Answers to End-of-Chapter Questions Part 2

4. People are more likely to buy houses because the real interest rate when purchasing a house has fallen from 3 percent (=5 percent 2 percent) to 1 percent (=10 percent 9 percent). The real cost of financing the house is thus lower, even though mortgage rates have risen. (If the tax deductibility of interest payments is allowed for, then it becomes even more likely that people will buy houses.)

Quantitative Problems
8. 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 interest rate would you require from the bank over the next year? How much money will you have at the end of one year? If you are saving to buy a stereo that currently sells for $1,050, will you have enough to buy it? Solution: 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.

9. 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. Solution: C + Pt +1 Pt 70 + 880.10 871.65 R= = = 0.09, or 9%. Pt 871.65

This is a holding period return. Note that you do not need to annualize the result since the holding period is one year. 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

80 + Pt +1 980.30 = 0.09 for Pt +1. Pt +1 = 988.53. 980.30

Again, note that the 9% is a one-year holding period return. 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.

Additional Questions: (these are not in the text)

15. Ignoring reinvestment income, calculate the annual return for the following three investments. Note that bonds trade based 32nds of 1%, so 95-10 means 95% + 10/32nds of 1%, or 95.3125%. a. Two-year bond held for two years (until maturity). Par is $1,000; coupon is 6%. You pay 9400 for the bond. Beginning investment is $9,400 Annual coupon is $60 Maturity value is $1,000 Holding period return = (1000 + 60 +60)/940 -1 = 19.15% Annualized return = (1+.1915)^(1/2)-1 = 9.16%

b. Five-year bond held for two years. Par is $1,000; annual coupon is 6%. You buy for 92-16 and sell for 97-12 two years later. Beginning investment is $925 Annual coupon is $60 Sale proceeds = $973.75 Holding period return = (973.75 + 60 +60)/925 -1 = 18.24% Annualized return = (1+.1824)^(1/2)-1 = 8.74%

c. Ten shares of common stock held for three years. The annual dividend is $1. You buy at $36 and sell at $39.50 per share. Beginning investment is $360 Annual Dividend is $1 x 10 Sale proceeds = $395 Holding period return = (395 + 10 + 10 +10)/360 -1 = 18.06% Annualized return = (1+.1806)^(1/3)-1 = 5.69%

16. Calculate the annual yield for each of the simple interest certificates of deposit. a. 12% rate, paid monthly: (1+.01)^12-1 = 12.68% b. 9% rate, paid quarterly: (1+.0225)^4-1 = 9.30% c. 8% rate paid semi-annually: (1+.04)^2-1 = $8.16% d. 7% rate, paid daily: (1+ .07/365)^365-1 = 7.25% e. 7% rate, paid semi-annually: (1 + .035)^2-1 = 7.12%