Answers to Chapter 2 Questions 1.

Time value of money specifically assumes that any interest or other return earned on an investment is reinvested and interest is, in turn, earned on the earlier interest payments. That is, interest is compounded. This is in contrast to the earning of simple interest which is a 12-month (nominal or stated) interest rate. Simple interest on an investment assumes you do not reinvest the annual interest earned. 2. a. b. c. d. e. PV = $5,000 (PVIF 6%/1, 5(1)) = $5,000 (0.747258) = $3,736.29 PV = $5,000 (PVIF 8%/1, 5(1)) = $5,000 (0.680583) = $3,402.92 PV = $5,000 (PVIF 10%/1, 5(1)) = $5,000 (0.620921) = $3,104.61 PV = $5,000 (PVIF 10%/2, 5(2)) = $5,000 (0.613913) = $3,069.57 PV = $5,000 (PVIF 10%/4, 5(4)) = $5,000 (0.610271) = $3,051.35

From these answers we see that the present values of a security investment decrease as interest rates increase. As rates rose from 6 percent to 8 percent, the (present) value of the security investment fell $333.37 (from $3,736.29 to $3,402.92). As interest rates rose from 8 percent to 10 percent, the value of the investment fell $298.31 (from $3,402.92 to $3,104.61). This is because as interest rates increase, fewer funds need to be invested at the beginning of an investment horizon to receive a stated amount at the end of the investment horizon. Also as interest rates increase, the present values of the investment decrease at a decreasing rate. The fall in present value is greater when interest rates rise from 6 percent to 8 percent compared to when they rise from 8 percent to 10 percent. The inverse relationship between interest rates and the present value of security investments is neither linear nor proportional. From the above answers, we also see that the greater the number of compounding periods per year, the smaller the present value of a future amount. This is because, the greater the number of compounding periods the more frequently interest is paid and thus, a greater amount of interest that is paid. Thus, to get to a stated amount at the end of an investment horizon, the greater the amount that will come from interest and the less the amount the investor must pay up front. 3. a. FV = $5,000 (FVIF 6%/1, 5(1)) = $5,000 (1.338226) = $6,691.13 b. FV = $5,000 (FVIF 8%/1, 5(1)) = $5,000 (1.469328) = $7,346.64 c. FV = $5,000 (FVIF 10%/1, 5(1)) = $5,000 (1.610510) = $8,052.55 d. FV = $5,000 (FVIF 10%/2, 5(2)) = $5,000 (1.628895) = $8,144.47 e. FV = $5,000 (FVIF 10%/4, 5(4)) = $5,000 (1.638616) = $8,193.08

