E120

Homework 5 Solutions
1. Suppose the face value of this bond is F V (you get this much in year 30), then the
FV
bond (zero-coupon) is priced at 1.06
30 now.
(a) Since the YTM is 6% when you sell it 5 years from now, this bond is worth
 1 1/5
25
1 = 6%
at that time. The internal rate of return is (1+6%)
1

FV
(1.06)25

(1+6%)30

FV
(1.07)25

in five years.
 1 1/5
25
1 = 1.138%
The internal rate of return is (1+7%)
1

(b) The bond is worth

(1+6%)30

(c) The bond is worth

FV
.
(1.05)25


The internal rate of return is

1
(1+5%)25
1
(1+6%)30

1/5
1 = 11.14%.

(d) No. We are also subjected to interest risk. If investors expect interest rate to rise,
our bond value may fall. If investors expect interest rate to fall, our bond value
may rise.
2. The cash flow is (250, 20, 20, ..., 20, 5, 5, ...). There are 20 positive $20M gains
and infinite $5M costs after that. Therefore the PV of this cash flow is
P V = 250 +

20
X
i=1

5
20(1 1/(1 + r)20 )

r
r(1 + r)20

pv

300

200

100

= 250 +

X
5
20

i
(1 + r)
(1 + r)i
i=21

0.0

0.2

0.4

0.6

0.8

Therefore there is no positive IRR for this investment.

1.0

3.
50, 000 = 550 8

1 1/(1 + rm )1 2
rm

which gives you rm = 0.8484%. Therefore the IRR is 0.8484% per month.
And the monthly rate from the 15% EAR is
0
rm
= (1 + 15%)1/12 1 = 1.17%

Hence we turn down the offer since the IRR is less according to the IRR rule. the PV
is
0 1
1 1/(1 + rm
)2
P V = 50000 550 8
0
rm

= 1010
Therefore the professor should take this offer since the present value is positive. And
this decision is more reasonable since this is indeed a loan type of cash flow. People
prefer low interest rate when taking loans.
4. First, observe that the price of the bond P , the coupon rate c, the face value F V , the
yield to maturity y, and the time to maturity n are linked thus:
P =
=
P
FV

cF V
1+y
cF V
y

cF V
cF V
+ (1+y)
2 + . . . + (1+y)n +


1
FV
1 (1+y)
+ (1+y)
n
n

FV
(1+y)n

so that
both sides by F V, we obtain:
 by dividing

1
1
= yc 1 (1+y)
+ 1 (1+y)
n
n

Observe that the left hand side, P/F V 

, is an average
 of the terms on the right hand
1
1
side: c/y and 1 (where the weights are 1 (1+y)
and (1+y)
n
n ).
(a) if c > y, then the RHS is a weighted average of something larger than 1, and 1
itself. Hence the RHS is strictly larger than 1. This implies P/F V > 1, so that
P > FV .
(b) if P > F V , then the LHS is larger than 1, so that the weighted average on the
RHS is also larger than 1, which means c/y > 1. This implies c > y.
5. (a) False.
We have the effective monthly rate rm must satisfy (1+rm )12 = (1+ 12%
)2 . Solving
2
for rm shows that it is not equal to 1%.

(b) True.
Note that for Y T M 15%, we have (1+ Y50T M )i (1+Y200
, so that each term in
T M )i
2
the cash flow for bond A has present value less than each corresponding term in
bond B. So that the PV remains smaller.
(c) False.
Note that the coupon rate is 10% > 8%, which is the yield to maturity, hence the
bond is a premium bond, i.e. its price must be larger than its face value. But the
problem stated the price is one half of the face value, this is impossible!!
Or you can try solving for n in the equation:
1
FV
2

0.1F V
1.08

+ ... +

0.1F V
1.08n

FV
.
1.08n

Cancel F V on both sides, and solve for n, you should get n equals to some negative
value, contradicting the statement.
(d) True, assuming interest rate r 0 (technically, the math below shows it will hold
true for r > 2).
(0, 2, 2, 2, 2, . . .) (0, 1, 3, 1, 3, . . .) (0, 0, 0, 0, . . .) (0, 1, 1, 1, 1, . . .)
1
1
1
1
+ (1+r)
0 1+r
2 + (1+r)3 + (1+r)4 + . . .
1
0 2+r
where the last if and only if uses the fact x + x2 + x3 + . . . =

x
,
1x

and x =

1
.
1+r

(e) True.
Use the fact that

P
i=1

ixi =

x
,
(1x)2

with x =

1
,
1+0.1

we obtain the present value

of the cash flow (from our perspective) to be 0.249433, so that we should not
accept sisters proposal.
P
1
xi = 1x
. Take derivative on both
Remark When 1 < x < 1, we have
i=0
P
P

x
1
i
i1
ix
=
sides, we get (1x)
ix
.
Therefore
=
for any 1 < x < 1.
2
i=1
i=1
(1x)2
There is another more tricky way to solve it even without calculus. Ill give that
solution next discussion.