Warm up Problems for Discounting and Bonds

**These questions are designed to represent elementary principles, and are NOT representative of problems that you
will find on any exams.

1. You are required to pay $100,000 five years from now. You talk to your bank, and they will give you an interest rate of 3%
per annum. How much money do you need to invest today in order to meet the required future payment,

1a) if the bank compounds annually?

V
N
=$100,000 R=3% m=1 n=5

V
0
=V
N
/(1+(R/m))
(m*n)

V
0
=$100,000/((1+(.03/1))
(5*1)
)

V
0
=$86,260.88

1b) if the bank compounds monthly?

V
N
=$100,000 R=3% m=12 n=5

V
0
=V
N
/(1+(R/m))
(m*n)

V
0
=$100,000/((1+(.03/12))
(5*12)
)

V
0
=$86,086.91

1c) if the bank compounds continuously?

V
N
=$100,000 R=3% T=5

V
0
=V
N
*e
-(R*T)

V
0
=$100,000*e
-(0.03*5)

V
0
=$86,070.80


2. You have just closed on a new house. The price of the home is $250,000. If you can secure a 30-year mortgage at 9%
compounded monthly, what is your monthly payment?

A
0
=$250,000 R=9% m=12 n=30

c=A
0
*(R/m)/(1-(1+(R/m))
-(m*n)
)

c=$250,000*(.09/12)/(1-(1+(.09/12))
-(12*30)
)

c=$2011.56


3. You are offered an 8% coupon bond with a face value of $1000. The bond has three years to maturity, the coupons are paid
semiannually, and the yield to maturity is 10%. What price are you willing to pay for this bond?

F=$1000 c=$40 R=.10 m=2 n=3

V
0
=(c/(R/m))*(1-(1/((1+(R/m))
m*n
)))+F/((1+(R/m))
m*n
)

V
0
=($40/(.10/2))*(1-(1/((1+(.10/2))
2*3
)))+$1000/((1+(.10/2))
2*3
)

V
0
=$949.24
4. The current two-year spot rate in the market is 6%. You are offered a forward rate, to invest your money for one year starting
one year from today, of 6.5%. What is the current one-year spot rate in the market?

n=1 t=1 r
n+t
=6% f
n,t
=6.5%

(1+r
n
)
n
=(1+r
n+t
)
n+t
/(1+f
n,t
)
t

(1+r
1
)
1
=(1+.06)
1+1
/(1+.065)
1

(1+r
1
)=(1.06)
2
/1.065

(1+r
1
) =1.055023

r
1
=5.5023%


5. You have $100 that you can invest in the market at a rate of 15% compounded annually. How much money will you have in
15 years?

V
0
=$100 i=15% N=15

V
N
=V
0
*(1+i)
N

V
N
=$100*(1+.15)
15

V
N
=$813.71


6. If you put away $100 per month for the next 25 years. How much money will you have if your investment compounds
monthly at 12%?

C=$100 i=.12/12 n=25*12

FV=a/i*[(1+i)
n
-1]

FV=$100/.01*[(1.01)
300
-1]

FV=$187,884.70


7. If you take out a loan with an annual interest rate of 7%, what is the effective annual rate if the interest is compounded,

7a) annually?

R=.07 m=1

r=(1+(R/m))
m
-1

r=(1+(.07/1))
1
-1

r=1.07-1

r=7%

7b) semi-annually?

R=.07 m=2

r=(1+(R/m))
m
-1

r=(1+(.07/2))
2
-1

r=1.071225-1

r=7.1225%

7c) monthly?

R=.07 m=12

r=(1+(R/m))
m
-1

r=(1+(.07/12))
12
-1

r=1.0722901-1

r=7.22901%

8. Find the current market price of a STRIP that matures in 5 years and has a face value of $100. Assume the APR is 7.5% with,

8a) annual compounding.

F=100, i=R/m=7.5%/1, N=Tm=5
Annual: V
0
=100/(1.075)
^5
=$69.66

8b) quarterly compounding.

Quarterly: V
0
=100/(1+0.075/4)
20
=68.97

8c) continuous compounding.

Continuous V
0
=100e
-RT
=100exp(-0.075x5)=68.73

9. One and half years from today, you would like to buy a new car that requires a down payment of $5,000.

9a) How much do you have to save today assuming Bank A is offering a nominal interest rate of 3.2% with quarterly
compounding?

F=5000, i=R/m=3.2%/4=0.8%, N=Tm=6
V
0
=5000/(1.008)
6
=$4766.58


9b) If Bank B is advertising a special rate 3.6% with semiannual compounding. Should you switch your account to bank B?

Bank B: i =3.6%/2=1.8%, N=1.5*2=3
V
0
=5000/(1.018)
3
=$4739.44
Switch because you have to save less with Bank B to get the same amount at the end of 1.5 years.
Alternatively, you can recognize (after computing) that bank B is offering a larger effective rate (see problem 7).

10. You are buying a new home and you can only afford monthly payments of $2000. The current APR is 7.9%. How large of
a loan can you afford if the term is:

10a) 20 years?

This is just an annuity that will pay $2000 per month for the next 20 years.
The present value for 20-year term is:
Annuity =a*(1-(1+i)
-N
)/i
=2000*(1-(1+0.00658)
-240
)/0.00658
=240,897.90



10b) 30 years?

For 30 year term, the present value of the annuity is:
=275,176.82