SUGGESTED ANSWERS

CHAPTER 4: Interest Rates

Practice Questions
1. Problem 4.8.
The cash prices of six-month and one-year Treasury bills are 94.0 and 89.0. A 1.5-year bond
that will pay coupons of $4 every six months currently sells for $94.84. A two-year bond that
will pay coupons of $5 every six months currently sells for $97.12. Calculate the six-month,
one-year, 1.5-year, and two-year zero rates.

The 6-month Treasury bill provides a return of 6  94  6383% in six months. This is
2  6383  12766% per annum with semiannual compounding or 2ln(106383)  1238%
per annum with continuous compounding. The 12-month rate is 11  89  12360% with
annual compounding or ln(11236)  1165% with continuous compounding.
For the 1 12 year bond we must have
4e0123805  4e011651  104e15 R  9484
where R is the 1 12 year zero rate. It follows that
376  356  104e 15 R  9484
e 15 R  08415
R  0115
or 11.5%. For the 2-year bond we must have
5e0123805  5e011651  5e011515  105e2 R  9712
where R is the 2-year zero rate. It follows that
e 2 R  07977
R  0113
or 11.3%.

2. Problem 4.9.
What rate of interest with continuous compounding is equivalent to 15% per annum with
monthly compounding?

The rate of interest is R where:

 015 
12

e  1 
R

 12 
i.e.,
 015 
R  12 ln 1  
 12 

 01491
The rate of interest is therefore 14.91% per annum.
 3. Problem 4.10.
A deposit account pays 12% per annum with continuous compounding, but interest is actually
paid quarterly. How much interest will be paid each quarter on a $10,000 deposit?

The equivalent rate of interest with quarterly compounding is R where

4
012  R
e  1  
 4
or
R  4(e003  1)  01218

The amount of interest paid each quarter is therefore:

01218
10 000   30455
4
or $304.55.

4. Problem 4.11.
Suppose that 6-month, 12-month, 18-month, 24-month, and 30-month zero rates are 4%,
4.2%, 4.4%, 4.6%, and 4.8% per annum with continuous compounding respectively. Estimate
the cash price of a bond with a face value of 100 that will mature in 30 months and pays a
coupon of 4% per annum semiannually.

The bond pays $2 in 6, 12, 18, and 24 months, and $102 in 30 months. The cash price is
2e00405  2e004210  2e004415  2e00462  102e004825  9804

5. Problem 4.12.
A three-year bond provides a coupon of 8% semiannually and has a cash price of 104. What
is the bond’s yield?

The bond pays $4 in 6, 12, 18, 24, and 30 months, and $104 in 36 months. The bond yield is
the value of y that solves
4e05 y  4e10 y  4e15 y  4e20 y  4e25 y  104e30 y  104
Using the Goal Seek tool in Excel y  006407 or 6.407%.

6. Problem 4.13.
Suppose that the 6-month, 12-month, 18-month, and 24-month zero rates are 5%, 6%, 6.5%,
and 7% respectively. What is the two-year par yield?

Using the notation in the text, m  2 , d  e0072  08694 . Also

A  e00505  e00610  e006515  e00720  36935
The formula in the text gives the par yield as
(100  100  08694)  2
 7072
36935
To verify that this is correct we calculate the value of a bond that pays a coupon of 7.072%
per year (that is 3.5365 every six months). The value is
3536e00505  35365e00610  3536e006515  103536e00720  100
verifying that 7.072% is the par yield.
 7. Problem 4.19.
Why are U.S. Treasury rates significantly lower than other rates that are close to risk free?

There are three reasons (see Business Snapshot 4.1).

1. Treasury bills and Treasury bonds must be purchased by financial institutions to fulfill a
variety of regulatory requirements. This increases demand for these Treasury instruments
driving the price up and the yield down.
2. The amount of capital a bank is required to hold to support an investment in Treasury
bills and bonds is substantially smaller than the capital required to support a similar
investment in other very-low-risk instruments.
3. In the United States, Treasury instruments are given a favorable tax treatment compared
with most other fixed-income investments because they are not taxed at the state level.

8. Problem 4.21.
Explain why an FRA is equivalent to the exchange of a floating rate of interest for a fixed
rate of interest?

A FRA is an agreement that a certain specified interest rate, RK , will apply to a certain
principal, L , for a certain specified future time period. Suppose that the rate observed in the
market for the future time period at the beginning of the time period proves to be RM . If the
FRA is an agreement that RK will apply when the principal is invested, the holder of the
FRA can borrow the principal at RM and then invest it at RK . The net cash flow at the end of
the period is then an inflow of RK L and an outflow of RM L . If the FRA is an agreement that
RK will apply when the principal is borrowed, the holder of the FRA can invest the borrowed
principal at RM . The net cash flow at the end of the period is then an inflow of RM L and an
outflow of RK L . In either case we see that the FRA involves the exchange of a fixed rate of
interest on the principal of L for a floating rate of interest on the principal.

9. Problem 4.26
A bank can borrow or lend at LIBOR. Suppose that the six-month rate is 5% and the nine-
month rate is 6%. The rate that can be locked in for the period between six months and nine
months using an FRA is 7%. What arbitrage opportunities are open to the bank? All rates are
continuously compounded.

The forward rate is

0.06  0.75  0.05  0.50
 0.08
0.25
or 8%. The FRA rate is 7%. A profit can therefore be made by borrowing for six months at
5%, entering into an FRA to borrow for the period between 6 and 9 months for 7% and
lending for nine months at 6%.

10. Problem 4.27.

An interest rate is quoted as 5% per annum with semiannual compounding. What is the
equivalent rate with (a) annual compounding, (b) monthly compounding, and (c) continuous
compounding?
a) With annual compounding the rate is 10252  1  0050625 or 5.0625%
b) With monthly compounding the rate is 12  (10251 6  1)  004949 or 4.949%.
c) With continuous compounding the rate is 2  ln1025  004939 or 4.939%.