2ExerciseA financial adviser has just given you the following advice: “Long-term bonds are a great investment because their interest rate is over 10%”.Is the financial adviser necessarily right?
3SolIf interest rates rise sharply in the future, long-term bonds may suffer such a sharp fall in price that their return might be quite low, possibly even negative.
4ExerciseIf there is a decline in interest rates, which would you rather be holding, long-term bonds or short-term bonds?Why?
5SolYou would rather be holding long-term bonds because their price would increase more than the price of the short-term bonds, giving them a higher return
6ExerciseA lottery claims is grand prize is $ 10 million, payable over 20 years at $ 500,000 per year.If the first payment is made immediately, what is this grand prize really worth?Use a discount rate of 6%
7SolThis is a simple present value problem. Using a financial calculator:Compute PV: PV = $6,079,058.25
8ExerciseConsider a coupon bond that has a $ 1,000 par value and a coupon rate of 10%.The bond is currently selling for $ 1,150 and has eight years to maturity.What is the bond’s yield to maturity?
9SolTo calculate the bond’s yield to maturity using a financial calculator:N 8; I 100; FV 1000; PV 1150Compute i 7.44
10ExerciseYou are willing to pay $ 15,625 now to purchase a perpetuity that will pay you $ 1,250 each year, forever, starting at the end of this year.If your required rate of return does not change, how much would you be willing to pay if this where a 20-year, annual payment, ordinary annuity, instead of a perpetuity?
11Sol15,625 1,250/ii 0.08The answer to the final part, using a financial calculator:N 20; i 8; P 1250; FV 0Compute PV : PV 12,272.69
12ExerciseAssume you just deposited $ 1,000 into a bank account. The current real interest rate is 2%, and inflation is expected to be 6% over the next year.What nominal rate would you require from the bank over the next year?How much money will you have at the end of one year?
13Exercise (Cont.)If you are saving to buy a stereo that currently sells for $ 1,050, will you have enough to buy it?
14Sol The required nominal rate would be: i ir e 2% 6% 8%. At this rate, you would expect to have $1,000 1.08, or $1,080 at the end of the year. Can you afford the stereo? In theory, the price of the stereo will increase with the rate of inflation. So, one year later, the stereo will cost $1,050 1.06, or $1,113. You will be short by $33.
15ExerciseFind the price of a 10% coupon bond with a face value of $ 1,000, a 12.25% yield to maturity and eight years to maturity
16Sol N = Years to maturity = 8 FV = 1,000 i = 12.25% Coupon payments = 100PV =
17ExerciseA 10-year, 7% coupon bond with a face value of $ 1,000 is currently selling for $Compute your rate of return if you sell the bond next year for $
19ExerciseYou have paid $ for an 8% coupon bond with a face value of $1,000 that mature in five years.You plan on holding the bond for one year. If you want to earn a 9% rate of return on this investment, what price must you sell the bond for?