BFC5926 Financial Institutions and Markets

Week 3: Workshop Solutions

1. Differentiate between simple and compound interest. What is the

difference between the holding period yield and yield to maturity?

a. Differentiate between simple and compound interest.

SIMPLE INTEREST: the calculation of interest is based on the initial

principal amount invested or borrowed. For example, funds invested in a
bank term deposit for six-months where simple interest is paid monthly. The
investor will receive the interest payment each month by cash and the
amount invested in the term deposit will remain the same. The principal will
be repaid at maturity.

COMPOUND INTEREST: compounding refers to the situation where interest

earned in one period is added to the principal. Interest in the next period is
then earned on the larger total amount (principal plus interest) and is also
added to the total amount at the end of the next period.

For example, an original investment of $1000 earns 10% p.a. compounding

annually. At the end of the first year the interest earned is 10% of $1000 =
$100. The $100 interest is added to the original principal amount. During the
second year interest is earned on the new accumulated principal amount of
$1100. Interest earned is 10% of $1100 = $110. The $110 is then added to
the existing $1100 to give a new balance of $1210. And so the process
proceeds until maturity.

b. What is the difference between the holding period yield and yield to
maturity?

The yield to maturity refers to the return received where an investment is

held until it matures.

For example, a 180 day bank bill is purchased at the discounted price and, if
held for the 180 days, the face value is paid at maturity. The yield to maturity
is the cost of issuing the bill by the borrower; that is, the discount divided by
the discounted amount adjusted for the 180 days.

The holding period yield refers to the return received by an investor for the
period over which an investment is actually held
For example, a 180 day bank bill is purchased at a discount price, but is later
sold (rediscounted) before the maturity date. The rediscounted price will be
based on current yields in the market at sale date.

The difference between the sale price and the purchase price is the return to
the investor.

The return divided by the purchase price, and adjusted for the number of
days the security was held, represents the HPY

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BFC5926 Financial Institutions and Markets

2. Find the present value of the following ordinary annuities:

a) $880 per year for 10 years at 12 percent.
b) $1,000 per year for 7 years at 7 percent.
c) $900 per year for 6 years at 0 percent.

(a) $4,972.20
(b) $5,389.29
(c) $5,400

3. Find the interest rate, or rates of return, on each of the following:

a) You borrow $700 and promise to pay back $749 at the end of 1
year.
b) You lend $700 and receive a promise to be paid $749 at the end
of 1 year.
c) You borrow $85,000 and promise to pay back $201,229 at the
end of 10 years.
d) You borrow $9,000 and promise to make payments of $2,684.80
per year for 5 years.

(a) & (b)PV=$700, interest payment over one year $49, FV=$749
find i; i= 7%
(c) PV = $85,000, FV=$201,229; find i; I = 9%
(d) PV=$9,000, ordinary annuity of $2,684.80 for 5 years; find i; i=
15%

4. Explain why an investor should consider the time pattern of the

cash flows from an investment rather than just compare the total
amount cash received.

The time value of money is effectively the opportunity cost of capital.

Money received today is worth more than money received in the future as
the money today can be invested and produce an income accordingly.

An investment can therefore be judged, all things being equal, on the

speed in which the resulting cash flows are received.

An investment whose money is paid mainly at the start of the investment

period is worth more typically than one where most of the payments are
delayed. It would have a higher present value.