METU Department of Economics

Econ311
Instructor: Elif Akbostancı

PROBLEM SET I - Solutions

Q.1. Your saving account pays an annual interest of 4%, so how long will it take it to triple its
initial value?
n
X ( 1.04) =3 X

n . ln (1.04 )=ln(3)

n(0.0392)=1.0986

n=(1.0986)/(0.04)=28.01 28 years

Q.2. A lottery claims its grand prize is $10 million, payable over 5 years at $2,000,000 per
year. If the first payment is made immediately, what is this grand prize really worth? Use an
interest rate of 6%.
In this case:
PV = $2,000,000 + $2,000,000/(1.06) + $2,000,000/(1.06)2 + $2,000,000/(1.06)3
+ $2,000,000/(1.06)4 = $8,930,211
Q.3. Suppose you are a city planner and you are offered a building project. Project last six
years and the benefits and costs of project in each year are presented in the following table:

Years Costs (million TL) Benefits (million TL)

2018 60 0

2019 30 10

2020 15 20

2021 10 30

2022 5 40

2023 0 40

The costs are paid on the first day of the year, and the benefits are realized on the last day of
the year. Using the interest rate of 5%, determine the present value of costs and benefits.
Should you approve or reject the project.
 PV of Benefits = 0/(1 + 0.05) + 10/(1 + 0.05)2 + 20/(1 + 0.05)3 + 30/(1 + 0.05)4

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 + 40/(1 + 0.05)5 + 40/(1 + 0.05)6
[12.15+23.15+ 33.07+42+ 40]
PV of Benefits= 6 = 112.21 million TL
(1+0.05)

 PV of Costs = 60 + 30/(1 + 0.05) + 15/(1 + 0.05)2 + 10/(1 + 0.05)3 + 5/(1 + 0.05)4

[34.72+16.53+10.5+5]
PV of Costs=60+ 4 = 114.93 million TL
(1+0.05)

And the present value of the benefits is 112.21 million TL which is lower than the cost 114.93
million TL; you would reject the project.
Q.4. In order to purchase a motorcycle, you take a $10,000 loan from the bank that has an
interest rate of 8% and will be paid in 6 years, starting with the first payment one year ahead.
What will be yearly payment to the bank?
FP FP FP
LV = 1
+ 2
+ …+ n ; where LV is the amount of loan, FP is fixed yearly
(1+i) (1+i) (1+i)
payment and n is the maturity of the loan.
FP 1 FP
$10,000 = ❑
[1− 6
]  $10,000 = (0.3698)  $10,000 = FP (4.6228)
(0.08) ( 1+0.08 ) ( 0.08 )

And FP = $2163.15
Q.5. Consider a coupon bond that has a $1,000 par value and a coupon rate of 10%. The bond
is currently selling for $1,044.89 and has two years to maturity. What is the bond’s yield to
maturity?
$ 100 $ 100 $ 1000
$1,044.89 = 1
+ 2
+ 2 ; solving for the i gives a yield to maturity of 0.075 or
(1+i) (1+i) (1+i)
7.5%.
Q.6. Consider a bond with a 4% annual coupon and a face value of $1,000. Complete the
following table. What relation do you observe between years to maturity, yield to maturity
and the current price?

Years to Maturity Yield to Maturity Current Price

2 2%

2 4%

3 4%

5 2%

5 5%

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When yield to maturity is above the coupon bond rate, the bond’s current price is below its
face value. The opposite holds true when yield to maturity is below the coupon bond rate. For
a given maturity, the bond’s current price falls as yield to maturity rises. For a given maturity,
a bond’s current price rises as its maturity decreases. When yield to maturity equals the
coupon rate, a bond’s current price equals its face value regardless of years to maturity.
Q.7. Suppose that you are offered a $8,000 face value coupon bond with a coupon rate of 8%
with a maturity of 8 years and price of $8,800.
a. Write down the equation that can be solved for yield to maturity on this bond.
b. Calculate the present value of the future payments when interest rate is 5%.
c. Is the yield to maturity above or below 5%?
d. Calculate the present value when the interest rate is 8%?
e. Is the yield to maturity above or below 8%?
f. What is the yield to maturity for this bond?
a. FV = 8000
PB = 8800
c = 8%  640
n=8
640 640 640 8000
8800 = ¿ 1
+ 2
+ …+ +
(1+i) (1+i) ( 1+ i ) (1+i)8
8

640 640 640 8000 640 1

b. PV = 1
+ 2
+…+ 8
+ 8 = [1 - 8] +
(1+0.05) (1+ 0.05) ( 1+0.05 ) (1+0.05) 0.05 (1+0.05)
8000
8 = 9551
(1+0.05)

c. Yield to maturity needs to be above 5%, since the face value is lower than the price of the
bond for the market interest rate of 5 percent. The fixed payment must be discounted at a rate
higher than this rate to equate the price to present value.

