University of the Philippines

SCHOOL OF ECONOMICS

Economics 121
Money and Banking

PROBLEM SET 1*

1. Suppose that you take out a Php2,000,000, 20-year mortgage loan to buy a condo. The interest rate
on the loan is 6%, and payments are made at the end of each year. What is your annual payment on
the loan?

This is a fixed payment loan (i.e., an annuity).

Given: loan value = 2,000,000, interest rate = 6%, number of years until maturity = 20.
𝐶 𝐶 𝐶 𝐶 1
𝐿𝑉 = + 2
+ ⋯+ 20
= [1 − ]
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖) 𝑖 (1 + 𝑖)20

𝑖 ∗ 𝐿𝑉 . 06 ∗ 2,000,000
𝐶= = = 174,369.114
1 1
[1 − ] [1 − ]
(1 + 𝑖)20 (1 + .06)20

Annual payment is approximately Php174,369 annually.

2. You have just read an advertisement stating, “Pay us $100 a year for 10 years and we will pay you
$100 a year thereafter in perpetuity.” If this is a fair deal, what is the rate of interest?

“Pay us $100 a year for 10 years…” like the fixed payment!

Present value (i.e., at t = 0) is:
100 100 100 100 1
𝑃𝑉1 = + 2
+ ⋯+ 20
= [1 − ]
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖) 𝑖 (1 + 𝑖)10
“(We) will pay you $100 a year thereafter in perpetuity.” perpetuity
100
At t = 10, value of this perpetuity is 𝑖
.
Its present value at t = 0 is:
100
𝑃𝑉2 = 𝑖 fixed payment vs. perpetuity
(1 + 𝑖)10
If the deal is fair, the two cash flows should be equal in value 𝑃𝑉1 = 𝑃𝑉2.
100
100 1 𝑖
[1 − 10 ]=
𝑖 (1 + 𝑖) (1 + 𝑖)10

Reducing, this becomes:

1 1
[1 − ]=
(1 + 𝑖)10 (1 + 𝑖)10

[(1 + 𝑖)10 − 1] = 1
 𝑖 = 7.177%
The rate of interest in a fair deal would be around 7.2%.

3. The following statements are true. Explain why.

a. If a bond’s coupon rate is higher than its yield to maturity, then the bond will sell for more than
face value.

Yield to maturity, y, is another term for the market rate of interest.

Recall from class that the price of a bond is:
𝐶 1 𝐹 𝑟∗𝐹 1 𝐹
𝑃𝑏𝑜𝑛𝑑 = [1 − 𝑇 ]+ 𝑇
= [1 − 𝑇 ]+
𝑦 (1 + 𝑦) (1 + 𝑦) 𝑦 (1 + 𝑦) (1 + 𝑦)𝑇
where C is the bond’s coupon payment, r is the bond’s coupon rate, F is the bond’s face value, y
is the yield to maturity, and T is the number of years until maturity.

This can be rewritten as:

r/y is the ratio between the coupon rate
r is coupon rate 𝑃𝑏𝑜𝑛𝑑 𝑟 1 1
= [1 − ] + and yield to maturity
t is n years til maturity 𝐹 𝑦 (1 + 𝑦)𝑇 (1 + 𝑦)𝑇
y is interest rate/yield to maturity We isolate r/y because we want
𝑃𝑏𝑜𝑛𝑑 1
coupon payment is = 𝑟 𝐹 − (1 + 𝑦)𝑇 to know if r/y>1
= (if coupon rate is higher than
face value*coupon rate 𝑦 1 yield to maturity, then the bond will sell for
[1 − ]
(R*F) (1 + 𝑦)𝑇 more than its face value)

𝑟
If a bond’s coupon rate is higher than its yield to maturity, then > 1 and
𝑦

𝑃𝑏𝑜𝑛𝑑 1 and for r/y to be >1, the Pbond/F >1

𝐹 − (1 + 𝑦)𝑇 and Pbond >F
>1
1
[1 − ]
(1 + 𝑦)𝑇

𝑃𝑏𝑜𝑛𝑑
meaning, 𝐹
>1, and 𝑃𝑏𝑜𝑛𝑑 > 𝐹. The bond will sell at higher than face value (i.e., at a
premium).

b. If a bond’s coupon rate is lower than its yield to maturity, then the bond’s price will increase
over the remaining maturity.
This is just the opposite case. Analogous solution. The > sign in the final equation becomes a <
sign.
𝑟 𝑃𝑏𝑜𝑛𝑑
Meaning, if a bond’s coupon rate is lower than its yield to maturity, then 𝑦
< 1, 𝐹
<1, and
𝑃𝑏𝑜𝑛𝑑 < 𝐹. The bond will sell at lower than face value (i.e., at a discount).

4. A 10-year government bond has a face value of $1000 and a coupon rate of 5% paid annually. Assume
that the interest rate is 6% per year. What would be the present value of the bond?
 𝑟∗𝐹 1 𝐹 . 05 ∗ 1000 1 1000
𝑃𝑏𝑜𝑛𝑑 = [1 − 𝑇 ]+ 𝑇
= [1 − 10 ]+
𝑦 (1 + 𝑦) (1 + 𝑦) . 06 (1 + .06) (1 + .06)10

= 368.004 + 558.395 = 926.399

The present value (price) of the bond is about $926.4.

5. The 2-year interest rate is 10% and the expected annual inflation rate is 5%
a. What is the expected real interest rate?
Recall that (1 + 𝑖) = (1 + 𝑟)(1 + 𝜋)
Where r is the real interest rate and 𝜋 is inflation. Solving for r, the real interest rate is:
(𝑖 − 𝜋)
𝑟= real interest rate= real i / nominal i
(1 + 𝜋) r = real i / nominal i
Expected r is:
(𝑖 − 𝜋 𝑒 )
𝑟𝑒 =
(1 + 𝜋 𝑒 )
The 2-year interest rate is 10%, meaning
(1 + 𝑖)2 = 1 + .10
Therefore the annual nominal interest rate is,
𝑖 = 4.88%

Can now solve for expected real interest rate:

(.0488 − .050)
𝑟𝑒 = = −.114%
(1 + .050)
Using the shorthand equation:
𝑟 𝑒 ≈ (𝑖 − 𝜋 𝑒 ) = (. 0488 − .050) = −.120
b. If the expected rate of inflation suddenly rises to 7%, what does Fisher’s theory say about how
the real interest rate will change? What about the nominal rate?

Fisher’s theory says a change in expected inflation causes the same proportionate change in the
nominal interest rate (i.e., no effect on the required real interest rate.)
According to this theory, a rise in expected inflation from 5% to 7%, would have no impact on the
real interest rate. However, the nominal rate would change (recalling that, 𝑖1 = 4.88%):
𝑖2 = (1 + 𝑟)(1 + 𝜋2𝑒 ) − 1 = (1 − .00114)(1 + .07) − 1 = 6.878%
Using the shorthand:
𝑖2 ≈ 𝑟 + 𝜋2𝑒 = −0.00114 + .07 = 6.886%
Note that expected inflation rose by 2 percentage points from 5% to 7%, leading to a similar 2 ppt
increase in the nominal interest rate (from 4.9% to around 6.9%).

*Based on Brealey, Myers and Allen, 11th ed.