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Exercises 2010 September 29-30

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Exercise A 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?

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If 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. Sol

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Exercise If there is a decline in interest rates, which would you rather be holding, long-term bonds or short-term bonds? Why?

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Sol You 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

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Exercise A 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%

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Sol This is a simple present value problem. Using a financial calculator: Compute PV: PV = $6,079,058.25

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Exercise Consider 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?

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Sol To calculate the bond’s yield to maturity using a financial calculator: N 8; I 100; FV 1000; PV 1150 Compute i 7.44

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Exercise You 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?

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Sol 15,625 1,250/i i 0.08 The answer to the final part, using a financial calculator: N 20; i 8; P 1250; FV 0 Compute PV : PV 12,272.69

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Exercise Assume 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?

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Exercise (Cont.) If you are saving to buy a stereo that currently sells for $ 1,050, will you have enough to buy it?

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Sol The required nominal rate would be: i i r 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.

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Exercise Find 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

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Sol N = Years to maturity = 8 FV = 1,000 i = 12.25% Coupon payments = 100 PV = 889.20

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Exercise A 10-year, 7% coupon bond with a face value of $ 1,000 is currently selling for $ 871.65. Compute your rate of return if you sell the bond next year for $ 880.10

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Sol R= (70 + 880.10 – 871.65) / 871.65 = R= 0,09 = 9%

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Exercise You have paid $980.30 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?

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Sol (80 + 980.30 – P t+1) / 980.30 = 9% P t+1 = 988.53

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