Problem 1. Today is t=0. Consider the following bonds in which the first coupon payment (if any) will begin in t=1.
Bond.....................Coupon Rate (Annual payment).................Maturity (years)
A..............................................0%....................................................3
B..............................................7%....................................................3
a. Derive the t=0 price of each bond when the yield-to-maturity is 6%.
b. Derive the t=0 price of the bond when the yield-to-maturity is 5%.
c. Which of the bonds is most sensitive to the decline in the interest rate from 6% to 5%? Why?
Problem 2. Today is t=0. David is considering investing in a two-year zero-coupon Treasury note with a face amount of $10,000. The price is $8,900 today. David's financial adviser tells him that the rate of return on the Treasury note is relatively low compared to other investment opportunities. He offers David the alternative investment of a $10,000 two-year IBM bond with a 5% coupon rate (annual payment) and a price of $8,800 today. At the same time, a friend is opening a new business and asks David to lend him $10,000. The friend promises to pay David $6,000 at t=1 and $7,000 at t=2. Assume that David will be able to reinvest any cash received at t=1 at a reinvestment rate of 6%.
a. Calculate the future value of the three proposed investments at t=2.
b. Derive the expected rate of return of the three investments.
c. Discuss the risk of each proposed investment.
d. If David abhors risk, which investment should he undertake? Why?
Problem 3. Today is t=0. Sarah's three children have finally graduated from college and she decides to buy a new car whose price is $24,000. The car dealer offers her the following payment plan: $4,800 down payment today and a three-year car loan. The amount financed is $19,200 and the payments are $7,900 in t=1, t=2 and t=3. Sarah's rich uncle also offers to pay the full price of the car today but will require her to pay him back $5,500 in each of the next five years (t=1 through t=5). Sarah's alternative borrowing instrument is a home equity loan from her bank.
a. How should Sarah finance her car purchase if the home equity loan rate is 8%?
b. How should Sarah finance her car purchase if the home equity loan rate is 14%?
Problem 4. Today is t=0 and you are thinking of retiring. Your retirement plan will pay you either $300,000 immediately, or 4 yearly payments of $90,000 starting at t=1.
a. Which alternative would you chose if the interest rate is 5% per year?
b. Suppose your financial adviser tells you that you can invest the $300,000 cash at t=0 in an IBM zero-coupon bond with a face amount of $420,000 at t=4. Will this potential investment opportunity change your decision in (a)? Explain.