6

63 FV = $201.15 7 .198.000 (17.934.51 (from $6.346.0415186) = $36.451(PVIF 4%/1.796 (5.46 b.51 PV = $550.219.000(FVIFA 6%/1. the greater the future value of a future amount. 21(1)) = $183.212364)(1 + . PV = $5.000(FVIFA 6%/4.310 (1.052.000 (23.0104826) = $5. FV = $2.325. FV = $5. 8(1)) = $51.130.164 (0.212364) = $21.65 FV = $251.79031453) = $12. a greater amount of interest that is paid.61 6.06) = $5. FV = $5. the greater the number of compounding periods the more frequently interest is paid and thus. the value of the investment rose $705.000 (4.168639) = $85. FV = $5.250(FVIF 18%/1.123667)(1..211. 5(1))(1 + .729.40388323) = $20. PV = $5.061. 5(4))(1 + .55).015) = $87.168639)(1. we also see that the greater the number of compounding periods per year.788.637092) = $28. PV = $15. the (future) value of the security investment rose $655. PV = $5.From these answers we see that the future values of a security investment increase as interest rates increase.84 8.68947896) = $15. From the above answers.000(PVIFA 6%/1.355 (5.842.50 7.346.000 (5. 5(4)) = $5.585.06) = $29.05 FV = $76.000(PVIFA 6%/4.451 (0. EXCEL Problem: FV = $179.03383372) = $925.91 (from $7.767.53 d.817.11 FV = $183.25 FV = $9. 5(1)) = $5.250 (1.073(PVIF 22%/1. 6(1)) = $15. 15(1)) = $76.47356576) = $417.01 PV = $886.352.06/4) = $5.000(PVIFA 6%/1.84 5 a.59 d.000 (23. 25(1)) = $550.64 to $8. a. The inverse relationship between interest rates and the present value of security investments is neither linear nor proportional. This is because as interest rates increase.618.185. This is because. 4(1)) = $2.557(PVIF 12%/1.34 c.015) = $117.355(FVIF 12%/1.362.000 (5.06) = $22.000(FVIFA 6%/4.123667) = $115. 5(4)) = $5.). The greater the amount of interest paid and the greater the future value of a present amount. FV = $5. 16(1)) = $886. The rise in present value is greater when interest rates rise from 8 percent to 10 percent compared to when they rise from 6 percent to 8 percent.843.000(FVIFA 6%/1. the future values of the investment increase at an increasing rate. As rates rose from 6 percent to 8 percent.19 c. 5(1)) = $5.15 PV = $51.557 (0. 5(1))(1 + .073 (0.000 (17. 4.691. 9(1)) = $9. Also as interest rates increase.637092)(1 + . PV = $5.82 b.000(PVIFA 6%/4.06) = $5.310(FVIF 6%/1.164(PVIF 20%/1.13 to $7.000 (4.823.01 FV = $313.06/4) = $5. 5(4))(1 + . As interest rates rose from 8 percent to 10 percent. a stated amount of funds invested at the beginning of an investment horizon accumulates to a larger amount at the end of the investment horizon.796(FVIF 8%/1.9387778) = $4.876.

325.04/1) = $314.13/1) = $4. 5(1))(1 + .332(FVIFA 1%/1.83 FV = $74.322. 7(1))(1 + .998.37 PV = $39.78 PV = $20.27 FV = $74.484(FVIFA 10%/1.51 PV = $7.98 12.821. 4(1)) = $148.38 PV = $31.683.006. EXCEL Problem: FV = $155.167. PV = $678.278.10/1) = $500.54(FVIFA 31%/1.011.74 PV = $49.28 FV = $163.330.193. 12(2)) = $45.583.863.94 PV = $69.696.161.688.93 PV = $678.49 PV = $69. 7(1)) = $2. FV = $950(FVIFA 11%/2.35 FV = $182.555(FVIFA 8%/1. 13(1)) = $35.555(FVIFA 8%/1.968.844.282.09(FVIFA 13%/1. FV = $123(FVIFA 13%/1. EXCEL Problem: PV = $55.10 8 . 8(1))(1 + .205.012.13/1) = $3.79 14.879.93(FVIFA 4%/1.12 FV = $123(FVIFA 13%/1. 13(1))(1 + . 13(1))(1 + .50 FV = $167.449.968.712.08/1) = $52.26(FVIFA 6%/1.946.54(FVIFA 31%/1. 23(1))(1 + .55 PV = $20.712.654.54 13.388.711.322. EXCEL Problem: PV = $55.15 PV = $31.519. 23(1)) = $301. 8(1)) = $48.84 FV = $4.54 PV = $49. 4(1))(1 + .732.332(FVIFA 1%/1.31/1) = $194.09(FVIFA 13%/1.40 FV = $167.560.9. 13(1)) = $3.934.79 PV = $7. 9(1))(1 + .57 FV = $4. 9(1)) = $1. 5(1)) = $454.08 10.04 FV = $204.06/1) = $39.240.95 11.01/1) = $1.567.26(FVIFA 6%/1.484(FVIFA 10%/1.93(FVIFA 4%/1.94 PV = $39.

