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CHAPTER 6

SOLUTIONS TO PROBLEMS: P6-3, 6-5, 6-7, 6-9, 6-15, 6-17, 6-22, 6-25, 6-26

P6-3 Personal finance: Real and nominal rates of interest (LG 1; Intermediate)
a. Jonathan can buy £1,000  £20 = 50 yarns today.
b. Compound value = £1,000  (1 + 0.06) = £1,060
c. Expected cost of yarn after a year = £20  (1 + 0.03) = £20.60
d. Number of yarns Jonathan can buy after a year from proceeds =
£1,060  £20.60 = 51.46 yarns
e. Jonathan’s real rate of return can be calculated as:
(1 + 0.06) = (1.0.03)  (1 + r*)
r* = (1.06 1.03) – 1 = 0.0291 or 2.91%
The real rate of return, 2.91%, indicates that the actual increase in the number of units Jonathan
can buy after a one-year period if he invests in T-bonds, will be 6%. This is due to the fact that
the portion of the return that is equal to inflation (3%) is required only to maintain the ability to
buy the same number of units after a year.

P6-5 Nominal interest rates and yield curves (LG 1; Challenge)

a. Real rate of return can be calculated using (1 + r) = (1 + r*) × (1 + i):
Nominal Rate of Real Rate of
Maturity Return at 3%
Return
Inflation
3 months 6% 2.91%
2 years 7.50% 4.37%
5 years 8% 4.85%
10 years 10% 6.80%
20 years 12% 8.74%

b. Real rate of return if nominal rates drop by 1%:

Nominal Rate Real Rate of

Maturity
of Return New Nominal Return at
Rate 3% Inflation
3 months 6% 5.00% 1.94%
2 years 7.50% 6.50% 3.40%
5 years 8% 7.00% 3.88%
10 years 10% 9.00% 5.83%
20 years 12% 11.00% 7.77%

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c.
Yield Curve
15%

10%

5%

0%
3 Months 2 Years 5 Years 10 Years 20 Years

The given yield curve suggests that the interest rates will go up in future as per the expectations
theory.

d. The liquidity preference theory suggest that investors prefer to part with their liquidity for as
short a time as possible, and therefore seek additional return if they have to part with their
liquidity for a longer time. In the given yield curve, the interest for longer duration bonds is
higher, in line with this explanation.
e. The market segmentation theory suggests that the interest rate for a given maturity period
depends on the demand for borrowing and supply of investment for that period. Based on the
yield curve, it can be concluded that there is a relatively higher demand for investment than the
available investment for longer periods, driving up the interest rates for longer-maturity periods.

P6-7 Term structure of interest rates (LG 1; Intermediate)

a.

b. and c.
Five years ago, the yield curve was slightly upward sloping, suggesting (under the expectations
theory) investors expected future short-term interest rates to be only slightly higher than current
short-term rates. Two years ago, the yield curve had a sharp downward slope, suggesting
investors expected a dramatic decline in short-term interest rates (perhaps due to a coming
recession). Today, the yield curve is upward sloping, suggesting investors expect short-term rates
to rise.

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d. Consider two 10-year investment options five years ago: (i) a 10-year bond offering 9.5% or (ii) a
5-year bond offering 9.3% and another 5-year bond in 5 years. Under the expectations theory of
the term structure, the options should offer the same return. Assuming the options offered the
same return and denoting expected return on a 5-year bond 5 years ago E(r):
(1.095)10 = (1.093)5 1+E(r))5 → (1.095)10 (1.093)5 = (1+E(r))5
E(r) = √1.58869 – 1 = 0.097 = 9.7%
Alternatively, return on 5-year bond in five years = [(10 9.5%) – (5 9.3%)] 5 = 9.7%.

P6-9 Risk premiums (LG 1; Intermediate)

a. Nominal return = real rate + inflation rate
Real rate = 4% – 2% = 2%

b. Nominal return = real rate + inflation rate + risk premium

A: 2% + 6% + 4% = 12%
B: 2% + 5.5% + 5% = 12.5%
C: 2% + 5% + 2% = 9%
D: 2% + 4.8% + 3% = 9.8%
E: 2% + 6% + 6% = 14%

c. It is because the security has a different maturity. The expected inflation is an average inflation
over the period until its maturity.

