ECO393 [LECTURE 2: HOME ASSIGNMENT]

Lecture Two Content Outline: Understanding Interest Rate

Objective:

 Discuss how the yield to maturity is measured.

 Demonstrate a bond’s interest rate does not necessarily indicate how good an investment the
bond.
 Explore the distinction between real interest rates and nominal interest rates.
Readings:

- Chapter 4 – Understanding Interest Rate, Mishkin Frederic, S. (2004). The economics of

money, banking, and financial markets. Mishkin Frederic–Addison Wesley Longman.

Contents:

 Measuring interest rates

 The distinction between interest rates and returns
 The distinction between real and nominal interest rates

Homework:

Question 1: Your favorite uncle advises you to purchase long-term bonds because their
interest rate is 10%. Should you follow his advice?

Answer: It depends on where you think interest rates are headed in the future. If you think

interest rates will be going up, you should not follow your uncleʹs advice because you would

then have to discount your bond if you needed to sell it before the maturity date. Long-

term bonds have a greater interest-rate risk.

Question 2: Would it make sense to buy a house when mortgage rates are 14% and
expected inflation is 15%? Explain your answer.

Answer: Even though the nominal rate for the mortgage appears high, the real cost of

borrowing the funds is -1%. Yes, under this circumstance it would be reasonable to make

this purchase.

Question 3: If the interest rate is 10%, what is the present value of a security that pays you
$1,100 next year, $1,210 the year after, and $1,331 the year after that?

Answer: $1,100/(1 + 0.10) + $1,210/(1 + 0.10)2 + $1,331/(1 + 0.10)3 = $3,000.

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 ECO393 [LECTURE 2: HOME ASSIGNMENT]

Question 4: (Please submit the answer for this question) Write down the formula that is used
to calculate the yield to maturity on a 20-year 10% coupon bond with $1,000 face value
that sells for $2,000.

Answer: $2,000 = $100/(1 + i) + $100/(1 + i)2 + . . . + $100/(1 + i)20 + $1,000/(1 + i)20

Question 5: (Please submit the answer for this question) What is the yield to maturity on a
$1,000-face-value discount bond maturing in one year that sells for $800? What is the yield
to maturity on a simple loan for $1 million that requires a repayment of $2 million in five
years’ time?

Answer:

 If the one-year bond did not have a coupon payment, its yield to maturity would be

($1,000 - $800)/$800 = $200/$800 = 0.25 = 25%

 The present value of the $2 million payment five years from now is $2/(1 + i)5 million,

which equals the $1 million loan. Thus 1 = 2/(1 + i)5. Solving for i, (1 + i)5 = 2, so that

i = 0.149 = 14.9%.

Question 6: (Please submit the answer for this question) If mortgage rates rise from 5% to
10% but the expected rate of increase in housing prices rises from 2% to 9%, are people
more or less likely to buy houses?

Answer: People are more likely to buy houses because the real interest rate when purchasing a house

has fallen from 3% (5-2%) to 1% (10-9%) and is thus lower, even though nominal mortgage rates

have risen.

Question 7: (Please submit the answer for this question) Francine the Financial Adviser has
just given you the following advice: “Long-term bonds are a great investment because their
interest rate is over 20%.” Is Francine necessarily right?

Answer: No. If interest rates rise sharply in the future, long-term bonds may suffer such a sharp fall

in price that their return might be quite low; possibly even negative.

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