S.g. and nondurable goods (e.e.S. These funds are invested until they are needed by the governmental agency. Additionally. 9 .15. foreign investors alter their investment decisions as financial conditions in their home countries change relative to the U. interest rates compared to foreign rates. For example. Loanable funds are also supplied by some government units that temporarily generate more cash inflows (e. education expenses. the Federal Reserve) implements monetary policy by influencing the availability of credit and the growth in the money supply . Additionally. has resulted in foreign market participants as major suppliers of funds in U. the federal government (i. In addition to interest rates on these investments. Finally. financial securities than on comparable securities in their home countries.S.. In addition to the interest rate on borrowed funds. the total supply of funds from that household will also generally increase. EAR = (1 + . near term educational or medical expenditures will reduce the supply of funds from a given household. the greater the utility the household receives from the purchased good. Monetary policy implementation in the form of increases the money supply will increase the amount of loanable funds available. economy. during times of high growth households may replace part of their cash holdings with earning assets. Households determine their supply of funds not only on the basis of the general level of interest rates and their total wealth. cars. financial markets. foreign investors increase the supply of funds to U. taxes) than they have budgeted to spend. The greater a security=s risk.12/12)12 . but also their total wealth. Households supply funds when they have excess income or want to reinvest a part of their wealth. Households (although they are net suppliers of funds) borrow funds in financial markets. Higher interest rates will also result in higher supplies of funds from the business sector. Indeed the high savings rates of foreign households combined with relatively high U.1 = 12. foreign suppliers assess not only the interest rate offered on financial securities..g.68% 16. When businesses mismatch inflows and outflows of cash to the firm they have excess cash that they can invest for a short period of time in financial markets. and their future spending needs. markets. Further. Similar to domestic suppliers of loanable funds. durable goods (e. As the total wealth of the consumer increases.. 17. the less households are willing to invest at each interest rate.S. The household sector (consumers) is the largest supplier of loanable funds. medical expenses).. When expected risk-adjusted returns are higher on U. For example. nonprice conditions and requirements (discussed below) affect a household=s demand for funds at every level of interest rates. the risk on the security.g. appliances). but also on the risk on financial securities change. Additionally. the supply of funds provided from households will depend on the future spending needs. the higher the demand for funds. The demand for loanable funds by households comes from their purchases of homes.S. financial markets as alternatives to their domestic financial markets. the expected risk on financial securities and the business= future investment needs will affect the supply of funds from businesses.S. foreign investors increasingly view U.

The shift in the supply curve creates a disequilibrium in this financial market. future spending needs. The shift in the supply curve again creates a disequilibrium in this financial market. Further.. road improvements. as the total wealth of financial market participants decreases the absolute dollar value available for investment purposes decreases.S. Higher borrowing costs also reduce the demand for borrowing from the business sector.. Accordingly. Accordingly. business. Expenditures in the federal government=s budget are spent regardless of the interest cost. Higher interest rates cause state and local governments= to postpone such capital expenditures. foreign borrowers consider nonprice terms on loanable funds as well as economic conditions in the home country. foreign participants might also borrow in U. and holding all other factors constant. etc. Governments also borrow heavily in financial markets. plant and equipment) and in short-term assets (e. and holding all other factors constant. In addition to interest costs. and foreign economic conditions. and a decrease in the equilibrium quantity of funds traded. Wealth.g. or the supply curve shifts up and to the left.g.g. Finally. the greater the number of profitable projects available to businesses.. Foreign borrowers look for the cheapest source of funds globally. or the better the overall economic conditions. As the total wealth of financial market participants (households. the federal government=s borrowing is not influenced by the level of interest rates. state and local governments= demand for funds vary with general economic conditions. State and local governments often issue debt to finance temporary imbalances between operating revenues (e. 10 . Similar to households and businesses. Factors that affect the supply of funds include total wealth risk of the financial security. the increase in the supply of funds due to an increase in the total wealth of market participants results in a decrease in the equilibrium interest rate. the decrease in the supply of funds due to a decrease in the total wealth of market participants results in an increase in the equilibrium interest rate. 18. school construction). Most foreign borrowing in U. the less businesses borrow at any interest rate.. at every interest rate the supply of loanable funds increases. monetary policy objectives. As competitive forces adjust. taxes) and budgeted expenditures (e. inventory and accounts receivable) with debt market instruments.e. In contrast. As competitive forces adjust. businesses will finance investments with internally generated funds (i. The more restrictive the conditions on borrowed funds..S. In addition to interest rates.) increases the absolute dollar value available for investment purposes increases. at every interest rate the supply of loanable funds decreases. retained earnings). Rather when interest rates are high. and an increase in the equilibrium quantity of funds traded. or the supply curve shifts down and to the right. financial markets.Businesses often finance investments in long-term (fixed) assets (e. nonprice conditions also affect business= demand for funds. the greater the demand for loanable funds. financial markets comes from the business sector.g. Conversely.