P6-15 Basic bond valuation (LG 5; Intermediate)

a. The value of the bond will be determined by two cash flows: an annuity of coupon payments;
and the one-off cash payment worth its face value at maturity.

C 1 M
B0 = 1- +
r 1+r n (1 + r)n

8 1 100
B0 = 1- +
.04 1+.04 12
(1 + .04)12

PV = €75.0806 + 62.4597 = €137.54

b. One of the possible reasons may be that the Motorway Development Corporation (MDC) has
issued this bond with a lower credit rating but then has improved its credit rating over the
period. Or there may be a change in the demand and supply for investment in the market,
resulting in this bond being sold at a premium.
c. If the applicable discount rate goes up to 10%, the PV will change as:

8 1 100
B0 = 1- +
.10 1+.10 12
(1 + .10)12

PV = €54.5095 + 31.8631 = €86.37

The bond is now valued sub-par at €86.37 (or being sold at a discount) as the applicable
discount rate is higher than the coupon rate being offered by the bond.

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P6-17 Bond value and changing required returns (LG 5; Intermediate)

C 1 M
B0 = 1- +
r 1+r n (1 + r)n

a. Original price

80 1 1,000
Price = 1‐ + $1,000.00
0.08 1+0.08 10
(1 + 0.08)10

40 1 1,000
Price 1‐ 10
$731.5967
0.08 1+0.08 1 0.08

New price
80 1 1,000
Price 1‐ 10
$877.1087
0.10 1+0.10 1 0.10

40 1 1,000
Price 1‐ 10
$631.3260
0.10 1+0.10 1 0.10

% change =( New price- Old price)  Old price

The percentage change in Bond X = -12.29%
The percentage change in Bond Y = -13.71%

b. New price
80 1 1,000
Price 1‐ 10
$1,147.2017
0.06 1+0.06 1 0.06

40 1 1,000
Price 1‐ 10
$852.7983
0.06 1+0.06 1 0.06

The percentage change in Bond X = -14.72%

The percentage change in Bond Y = -16.57%
c. Bond Y is riskier than bond X. It is because bond Y has fewer coupons, it has more interest rate
risk.

P6-22 Yield to maturity (LG 6; Intermediate)

a. Using the approximation formula where YTM = rd:
$1,000 -B0
I+
rd = n
B0 +$1,000
2

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A B C D E
M 400 300 1000 100 2000
Coupon 9% 10% 10% 10% 6%
i 36 30 100 10 120
B0 375 300 1200 120 1800
n 10 18 14 12 4
Numerator 38.50 30 85.71 8.33 170
Denominator 387.5 300 1100 110 1900
rd 9.94% 10% 7.79% 7.58% 8.95%

b. If YTM exceeds coupon rate, the bond sells at a discount, and if the coupon rate exceeds YTM,
the bond sells at a premium. When YTM equals the coupon rate, the bond sells at par value.

P6-25 Bond valuation—Semiannual interest (LG 6; Challenge)

C 1 M
B0 = 1- +
r 1+r n (1 + r)n

Semiannual
Par Annual Annual Semiannual
Years to Periods Coupon Bond
Bond Value Coupon Required Required
Maturity (n) Payment Value
(M) Rate return Return (r)
(C)
A 12 24 $1,000 10% 50 8% 4% $1,152.47
B 20 40 $1,000 12% 60 12% 6% $1,000.00
C 5 10 $500 12% 30 14% 7% $464.88
D 10 20 $1,000 14% 70 10% 5% $1,249.24
E 4 8 $100 6% 3 14% 7% $76.11

P6-26 Bond valuation—quarterly interest (LG 6; Challenge)

FV = 1,000, n = 8 × 4 = 32, i = 10% 4 = 2.5% PMT = (1,000 × 12%) 4 = $30
Using the equation for annuity, and present value of a single cash flow:

C 1 M
B0 = 1- +
r 1+r n (1 + r)n

30 1
1 1,000 1 0.025
0.025 1 0.025

655.48 453.77 $ 1,109.25

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