The University of Western Australia

School of Mathematics and Statistics

STAT33644: PRACTICE EXERCISES 1 (2011)
Deterministic interest rates. 1. In parts (a) (d) assume that interest is compounded (i) annually
and (ii) continuously, and compare the results you nd.
(a) A zero-coupon bond with face value $100 is now worth $97 and it expires in four months (i.e. 1/3 of
a year). Find the annualized (risk-free) interest rate.
(b) If the annual rate is 6%, what is the fair price of a zero-coupon bond which has face value $100 and
maturity 6 months?
(c) A zero-coupon bond has face value $100, maturity 2.65 years and its fair price is $87. Find the annual
rate.
(d) Find the fair price of a zero-coupon bond with face value $1000, maturity 3.2 years, and the annual
risk-free rate is 6%.
(e) The rst prize of a lottery is $10
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which is to be payed in 20 annual instalements of $500,000. What
is the present value of the rst prize if the risk-free rate is 10%.
(f) The seller of a cash-ow C
N
wants to make a prot so the price you pay for it probably is larger than
its fair price. Another way of valuing C
N
, in addition to its PV, is by its internal rate of return (IRR)
dened as the rate, r say, giving zero PV.
(i) Determine the PVs and IRRs of the cash-ows {100, 30, 30, 30, 30, 30}, and {150, 42, 42, 42, 42, 42},
assuming for each that r = 0.05. (Regard each cash-ow as an investment with initial cost 100 and 150,
repectively, and annual payments as shown. You will have to solve a polynomial equation using either
trial solutions or a suitable package.)
(ii) Which cash-ow do you prefer? Can you think of scale-free measures of comparison?
Warning: This is a discrete-time problem, so think about how you should represent the force of interest.
Answers. (a). (i) For discrete-time compounding the growth factor for 4 months is 1 + r/3, so solve
the equation 97 = 100/(1 + r/3), giving r = 9.28%. (ii) For continuous-time compounding, solve
97 = 100e
r/3
, i.e. r = 3 log 0.97, or 9.14%. The continuously compounded rate will always be smaller
because e
r
> 1 +r if r > 0.
(b) The interest rate for 6 months is 3%. Hence the discrete compounding price of the bond is
B = 100/1.03 = 97.09. The price with continuous compounding is B = 100e
0.03
= 97.04.
(c) (i) The growth factor for 2.65 years is (1 + r)
2
(1 + 0.65 r), and hence you have to solve the
equation
87 = 100[(1 +r)
2
(1 + 0.65r)]
1
.
This is a cubic equation which can be solved by trial and error. A trial starting value r
0
can be obtained
by replacing 1 + 0.65r with (1 +r)
0.65
, giving r
0
= (100/87)
1/2.65
1 = 0.05396. This is larger than the
true value, so work down through smaller values to solve (1+r)
2
(1+0.65r) = 1.149425. The table shows
my calculations.
r (1 +r)
2
(1 + 0.65r)
0.054 1.149909
0.053 1.147007
0.0538 1.149328
0.05383 1.149416
0.05384 1.149445
Either of the last two values of r is acceptable, or averaging, we obtain r = 5.3835%. (ii) Continuous
compounding is much easier to handle for this problem: Solve 87 = 100e
2.65r
, so r = 5.255%.
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(d) (i) For discrete compounding, B = 1000[(1 + r)
3
(1 + r/5)]
1
= 829.66. (ii) For continuous com-
pounding, B = 1000e
3.20.06
= 825.31.
(e) Working in millions of dollars, the prize is 10 and annual payments start immediately, c
0
= =
c
19
=
1
2
. Hence their present value is
PV =
1
2
19

n=0
1.1
n
=
1
2
1 1.1
20
1 1.1
1
= 4.68246,
i.e., the present value is $4, 682, 460, much less than the nominal value.
(f). (i) The IRR r solves the equation c
0
=

N
n=1
c
n
(1 + r)
n
= (c/r)
_
1 (1 +r)
N
_
, where the
second equality follows if c
n
c for n = 1, . . . , N. This can be written as a polynomial equation for
a = 1 +r:
(1 c
0
/c +ac
0
/c)a
N
= 1.
Note that c
0
< 0 in this question. The equation can be solved either by using an equation solver or by
guessing and calculation.
Cash ow 1: The equation reduces to (13 10a)a
5
= 3, giving r = 15.24% and the PV = 29.8843.
Cash ow 2: The equation reduces to (13 10a)a
5
= 3, giving r = 12.38% and the PV = 31.8380.
(ii) You probably should prefer Cash ow 1. A PV can be scaled up or down according to the unit of
monetary value. A scale-free comparison could be made through PV/|c
0
|, i.e. 0.30 and 0.2125, respec-
tively. The nice feature of the IRR is that it too is a scale-free measure of return, and Cash ow 1 looks
better on both measures.
2. You have just bought a house which you and your descendents will occupy in perpetuity. The
building is in perfect condition, and remains so forever, except for the roof. The roof must be replaced
within ve years, and then every 20 years after that. The cost of each replacement is $20,000, and the
annual risk-free rate is 5% (forever). What value should you attribute to the roof at the time you buy
the house? Note: The answer cannot exceed the price of immediate replacement.]
Answer. The vital clue is that the house will be occupied in perpetuity by your descendants. The
value of the roof really is the value you should impute to the ve years of use until the current roof has
to be replaced. This is simply the dierence between PVs calculated if you immediately replace the roof
or wait ve years.
Suppose the roof will last l = 0, 1, . . . years when it will be replaced and then every 20th year thereafter.
The PV of the cash ow of expenditure (in $ 10
3
) is
PV (l) = 20