Accordingly. the Federal Reserve increases the supply of funds available in the financial markets. and increasing the equilibrium quantity of funds traded. and the equilibrium interest rate falls. Foreign Economic Conditions. when financial market participants have near-term spending needs. The financial market. at every interest rate the supply of loanable funds increases. As competitive forces adjust. and an increase in the equilibrium quantity of funds traded. while the equilibrium quantity of funds traded decreases. and a decrease in the equilibrium quantity of funds traded. The shift in the supply curve creates a disequilibrium in this financial market that. Monetary Expansion. When financial market participants have few near-term spending needs. 11 . while the equilibrium quantity of funds traded increases. the Federal Reserve decreases the supply of funds available in the financial markets. At every interest rate the supply of loanable funds increases. Conversely. it becomes more attractive to supplier of funds. or the supply curve shifts up and to the left. the supply curve shifts down and to the right. Finally. The inflow of foreign funds to U. the growth in the money supply. The shift in the supply curve creates a disequilibrium in this financial market.Risk. the decrease in the supply of funds due to an increase in the financial security=s risk results in an increase in the equilibrium interest rate. when monetary policy objectives are to contract economic growth. and the equilibrium quantity of funds traded increases. the flow of funds to that country increases. the increase in the supply of funds due to a decrease in the risk of the financial security results in a decrease in the equilibrium interest rate. Future Spending Needs. when corrected results in an increase in the equilibrium interest rate. At every interest rate the supply of loanable funds decreases. Conversely.S. or the supply curve shifts up and to the left. and the equilibrium interest rate rises. Accordingly. holding all other factors constant. the supply curve shifts up and to the left. One method used by the Federal Reserve to implement monetary policy is to alter the availability of credit and thus. Conversely. At every interest rate the supply of loanable funds increases. the absolute dollar value of funds available to invest increases. as economic conditions improve in a country relative to other countries. at every interest rate the supply of loanable funds decreases. it becomes less attractive to supplier of funds. As competitive forces adjust. At every interest rate the supply of loanable funds decreases. or the supply curve shifts down and to the right. and holding all other factors constant. As the risk of a financial security decreases. financial markets increases the supply of loanable funds at every interest rate and the supply curve shifts down and to the right. and holding all other factors constant. and a decrease in the equilibrium quantity of funds traded. When monetary policy objectives are to enhance growth in the economy. reacts to this increased supply of funds by decreasing the equilibrium interest rate. the equilibrium interest rate falls. the absolute dollar value of funds available to invest decreases. as the risk of a financial security increases. or the supply curve shifts down and to the right. Accordingly. The shift in the supply curve creates a disequilibrium in this financial market.

