDERSTAND? 1. 6onsider a four:year ond selling at par with a 5 percent annual coupon. Suppose that yields on similar onds increase y <$ asis points. 'se duration +8&uation <.;- to estimate the percent change in the ond price. 6hec4 your answer y calculating the new ond price. Solution: = year, 5? annual coupon ond selling at par @uration ) .%!=..!A1$$$ ) ..%! 6onve3ity ) 1<!/....A1$$$ ) 1<.!/ mar4et rate increase of <$ asis points ? change in ond value ) :..%!B.$$<A1.$5C , +D-+1<.!/-+.$$< !- ) :.$1%5 The new ond price is #/;..!< so the actual change in value is :.$1%;.

!. @efine price risk and reinvestment risk. 83plain how the two ris4s offset each other. Solution: *rice ris4 is the varia ility of return caused y changes in the mar4et price of the ond, while reinvestment ris4 is the varia ility in ond return caused y varying reinvestment rates. >t the duration point these two ris4s offset each other. "f the ond is held to its duration, the investor will yield the e3pected 0TE. "f interest rates were to increase during the holding period, price ris4 would cause the ond price to fall, ut the reinvestment rate on coupon would increase. "f interest rates were to fall during the holding period, price ris4 would increase the capital gain on the ond ut falling rates would reduce the return from reinvestment of coupon. .. What is the duration of a ond portfolio made up of two onds: .5 percent of a ond with duration of 5.5 years and %. percent of a ond with duration of 1%.= years? Solution: 8stimate the weighted duration of the portfolio or: 5.5+..5- , 1%.=+.%.- ) 1..! years =. Fow can duration e used as a way to ran4 onds on their interest rate ris4? Solution: @uration is a measure of price varia ility, given a change in interest rates. The price ris4 varies directly with the duration of the ond. <. To eliminate interest rate ris4, should you match the maturity or the duration of your ond investment to your holding period? 83plain. Solution: @uration is a useful measure of interest rate ris4 ecause there is a direct relation etween ond price volatility and duration. @uration matching is a techni&ue that eliminates interest rate ris4. @uration matching matches the duration of the ond to the investor7s holding period. When a ond7s duration matches the holding period, the ond7s price ris4 directly offsets the ond7s reinvestment rate ris4, thus eliminating interest rate ris4.