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 DiscountRate CurrentPrice

3 5
3 7
6 7
9 7
9 9

Whatrelationshipdoyouobservebetweenyieldtomaturityandthecurrentmarketvalue?
Solution:

YearstoMaturity YieldtoMaturity CurrentPrice

3 5 $1,054.46
3 7 $1,000.00
6 7 $1,000.00
9 5 $1,142.16
9 9 $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.
C Pt 1 Pt 70 880.10 871.65
Solution: R 0.09, or 9%.
Pt 871.65

10. Youhavepaid$980.30foran8%couponbondwithafacevalueof$1,000thatmatureinfiveyears.
Youplanonholdingthebondforoneyear.Ifyouwanttoearna9%rateofreturnonthisinvestment,
whatpricemustyousellthebondfor?Isthisrealistic?
80 Pt 1 980.30
Solution: Tofindtheprice,solve 0.09 for Pt 1 . Pt 1 988.53.
980.30
Althoughthisappearspossible,theyieldtomaturitywhenyoupurchasedthebondwas
8.5%.Atthatyield,youonlyexpectthepricetobe$983.62nextyear.Infact,theyield
wouldhavetodropto8.35%forthepricetobe$988.53.

11. Calculatethedurationofa$1,0006%couponbondwiththreeyearstomaturity.Assumethatall
marketinterestratesare7%.
Solution:

Year 1 2 3 Sum
Payments 60.00 60.00 1060.00
PVofPayments 56.07 52.41 865.28 973.76
TimeWeightedPVofPayments 56.07 104.81 2595.83
TimeWeightedPVofPayments 0.06 0.11 2.67 2.83
DividedbyPrice
 Thisbondhasadurationof2.83years.Notethatthecurrentpriceofthebondis$973.76,
whichisthesumoftheindividualPVofpayments.

12. Considerthebondinthepreviousquestion.Calculatetheexpectedpricechangeifinterestratesdrop
to6.75%usingthedurationapproximation.Calculatetheactualpricechangeusingdiscountedcash
flow.
Solution: Usingthedurationapproximation,thepricechangewouldbe:
i 0.0025
P DUR P 2.83 973.76 6.44.
1 i 1.07
Thenewpricewouldbe$980.20.Usingadiscountedcashflowapproach,thepriceis
980.23only$.03different.

Year 1 2 3 Sum
Payments 60.00 60.00 1060.00
PVofpayments 56.21 52.65 871.37 980.23

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 1 2 3 Sum
Payment 3.60 3.60 43.60
PVofPayments 3.33 3.09 34.61 41.03
TimeWeightedPVofPayments 3.33 6.18 103.83
TimeWeightedPVofPayments 0.08 0.15 2.53 2.76
DividedbyPrice
Thedurationofaportfolioistheweightedaveragedurationofitsindividualsecurities.So,
theportfoliosduration3/7*(3)4/7*(2.76)2.86

i 0.005
Ifratesincreased, P DUR P 2.86 70,000,000 926,852.
1 i 1.08
15. Considerabondthatpromisesthefollowingcashflows.Therequireddiscountrateis12%.

Year 0 1 2 3 4
PromisedPayments 160 170 180 230

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 0.5
$733.69
1.12 1.121.5
(b) Thisisthesameaspart(a),buttherateisnow11%.
180 230
160 (1.11)1.5 170 (1.11)0.5 0.5
$733.74.
1.11 1.111.5
Noticethatthisisonly$0.05differentfrompart(a).
(c) Thedurationiscalculatedasfollows:

Year 1 2 3 4 Sum
Payments 160.00 170.00 180.00 230.00
PVofPayments 142.86 135.52 128.12 146.17 552.67
TimeWeightedPVofPayments 142.86 271.05 384.36 584.68
TimeWeightedPVofPayments 0.26 0.49 0.70 1.06 2.50
DividedbyPrice

Sincethedurationandtheholdingperiodarethesame,youareinsulatedfromimmediate
changesininterestrates!Itdoesntalwaysworkoutthisperfectly,buttheideaisimportant.