Chapter 6: Measuring and Calculating Interest Rates

and Financial Asset Prices

Problems and Issues
1. Suppose a 10-year bond is issued with an annual coupon rate of 8 percent when
the market rate of interest is also 8 percent. If the market rate rises to 9 percent,
what happens to the price of this bond? What happens to the bonds price if the
market rate falls to 6 percent? Explain why.
Assume: par value of bond = $100. If market interest rate rises to 9 percent, the
bonds price declines to yield approached 9 percent -- a market value about $93.50.
If the market rate falls to 6 percent, the bonds price will rise (to about $114.88) so
that its yield approximates the 6 percent yield.

2. Preferred stock for XYZ Corporation is issued at par $50 per share. If
stockholders are promised a $4 annual dividend, what was the stocks dividend
yield at time of issue? If the stocks market price has risen to $60 per share, what
is its dividend yield?
At par, current yield is 8 percent. In ratio terms this is $4/$50. If the stocks market
price climbs to $60, it still promises just $4 annually. Current yield = 6.6% or $4/$60.

3. You plan to borrow $2,000 to take a vacation and want to repay the loan in a
year. The banker offers you a simple interest rate of 12 percent with repayments
in two equal installments, 6 months and 12 months from now. What is your total
interest bill? What is the APR? Would you prefer an add-on interest rate with
one payment at the end of the year? If the bank applied the discount method to
your loan, what are the net proceeds of the loan? What is your effective rate of
interest rate?
Answer:
For simple interest: t r P I
I = $2,000 x 0.12 x 6/12 = $120 for the first six months interest.
I = $1,000 x 0.12 x 6/12 = $ 60 for the second six months interest.
The Total Interest Bill is $180.
APR:
APR = 2 x No. of payments x Annual interest cost
(Total no. of payments + 1) x Principal
= 2 x 2 x 180 = 12%
(2 + 1) x 2,000
No, do not prefer one paymenttotal repayment = $2,240 instead of $2,180 with
simple interest method.
Discount method: the interest = $240; borrower receives $1,760 ($2,000 - $240).
The effective interest rate is 13.6% (100 x $240/$1,760).

4. An investor is interested in purchasing a new 20-year government bond
carrying a 5 percent annual coupon rate with interest paid twice a year. The
bonds current market price is $875 for a $1,000 par value instrument. If the
investor buys the bond at the going price and holds it to maturity, what will
be his or her yield to maturity? Suppose the investor sells the bond at the end
of 10 years for $950. What is the investors holding-period yield?
Equation (6.7); (n) = 40, coupon pay (C) = $25 (0.05 x $1,000 / 2),
Market price of bond (P) = $875, and the final price (M) = $1,000.
Yield to maturity is found to be y = 3.04 * 2 = 6.08%.
Holding-period yield: equation (6.11); PV = -875; FV = $950; C = 25 N = 20;
h = 3.17 * 2 = 6.34%.
5. Calculate the bank discount rate of return (DR) and the YTM-equivalent
return for the following money market instruments:
a. Purchase price, $96; par value, $100; maturity, 90 days.
DR = [(100 96) / 100] x (360 / 90) = 0.16 or 16%
IR = [(100 96) / 96] x (365 / 90) = ((100-96)/96)*(365/90) = 0.168981
b. Purchase price, $96; par value, $100; maturity, 180 days.
DR = [(100 96) / 100] x (360 /180) = 0.08 or 8%
IR = [(100 96) / 96] x (365 / 180) = ((100-96)/96)*(365/180) = 0.0844907
c. Purchase price, $97.50; par value, $100; maturity, 270 days.
DR = [(100 97.50) / 100] x (360 / 270) = 0.033 or 3.3%
IR = [(100 97.5) / 97.5] x (365 / 270) = ((100-97.5)/97.5)*(365/270) = 0.034663
d. Purchase price, $975; par value, $1,000; maturity, 270 days.
DR = [(1000 975) / 100] x (360 / 270) = 0.033 or 3.3%
IR = [(1000 975) / 975] x (365 / 270) = ((1000-975)/975)*(365/270) = 0.034664

6. You have just placed $1,500 in a bank savings deposit and plan to hold that
deposit for eight years, earning 2 percent per annum. If the bank compounds
interest daily, what will be the total value of the deposit in eight years? How
does your answer change if the bank switches to monthly compounding?
Quarterly compounding?
For daily compounding:
FV = $1,500(1+0.02/365)^(8*365) = $1,500(1.1735) = $1760.30
For monthly compounding:
FV = $1,500(1+0.02/12)^(8*12) = $1,500(1.1734) = $1760.10
For quarterly compounding:
FV = $1,500(1+0.02/4)^(8*4) = $1,500(1.1730) = $1759.90





7. You decide to take out a 30-year mortgage loan to buy the home of your
dreams. The homes purchase price is $120,000. You manage to scrape together
a $20,000 down payment and plan to borrow the balance of the purchase price.
Hardy Savings and Loan Association quotes you a fixed annual loan rate of 6
percent. What will your monthly payment be? How much total interest will you
have paid at the end of 30 years? What would your monthly payment be if you
could increase your down payment to $50,000?
Monthly payment is:


The total interest paid is:
If you could raise your down payment to $50,000 you would situation would be


And your total interest paid is:

8. A depositor places $5,000 in a credit union deposit account for a full year but
then withdraws $1,000 after 270 days. At the end of the year, the credit union
pays her $150 in interest. What is this depositors daily average balance and
APY?
Daily Average Balance = $5,000 x 270 days + $4,000 x 95 days = $4,739.73
365 days
APY = 100[$150/$4,739.73] = 3.1647%

9. A commercial loan extended to CIBER-LAND Corporation for $2.5 million
assesses an interest charge of $250,000 up front. Using the discount loan
method of calculating loan rates, what is the effective interest rate on this
loan? Suppose that instead of deducting the interest owed up front, the
companys lender agrees to extend the full $2.5 million and add the amount
of interest owed to the face of CIBERs note. What, then, is the loans
effective interest rate?
Discount interest formula: $250,000/($2,500,000-$250,000) = 11.11%.
For the second part: assuming the interest assessed on the loan remains $350,000,
effective interest rate = $350,000/($2,500,000+$350,000) = 9.09%.