FIN 312 01W
Assignment #1 (Chapters 3 and 4) – 10 problems:
Questions (p62): 2
2. If there is a decline in interest rates, which would you rather be holding, long term bonds or short-term bonds? Why? Which type of bond has greater interest rate risk?
Longterm bonds because their price would increase more than the price of the shortterm bonds, ultimately producing a better return on investment while rates are declining. However, the long term bond increases your interest rate risk because as history has shown, markets can fluctuate wildly, an increase in rates would certainly hurt the long term bond holders more.
Quant Problems (p62) 2, 3, 4, 9
2. A lottery claims its grand prize is $10 million, payable over 20 years at $500,000 per year. If the first payment is made immediately, what is this grand prize really worth? Use an interest rate of 6%.
Solution: A lottery payment functions like an annuity, it can be paid over time or taken all at once, lottery winnings can be sold to investors for winners that decide to convert their payments in to a lump sum. This ends up being a present value problem like discussed on page 37.
Using my new financial calculator App I entered the following: N =20; PMT =500,000; FV =0; I =6%; Compute PV =$6,079,058.25
To break it down not using a calculator take 500,000 /.06, + 500,000 immediate payout, = 1 payment + .06 x 19 = 500,000 + 8,333,333.33 – 2,754,275.09 = $6,079,058.25
It isn’t ten million, but I’ll take it!!
3. Consider a bond with a 7% annual coupon and a face value of $1,000. Complete the following table:
On page 39 and 40 we are given an example of a bond with a coupon rate of 10%. It pays you 100 per year for ten years and the final payment will be 1100 when it pays back its face value. Using this same formula the bond in this problem will pay 70 per year, and then we figure out the years to maturity vs the yield to maturity to establish current pricing.
In example 3.4 on page 43 to solve this problem I used the Coupon Bond Formula and plugged it in to my ipad Mini app that I purchased while I was listening to your lecture. It was 14.99 but well worth it!! N= years to maturity, FV = face value of the bond, I= annual interest rate, and PMT = yearly coupon payment. Then CPT PV and you have your current price.
Years to Maturity Yield to Maturity Face Value.
3 5 1054.46 3 7 1000.00
What relationship do you observe between maturity and discount rate and current price? It seems that these things have an inverse relationship like you mentioned in your lecture. If YTM is below the coupon rate, the price is more than the face value, and vice versa. Also when the YTM is the same as the coupon, it is worth exactly the face value, regardless of maturity. Interesting information!
4. 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?
While this answer should technically be yes, I am not sure that this would actually be the case. I worked in Consumer Finance for 10 years, 5 of which were spent in direct mortgage lending. For 5 years after that I was an onsite sales consultant for DR Horton homes. I got laid off after Bear Sterns collapsed and the economy tanked and with the credit markets frozen, you had to have over 700 scores and a chunk of money down to obtain financing. The no proof of income/asset loans were gone forever, and subprime was impossible to get financed. It was at this point I decided to go back to school and finish my degree, and now at 42 years old I am about to become the first Overstreet to graduate college!! I was the one thaty told you I may go get a masters in finance and go in to banking. With all of this real world experience in mind, it...
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