at every interest rate the demand for loanable funds increases. Accordingly. Accordingly. and holding all other factors constant. The shift in the demand curve again creates a disequilibrium in this financial market. and an increase in the equilibrium quantity of funds traded. As the nonprice restrictions put on borrowers as a condition of borrowing increase the willingness of market participants to borrow decreases and the absolute dollar value borrowed decreases. the increase in the demand for funds due to economic growth results in an increase in the equilibrium interest rate. or the demand curve shifts up and to the right. or the demand curve shifts up and to the right. Utility Derived from Asset Purchased With Borrowed Funds. at every interest rate the demand for loanable funds increases. at every interest rate the demand of loanable funds decreases. domestic economic conditions. The shift in the demand curve again creates a disequilibrium in this financial market. and a decrease in the equilibrium quantity of funds traded. Accordingly. and an increase in the equilibrium quantity of funds traded. As competitive forces adjust. market participants are willing to borrow more heavily. As the utility derived from an asset purchased with borrowed funds increases the willingness of market participants (households. Conversely. As competitive forces adjust. etc. as the utility derived from an asset purchased with borrowed funds decreases the willingness of market participants (households. restrictiveness of nonprice conditions of borrowing. as the nonprice restrictions put on borrowers as a condition of borrowing decrease market participants willingness to borrow increases and the absolute dollar value borrowed increases. or the demand curve shifts down and to the left. and a decrease in the equilibrium quantity of funds traded. Accordingly. the increase in the demand for funds due to an increase in the utility from the purchased asset results in an increase in the equilibrium interest rate. Conversely. etc. Factors that affect the demand for funds utility derived from the asset purchased with borrowed funds. and foreign economic conditions. and holding all other factors constant. As competitive forces adjust.19.) to borrow increases and the absolute dollar value borrowed increases. Restrictiveness on Nonprice Conditions on Borrowed Funds. When the economy is experiencing a period of growth. Domestic Economic Conditions. 12 . and holding all other factors constant. As competitive forces adjust. or the demand curve shifts down and to the left. and an increase in the equilibrium quantity of funds traded. The shift in the demand curve results in an increase in the equilibrium interest rate. the decrease in the demand for funds due to an increase in the restrictive conditions on the borrowed funds results in a decrease in the equilibrium interest rate. or the demand curve shifts up and to the right. and holding all other factors constant. the decrease in the demand for funds due to a decrease in the utility from the purchased asset results in a decrease in the equilibrium interest rate. business. The shift in the demand curve creates a disequilibrium in this financial market. Accordingly.) to borrow decreases and the absolute dollar value borrowed decreases. business. at every interest rate the demand of loanable funds increases. at every interest rate the demand of loanable funds decreases.

the demand curve shifts down and to the left.075)]1/3 .25% . 22. Conversely. Accordingly.75% .085% 6. According to the pure expectations theory. or the demand curve shifts down and to the left.499% 1R2 = [(1 + . as foreign economies contract the global demand for funds decreases. at every interest rate the demand for loanable funds decreases. Foreign Economic Conditions. the equilibrium interest rate increases.25% + 0% + .1.07)(1 + .07)] R3 = [(1 + .85% Thus. Accordingly.1 = 6.06)(1 + . 20.06)(1 + .5% + DRP + .5% .052)(1 + . The shift in the demand curve results in a decrease in the equilibrium interest rate.06)(1 + .3.75% + 3. The fair interest rate on a financial security is calculated as i* = IP + RIR + DRP + LRP + SCP + MRP 8% = 1. DRP = 8% . the equilibrium interest rate decreases.07)(1 + .65% 21. economic growth in foreign countries increases the demand for funds globally.075)(1 + . and a decrease in the equilibrium quantity of funds traded.00% _____________________________ term to maturity (in years) 0 1 2 3 4 13 .1 = 6. Similar to domestic economic growth. and the equilibrium quantity of funds traded decreases. when economic growth is stagnant market participants reduce their borrowings increases..085% 1R4 = [(1 + .499% 6.Conversely. the one year rate one year from now is expected to be less than the one year rate today.0% .1 = 7..50% 23. and the equilibrium quantity of funds traded increases. 1R1 = 6% 1/2 .058)]2 .0785)] yield to maturity 7. 1R2 = [(1 + .85% = 1. the demand curve shifts up and to the right. Accordingly.832% 6.832% 1 1/4 .1 = 5.