n0
(1 +r)
l20n
=
20
(1 +r)
l

1
1 (1 +r)
20
.
The value attributable now to the roof (i.e. its remaining lifetime) is
(l) := PV (0) PV (l) =
20
1 (1 +r)
20
_
1 (1 +r)
l

.
With l = 5 and r = 0.05, you obtain (5) = (20/0.6231)(1 0.7835) = 6.9482, i.e. the value of the
remaining ve years of life is $6948.20.
3. Consider Example 2.1.2 (loan repayments). (a) Recalling that N = mn, let t = 1, 2, . . . , N count
the months and R
t
be the amount owing after the repayment at time t. (i) Show that R
t+1
= R
t
A
m
where = 1 +r

and r

is the monthly lending rate, i.e. r

= r/m. (ii) Solve this dierence equation to

obtain
R
t
=
t
B A
m

t
1
1
,
2
and hence derive the lecture-note expression for the monthly repayment A
m
.
(b) The total cash repayment over the life of the loan is NA
m
, a value which usually is between 2 to 3
times larger than the amount borrowed, B. Anyone about to buy a house and who does this calculation
usually gets a shock. However this calculation should take account of the smaller present value of future
repayments due to ination. So suppose the annual rate of ination is 0 < r. Calculate the present
value PV
N
() of all the monthly repayments, and write it in the form PV
N
() = N

A
m
, where the
multiplier N

can be regarded as the eective or ination adjusted lifetime of the loan. Determine the
form of N

. (It depends on and N, only, and its obvious that N

< N if > 0.)

(c) Assume a thirty year loan of B = $10
5
(a small loan but the scale doesnt matter), constant borrowing
rate r = 9% and monthly repayments (i.e. m = 12). Compute values of N

and PV
N
() for constant
ination rates = 1, 2, . . . , 6%. Present your answers in a table.
Answer. (a). Use a conservation of money argument for (i): the amount R
t
owing at t inates through
interest to R
t
at t+1. Paying A
m
at t+1 leaves a balance R
t+1
, i.e. R
t+1
= R
t
A
m
. Clearly R
N
= 0.
(ii) To solve for R
t
multiply through by
t1
to get the simple dierence equation for Q
t
:=
t
R
t
,
Q
t+1
= Q
t

t1
A
m
, (t = 0, . . . , N 1),
and Q
0
= R
0
= B. Replace t with j in the dierence equation and then sum it:
t1

j=0
(Q
j+1
Q
j
) = A
m
t1

j=0

j1
.
The left-hand side is called a telescoping sum and its value is Q
0
Q
t
= B Q
t
. The right-hand side is
a geometric sum:
A
m

1
t1

j=0

j
= A
m

1
1
t
1
1
= A
m
1
t
1
.
Hence Q
t
= B A
m
(1
t
)/( 1), i.e.
R
t
=
t
B A
m

t
1
1
. ()
Setting R
N
= 0 yields A
m
= rB/(1 (1 +r)
N
).
1
(b) Let = /m denote the monthly ination rate. The ination adjusted present value of N monthly
payments is
PV
N
() = A
m
N

t=1
(1 +)
t
= A
m

1
_
1 (1 +)
N
_
,
and it follows that
N

=
_
1 (1 +)
N
__
.
As a check, it is clear from the sum with = 0 that N
0
= N.
(c) The monthly borrowing rate is 0.09/12 = 0.0075. The monthly repayments with N = 360 is
A
m
= $804.62. The following results can be computed:
N

(months) PV
N
() ($)
0 360.0 289,664
1 310.9 250,163
2 270.5 217,68
3 237.2 190,848
4 209.5 168,537
5 186.3 149,886
6 166.8 134,204
1
Substitution into (*) gives Rt = B(1
(Nt)
)/(1
N
) and the amount of the loan repaid by t is B Rt =
B(
(Nt)

