Money & Banking, Spring 2016

Ch.04 Practice Problems Practice Problems on Yield to Maturity

simple loan:
(i) What is the yield to maturity on a loan of $200 you get today, which requires you to pay $230 two years
later?
Set LV = PV, which implies, 200 = 230 / (1+i)^2. Then you will get i = 7.24% .

fixed payment Loan:

(ii) What is the yield to maturity on a loan of $200 you received today, which requires you to pay $ 115 at
the end of each year for the next two years?

Set LV = PV, which implies 200 = [ 115 / (1+i) ] + [ 115 / (1+i)^2 ]. Then you will get i = 9.85% .

Note that you need to solve a quadratic equation. To do so, you can set x = 1/(i+i), which gives you
200 = 115x + 115x^2
or, 115x^2 + 115x - 200 = 0 [ Think of this as ax^2 + bx + c = 0]
or, x = 0.8602 [ x= {- b +/- square root of (b^2- 4ac)} / 2a ]
i.e., i = 9.85% [ Note x = 1/(i+i) ]

coupon bond:
(iii) If you bought a two-year coupon bond with face value of $500, coupon rate of 10% ( i.e. coupon
payment of $50) and yield to maturity of 7%, then what price did you pay?
P = 50/1.07 + 50/1.07^2 + 500/1.07^2 =527.12

one year-discount bond:

(iii) What is the yield to maturity on a one year discount bond with the face value of $1000 if you pay $975
for it today?
Set P = PV, which implies 975 = 100 / (1 + i). Then you can get i = 2.56% . Note that you can get the answer by using
i = (F - P) / P.

Consol or perpetuity ( a special case of coupon bond):

(v) what is the approximate value of yield to maturity ( as given by the current yield) for a consol you got
for $250 and pays you a coupon payment of $10 every year forever?

It is given approximately by: ic = C/PC = 10/250=4%

In case you need it, P = (C/i) * [ 1 - { 1/(1+i)^n } ] + F/(1+i)^n .

Rate of return:
What would the rate of return on a bond bought for $1000 and sold one year later for $800? The
bond has a face value of $1000 and a coupon rate of 8%.
Use RET = (C + Pt+1- Pt ) / Pt to get RET = -12% RET= -12%

Note that this is a nominal rate of return.

Nominal & Real Interest Rates:

Suppose you lend your friend $800 today for a year at 6% interest rate in dollar terms. The
inflation rate is expected to be around 4% during this arrangement.

(a) What is the nominal interest rate? 6%

(b) What is the real interest rate (ex-ante)? 2%

6% - 4%

(c) What is the ex-post real interest rate if the actual inflation rate is 5% instead of the expected
inflation rate of 4%?
6% - 5% 1%
(d) Who benefits (borrower, lender) when the actual inflation rate is higher than the expected
inflation rate?
borrower
The borrower was willing to pay 2% but ends up paying only 1% in real interest rate.

Interest-Rate Risk :
(a) Calculate the rate of capital gain or loss on a two-year zero-coupon bond with face value of
$1000 for which the interest rate changes from 5% to 6% one period later. 4.01%
Pt= 1000/1.05^2 =907.03 and Pt+1= 1000/1.06 = 943.40 .

(b) Calculate the rate of capital gain or loss on a four-year zero-coupon bond with face value of
$1000 for which the interest rate has changed from 5% to 6% one period later. 2.06%
Pt= 1000/1.05^4 =822.70 and Pt+1= 1000/1.06^3 = 839.62

[Hint: Note that it = 0.05, it+1 = 0.06, and C = 0. You need to figure out Pt and Pt+1 in each case by
considering appropriate interest rates. Then use them to compute the rate of capital gain or loss.
Rate of return is affected more (negatively here) in the case of the longer term bond. This problem
is related to interest rate risk concept. Note further that if the interest rate did not change, then P t+1
would have been 952.38 for the two-year-zero-coupon bond and 863.84 for the four-year-zero-
coupon bond. If you consider a ten year zero coupon bond and the same change to the interest
rate, then the rate of capital gain is -3.59% ]