1 + 1R2 = {(1 + 1R1)(1+E(2r1))}1/2 1. 1 + 1R4 = {(1 + 1R3)(1+E(4r1))}1/4 1.0225 = 1+E(4r1) 1+E(4r1) = 1.0298 = {1.10) 1R11 = .0225(1+E(4r1))}1/4 (1.24.0298) 5/1.1764879 E(6r1) = 17.21= 1.4049 = (1+1R1 )*1.65% 14 .026) 4 = 1.0225 (1+E(4r1)) (1.21/1.026 = {1.1826 26.08*1.026) 4/1.1288 E(5r1) = 12.12 = {(1+1R1)*1.0298(1+E(6r1))}1/6 (1. 1.08*1.026 = 1+E(5r1) 1+E(5r1) = 1.88% 1 + 1R6 = {(1 + 1R5)(1+E(6r1))}1/6 1.12 = {(1+1R1)(1+E(2r1))(1+E(3r1))}1/3 1.08 = 1+E(2r1) 1+E(2r1) = 1.1 1+1R1 = 1.08 (1+E(2r1)) 1.12 E(2r1) = .10 = {1.37% 1 + 1R5 = {(1 + 1R4)(1+E(5r1))}1/5 1.026 (1+E(5r1)) (1.0298) 5 = 1.4049/(1.026(1+E(5r1))}1/5 (1.0325 = {1.10}1/3 1.0298 = 1+E(6r1) 1+E(6r1) = 1.0325) 6/1.08374255 E(4r1) = 8.12 25.08(1+E(2r1))}1/2 1.0298 (1+E(6r1)) (1.08*1.0325) 6 = 1.

0565)(1 + . It based on the idea that investors will hold long-term maturities only if they are offered at a premium to compensate for future uncertainty in a security=s value.10+L2 1. 1R1 = 5.0005)] 1/3 .27. Specifically. which increases with an asset=s maturity.10 + L2) 1.10*(1+.465% 6. thus. the yield curve will nevertheless be upward sloping.0685 + .0675 + . The liquidity premium theory states that long-term rates are equal to geometric averages of current and expected short-term rates (as under the unbiased expectations theory).666% 6.2996/1. according to the liquidity premium theory. i. (1+1R2) = {(1+1R1)(1+E(2r1) + L2)}1/2 1. investors must be offered a liquidity premium to get them to but longer term securities.08145 15 .223% 1R2 = [(1 + .0005)(1 + . an upward-sloping yield curve may reflect investors= expectations that future short-term rates will be flat.0675 + .0010)] 1/4 -1= 1R4 = [(1 + .1 = 1+.2996 = 1. in a world of uncertainty.0565)(1 + .1 = 6.223% 5. plus liquidity risk premiums that increase with the maturity of the security. For example.e.0005)(1 + .0012)] 6.10*(1+.10 + L2)}1/2 1.18145 = 1+.0715 + .10+L2 L2 = . The liquidity premium hypothesis is an extension of the unbiased expectations hypothesis.0685 + .666% yield to maturity 6.0675 + . but because liquidity premiums increase with maturity.0010)(1 + . investors prefer to hold shorter term securities because they can be converted into cash with little risk of a loss of capital.14 = {1.1 = 6. short-term securities are more liquid. 28..465% 1R3 = [(1 + .65% _____________________________ term to maturity (in years) 0 1 2 3 4 29.0565)(1 + .65% 1/2 .

R1 = 4.045)(1 + .0751)(1 + E(3r1))]1/3 .0601)(1 + E(r3))]1/3 .055)(1 + E(2r1))]1/2 .04% 1 1 16 .055)] .065 = [(1 + .065)2 /(1.09 = [(1 + .1 = 7.1 Ψ [(1.25% = [(1 + .30.055)(1 + .0665)5] .1 = E(2r1) = 7.06)3] .1 = [(1 + .0635)4] .1 = [(1 + .01% 1R2 = 5.1 = 7.0751)] .1 = [(1 + .055)(1.18% 1 31.41% f1 = [(1 + 1R5)5/(1 + 1R6)4] .09)3 /(1.045)(1 + E(r2))] R3 = 6.1 = 7.0665)5/(1 + .1 Ψ E(r2) = 6.1 Ψ E(r3) = 9.25% 4 1 32.0675)6/(1 + .51% R3 = .86% 5 6f1 = [(1 + 1R6)6/(1 + 1R5)5] .1 = E(3r1) = 14.1 Ψ [(1. f = [(1 + 1R4)4/(1 + 1R3)3] .0635)4/(1 + . 1R2 = .50% = [(1 + .5% 1/2 .

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