N
)/(1
N
). This increases as t increases, but slowly when t is small.
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4. The present value PV
N
of a discrete-time cash-ow C
N
can be interpreted as dening an equivalent
cash-ow {PV
N
, 0, 0, . . . , 0}. Another way of comparing cash-ows is through their annual (or per-
period) worth dened as that value making the N-period cash-ow {0, , . . . , } equivalent to C
N
. (a)
Determine in terms of PV
N
. (b) A cash-ow C
N
= {c
0
, . . . , c
N
} determines an innite cash-ow C

dened by successively repeating (i.e. concatenating) C

N
. Show that C

can equally well be valued by

its present value or the annual worth
N
of C
N
.
Answer. (a). By denition the PV of {0, , . . . , } is PV
N
=

N
n=1
(1+r)
n
, giving = rPV
N
/
_
1 (1 +r)
N

.
This is the coupon of a bond with F = 0 which is equivalent to {PV
N
, 0, . . . , 0}, and hence equivalent
to C
N
.
(b) C

is equivalent to a perpetuity paying PV

N
every Nth year. Hence
PV (C

) = PV
N

n=0
(1 +r)
nN
=
PV
N
1 (1 +r)
N
= /r.
5. Consider a coupon bond with maturity N, coupons c and face value F. Let r denote the risk-free
interest rate (per period in the case of discrete-time interest accrual). One method for comparing the
values of dierent bonds is through the par yield r
p
of a bond. This is dened as the interest rate which
makes the present value of the bond equal to its face value.
Calculate r
p
assuming (i) discrete-time compounding, and (ii) continuous-time compounding.
Answer. If a is the per-period discount factor, then the price of a coupon bond is (from the lecture
notes)
B =
c
a 1
(1 a
N
) +Fa
N
.
The par yield is computed from the value of a which makes B = F. Substitute F for B on the left-hand
side, and subtract Fa
N
from both sides. This gives
F(1 a
N
) =
c
a 1
(1 a
N
).
Cancelling the common factor gives the solution a

1 = c/F. (i) For discrete-time compounding the

accumulation factor is a = 1 +r, so the par-yield turns out to be the coupon rate:
r
p
= a

1 =
c
F
.
(ii) The continuous-time version of the accumulation factor is a = e
r
, so a

= e
rp
, i.e., r
p
= log(1 +c/F).
[The right-hand side is approximately c/F, since this quantity is typically small. Coupons are never paid
continuously, so there is no actual continuous-time version of a coupon bond.]
6. The continuous-time instantaneous (short) interest rate varies in a secular manner, r(t) = r +
c sin(t), where |c| < r. Determine the following:
(a) The spot rate for the interval (0, t];
(b) The (future) value C(t) at t for a xed amount C invested at time zero;
(c) The long-term spot rate sr() and the long-term geometric mean of C(t). (With reference to the
discrete-time case, think of a denition of geometric mean for the continuous-time case.)
Answer. (a). The spot rate for the interval (0, t] is sr(t) = R(t)/t, where
R(t) =
_
t
0
r(u)du = rt + (c/)(1 cos t).
The average value of 1 cos t over a period is unity. So the force of interest R has a linear component
rt +c/ with a superposed (co)sinusoidal modulation.
(b) By denition, the future value of C invested at t = 0 is
C(t) = Ce
R(t)
= Ce
rt+(c/)(1cos t)
. (1)
4
(c) The long-term spot rate by denition is sr() = lim
t
sr(t) = r. (This long-term average lters
out the secular variation which always is present.)
Adapting the denition of geometric mean for the discrete-time case, you should dene the geometric
mean of C(t) as

C(t) = (C(t))
1/t
= C
1/t
e
R(t)/t
. Hence

C(t) = C
1/t
e
r+(c/t)(1cos t)
( e
r
if t 1.
7. Mr A has made a non-refundable deposit of the rst months rent (equal to $2000) on a six-month
apartment lease. Later in the day he nds a dierent apartment that he likes just as well, but its monthly
rent is $1800. He plans to rent for only six months. (a) Given an interest rate of 12%, decide whether
Mr A should switch to the second apartment.
(b) What if the monthly rent for the second apartment is $1650?
Answer. (a) There are two cash-ows:
C
1
= {2000, 2000, 2000, 2000, 2000, 2000} & C
2
= {3800, 1800, 1800, 1800, 1800, 1800}.
The monthly interest rate is 1%, so the aggregate discount factor you need to calculate the PV of C
1
is
5

n=0
1.01
n
=
1 1.01
6
1 1.01
1
= 5.8534.
Hence PV
1
= 11, 706.86. You can write C
2
= {2000, 0, . . . , 0} + {1800, . . . , 1800}, so it should be clear
that
PV
2
= 2000 + 1800 5.8534 = 12, 536.18.
So Mr A should not switch.
(b) A similar calculation with 1650 replacing 1800 gives PV
2
= 11, 658.16, so it is marginally better to
switch.
Note: The price of 1600 in the question sheet gives, with zero interest rate, PV
2
= 11, 600, and this
reduces for any positive interest rate.]
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