Problems
1. Calculate the present value of a $1,000 zero-coupon bond with 5 years to maturity if the required
annual interest rate is 6%.
Solution: PV = FV/(1 + i)n
where FV = 1000, i = 0.06, n = 5
PV = 747.25
2. A lottery claims its 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%.
Solution: This is a simple present value problem. Using a financial calculator,
N = 20; PMT = 500,000; FV = 0; I = 6%; Pmts in BEGIN mode.
Compute PV: PV = $6,079,058.25
3. Consider a bond with a 7% annual coupon and a face value of $1,000. Complete the following
table:
Years to Maturity Discount Rate Current Price
3 5
3 7
6 7
9 5
9 9
What relationship do you observe between yield to maturity and the current market value?
Solution:
Years to Maturity Yield to Maturity Current Price
3 5 $1,054.46
3 7 $1,000.00
6 7 $1,000.00
9 5 $1,142.16
9 9 $ 880.10
When yield to maturity is above the coupon rate, the band’s current price is below its
face value. The opposite holds true when yield to maturity is below the coupon rate. For a
given maturity, the bond’s current price falls as yield to maturity rises. For a given yield
to maturity, a bond’s value rises as its maturity increases. When yield to maturity
equals the coupon rate, a bond’s current price equals its face value regardless of years
to maturity.
4. 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 8 years to maturity. What is the bond’s yield to maturity?
Solution: To calculate the bond’s yield to maturity using a financial calculator,
N 8; PMT 1000 0.10 100; FV 1000; PV 1150
Compute I: I 7.44
5. Suppose that a commercial bank wants to buy Treasury Bills. These instruments pay $5,000 in
one year and are currently selling for $5,012. What is the yield to maturity of these bonds? Is this
a typical situation? Why?
Solution: The yield to maturity of these bonds solves the following equation: 5,000/(1+i) =
5,012. After some algebra, the yield to maturity happens to be around – 0.24%. This is not a
typical situation. In normal times banks will not choose to pay more than the face value of a
discount bond, since that implies negative yields to maturity.
6. What is the price of a perpetuity that has a coupon of $50 per year and a yield to maturity of
2.5%? If the yield to maturity doubles, what will happen to its price?
Solution: The price would be $50/.025 = $2000. If the yield to maturity doubles to 5%, the price
would fall to half its previous value, to $1000 = $50/.05.
7. Property taxes in DeKalb County are roughly 2.66% of the purchase price every year. If you just
bought a $100,000 home, what is the PV of all the future property tax payments? Assume that the
house remains worth $100,000 forever, property tax rates never change, and that a 9% discount
rate is used for discounting.
Solution: The taxes on a $100,000 home are roughly 100,000 0.0266 2,660.
The PV of all future payments 2,660/0.09 $29,555.55 (a perpetuity).
8. Suppose you want to take out a loan and that your local bank wants to charge you an annual real
interest rate equal to 3%. Assuming that the annualized expected rate of inflation over the life of
the loan is 1%, determine the nominal interest rate that the bank will charge you. What happens
if, over the life of the loan, actual inflation is 0.5%?
Solution: The bank will charge you a nominal interest rate equal to 1% + 3% = 4%. However, if
actual inflation turns out to be lower than expected, then you will be worse off than originally
planned, since the real cost of borrowing (measured by the real interest rate) turned out to be 4%
– 0.5% = 3.5%.
9. Lucia just bought two coupon bonds, one with a face value of $1,000 and the other with a face
value of $5,000. Both bonds have a coupon rate of 5% and sold at par today. Calculate both
bonds´ current yield and both bonds rate of return if Lucia is able to sell these bonds one year
later for $100 more of the buying price. Can you estimate what happened to the interest rate over
that year?
Solution: The current yield (CY) is calculated as the coupon payment over the selling price of
the bond. When a coupon bond sells at par, its current yield equals the coupon rate, since the
numerator of the CY is: Face Value x Coupon Rate (always) and the denominator is Face Value
(in this particular situation only in which Price = FV). Both bonds have a CY = 5%. If Lucia is
able to sell the $1,000 FV coupon bond for $1,100, then the rate of return is: 5% + 10% (since the
rate of capital gain is 100/1,000 =10%). The same reasoning yields a RET = 5% + 2% (g =
100/5,000) for the other bond. The interest rate must have fallen over that year for bond´s prices
to increase.
10. 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? Is this realistic?
Solution: To find the price, solve:
Although this appears possible, the yield to maturity when you purchased the bond
was 8.5%. At that yield, you only expect the price to be $983.62 next year. In fact, the
yield would have to drop to 8.35% for the price to be $988.53.
