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© 2014 Pearson Canada Inc.#
If the interest rate is 5 percent, what is the present value of a security that pays you $1, 050
next year and $1,102.50 two years from now? If this security sold for $2200, is the yield to
maturity greater or less than 5 percent? Why?
Answer:
PV = $1,050/(1 + .05) + $1,10250/
PV = $2,000
If this security sold for $2200, the yield to maturity is less than 5 percent. The lower the interest
rate the higher the present value.
Diff: 3 Type: SA Page Ref: 72
Skill: Applied
Objective List: 4.1 Understand how interest rates are measured
A relative has just won a state lottery paying $20 million in installments of $1 million per
year for twenty years. Your relative states that she is $20 million richer. Is she correct? Create a
simple example for two years to illustrate your position.
Answer: The relative is incorrect. The discounted present value of the payments is less than $20
million. The example should demonstrate that the discounted value of the payment due in one
year is less than $1 million.
Diff: 3 Type: SA Page Ref: 64
Skill: Applied
Objective List: 4.1 Understand how interest rates are measured
What is a coupon bond? Describe its basic properties.
Answer: A coupon bonds pays the owner a fixed interest payment every year until the maturity
date when a specified amount called the face value is repaid. A coupon bond is identified by
three pieces of information:
a. the corporation or government agency that issues the bond,
b. the maturity date of the bond, and
c. the bond's coupon rate, the dollar amount of the yearly coupon payment expressed as a
percentage of the face value of the bond.
Diff: 2 Type: SA Page Ref: 65
Skill: Recall
Objective List: 4.1 Understand how interest rates are measured
Explain why the current bond prices and interest rates are negatively related.
Answer: There are two ways to show why current bond prices and interest rates are negatively
related:
a. From the bond price formula: we can see that as the interest rate (yield to maturity) rises, all
denominators in the bond price formula must necessarily rise. Hence, a rise in the interest rates
as measured by the yield to maturity means that the price of the bond must fall.
b. An increase in the interest rate means that all the future coupon payments and final payment
will be worth less when discounted to the present, thus, the price of the bond must fall.
Diff: 2 Type: SA Page Ref: 70
Skill: Recall
Objective List: 4.1 Understand how interest rates are measured