CHAPTER 7

1.

Assume that the one-period spot interest rate is 3 percent and the twoperiod spot interest rate is 6 percent. Answer the following questions:
(a) What is the present value of $100 received one year from now?
(b) What is the present value of $100 received two years from now?
(c) You are going to receive $100 two years from now. What is its time
1 value? What is the forward interest rate?
(d) Suppose you invest $1 today at the two-period spot interest rate;
what is its value at time 2? Alternatively you invest $1 at the oneperiod spot rate and reinvest at the forward interest rate; what is the
value at time 2? How do these two investments compare?
R0,1 = 3%
PV =

100
= $97.09
1.03

PV =

100
= $89.00
2
(1.06 )

a.

b.

R0,2 = 6%

c. (1 + R0,2)2 = (1 + R0,1)(1 + f0,2)

(1 + 0.06)2 = (1.03)(1 + f0,2)
f0,2 = 9.087%

Time 1 value =

100
= $91.67
1.0909

d. 1(1 + R0,2)2 = 1(1+ 0.06)2 = $1.12

1(1 + R0,1)(1 + f0,2) = 1(1.03)(1.0909) = $1.12
2.

Treasury strips with $100 par values have the following prices: oneperiod, $90; two-period, $80. Answer the following questions:

(a) What are the one-period and two-period spot interest rates?
(b) What is the forward interest rate?
(c) If you invest $1 in one-period strips, what is the value after one
period?
(d) If you invest $1 in two-period strips, what is the value after two
periods?
(e) If you invest $1 at time 1 at the forward interest rate implied by the
strips, what is the value of this dollar at time 2?
90 =

100
1 + R 0,1

80 =

100
(1 + R 0,2 )2

a.

R 0,1 = 11.11%

R 0,2 = 11.80%

b. (1 + R0,2)2 = (1 + R0,1)(1 + f0,2)

(1.1180)2 = (1.1111)(1 + f0,2)
f0,2 = 12.50%
c. 1(1.1111) = $1.11
d. 1(1.1180)2 = $1.25
e. 1(1.1250) = $1.1250
3.

Treasury strips with $100 par values have the following prices: oneperiod, $94; two-period, $87. You are going to receive an annuity of
$100 for the next two periods. What is the present value of this
annuity? What is the time 1 value of this annuity? What is the time 2
value of this annuity?
PVA = (100)(0.94) + (100)(.87) = $181.00

Time 1:

181
= $192.55 = (181)(1 + R 0,1)
0.94

Time 2:
4.

181
= $208.05 = (181)(1 + R 0,2 )2
0.87

An annuity of $100 per period for two periods has a present value of
$178.33. If the term structure of interest rates is flat, compute the
interest rate.
178.33 =

100
100
+
1 + R (1 + R )2

R = 8%

In financial calculator:
N = 2; PV = -178.33; PMT = 100; FV = 0; I/YR = ?
I/YR = 8%

5.

Suppose the term structure in problem 1 applies. A two-period couponbearing bond has an annual coupon of $5.00 and par value of $100.
Answer the following questions:
(a) What is the bonds price?
(b) What is the bonds yield to maturity?
(c) Suppose you arrange (at time 0) to buy this bond in the forward
market for delivery at time 1 immediately after the coupon is paid.
What should the forward price be?
P=

a.

5
105
+
= $98.30
1.03 (1.06 )2

b. In financial calculator:
N = 2; PV = -98.30; PMT = 5; FV = 100;
I/YR = YTM
I/YR = YTM= 5.93%
c. (1.06)2 = 1.03(1 + f0,2)
F=

6.

f0,2 = 9.087%

105
105
=
= $96.25
1 + f 0,2 1.0909

As a reward for reading this book, you are given a choice between $100
received one year from now and $115 received two years from now.
How should you go about deciding which of these choices is better?
1 + f 0,2 =

115
100

f 0,2 = 15%

f0,2 > 15%

prefer $100 in one year

f0,2 = 15%

indifferent

f0,2 < 15%

prefer $115 in two years