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 640 1 8000
d. PV = = [1 - 8] + 8 = 8000 OR i=C/F therefore PB = F =8000
0.0 8 (1+0.08) (1+0.08)

e. Yield to maturity is below 8%, since the face value is lower than the price of the bond.

640 1 8000
f. 8800 = = [1 - 8] + 8 ; if it is solved i = 6.37%
i (1+i) (1+i)

Q.8. Calculate the after tax ex post real interest rate and after tax ex ante real interest rate for
each case.
a. Suppose the nominal interest rate is 21%, and the tax on interest income is 13%, actual
inflation rate is 16% and expected inflation rate is 20%.
b. Suppose the nominal interest rate is 6%, and the tax on interest income is 15%, actual
inflation rate is 3% and expected inflation rate is 4%.
a. After tax ex-post real rate: r = i(1-t) – π = 0.21*(1 – 0.13) – 0.16 = 0.0227 = 2.27%
After tax ex-ante real rate: r = i(1-t) – πe = 0.21*(1 – 0.13) – 0.20 = - 0.0173 = - 1.73%
b. After tax ex-post real rate: r = i(1-t) – π = 0.06*(1 – 0.15) – 0.03 = 0.021 = 2.1%
After tax ex-ante real rate: r = i(1-t) – πe = 0.06*(1 – 0.15) – 0.04 = 0.011 = 1.1%
Q.9. Suppose that there are two coupon bonds that you can invest in. The first one is a four-
year coupon bond with a coupon rate of 5% which has a face-value of 10 000 TL. The second
one is an eight-year coupon bond with a 4% coupon rate and with a face value of 12 000 TL.
Currently, the market interest rate is 7% , but suppose that next year the market interest rate
will be 6%. Calculate the rate of returns of holding each bond for one year. Which one do you
prefer?
Coupon Bond 1:
FV = 10000
i = 7%
c = 5%  C = 500
n=4

PB at time t
500
[
= 0.07 1−
1
( 1.07 ) ][
4
+
10000
]
( 1.07 ) 4
= 9322.5

500
PB at time t+1 = 0.06 1−[ 1
(1.06 )][
3
+
10000
]
(1.06 )3
= 9732.7

500 9732.7−9322.5
RET1 = + = 9.8%
9322.5 9322.5
Coupon Bond 2:

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FV = 12000
i = 7%
c = 4%  C = 480
n=8

PB at time t
480
= 0.07 1− [ 1
( 1.07 ) 8
][ ]
+
12000
( 1.07 )8
= 9850.3

480
PB at time t+1 = 0.06 1− [ 1
(1.06 )][ ]
7
+
12000
(1.06 )7
= 10660.2

480 10660.2−9850.3
RET2 = + = 13.1%
9850.3 9850.3

Bond 2 is preferred.
Q.10. Calculate the following
a. Suppose that annual interest rate is 15%, what is the monthly interest rate?
b. Suppose that annual interest rate is 15% what is the quarterly interest rate?
c. Suppose that monthly interest rate is 2% what is the annual interest rate?
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Q10 a. (1+ X )12=( 1+0.15 ) → X=1.15 12 −1=0.0117=1.17 %

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b. (1+ X )4 =( 1+0.15 ) → X=1.15 4 −1=0.0355=3.55 %

12 12
c. (1+0.02) =( 1.02 ) =1.27 →i monthly =1.27−1=0.27=27 %

DISCUSSION QUESTIONS
Elaborate the following statements.
Q.1. As interest rate rises, rate of return can turn out to be negative.
A rise in interest rate is associated with a fall in the price of bonds if the terms to maturity of
the bond are longer than the holding period, so it will result with capital loss on bonds. The
longer the maturity, the greater the change in the price associated with i-rate change
therefore the greater the capital loss. If the loss cannot be recovered by the current yield, than
the return on the bond is even negative.

Q.2. It is better for bondholders when the yield to maturity increases.

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When the yield to maturity increases, this represents a decrease in the price of the bond. If
the bondholder were to sell the bond at a lower price, the capital gains would be smaller
(capital losses larger) and therefore the bondholder would be worse off.

Q.3. Are the following statements true (T) or false (F)? Discuss.
a. Present value falls as the interest rate falls. (F)
b. Present value is higher the shorter the time until the payment. (T)

c. The yield to maturity of a coupon bond that is selling for less than its face value is less
than the coupon rate. (F)

d. The higher the coupon rate, given the maturity and the interest rate, the higher the present
value of the bond. (T)
e. When the real interest is low, there are greater incentives to lend and fewer incentives to
borrow. (F)
f. Checking account deposits are more liquid than the saving deposits but less liquid then the
currency. (T)
g. Present value is the value today of a payment that is promised to be made in the future. (T)
h. Simple loan and discount bond make payments only at maturity while fixed payment loan
and coupon bond make payments periodically until maturity. (T)
i. The yield to maturity on a coupon bond can always be calculated as long as the coupon
rate and the price of the bond are known. (F)
j. The real interest rate expresses the interest rate in terms of purchasing power rather than
the current currency. (T)